Prudential Regulation

Prudential regulations establish the outside limits and constraints placed on banks to ensure the safety and soundness of the banking system. They are the key elements to prevent, limit, or stop the damage caused by poor management. The establishment of an appropriate regulatory framework is essential to ensure that government supervisors can carry out and enforce their responsibilities. The absence or weakness of prudential regulation in critical areas could lead to banking failures and systemic instability.

The manner in which prudential regulations are implemented can have a profound effect on the financial marketplace, possibly leading to fragmentation of the financial markets. Care must be taken to implement a regulatory framework that is not distorted but that provides adequate protection to ensure a safe and sound financial system. For instance, it may be appropriate for all banking institutions in a country to be subject to the same banking laws and supervision in order to create a competitive market.6/ This is particularly important as a financial system develops and becomes more integrated with the international financial system. There is a need to harmonize regulation with international standards and create a level playing field so that domestic institutions can compete effectively and prosper both at home and abroad.

Broad authorities are needed to deal with troubled financial institutions, incompetent or abusive managements, insider or related company abuses, and concentrations of credit. Bank supervisors should have the ability to enact subsidiary regulations under broader powers granted by the legislative body in the country. In this way, the regulations can be easily amended to reflect changing conditions through regulatory action rather than new banking legislation.

Notwithstanding the necessity of an appropriate regulatory framework, it is important to recognize that regulation cannot preclude, nor should it attempt to preclude, every improper or ill-advised banking practice. Furthermore, it should be understood that, while economic deregulation and financial liberalization are important for a country to develop a viable and robust financial system, deregulation will remove the protections previously afforded the banking system. Increased competition, a changing price structure, new market entrants, and other factors will increase the risks banks assume. Regulation and supervision cannot prevent all bank failures. However, good regulation and supervision can serve to minimize the adverse impact of moral hazard and relative price shocks on the financial system, thus decreasing the likelihood of bank failures and financial system distress. This section reviews the principal types of regulations required to ensure the establishment of a sound financial system and the problems caused by their absence.

CRITERIA FOR ENTRY. Since newly licensed banks are particularly vulnerable to failure, the initial decision to grant a license is an important one. In making this decision, bank supervisors should have the ability to screen access to ownership and management to prevent individuals lacking professional qualifications, experience, financial backing, and sound ethical standards from obtaining a banking license either through de novo entry or acquisition of an existing institution. Unfortunately, in many developing countries, licenses are granted by agencies of the government other than those with direct supervisory responsibility. Often the granting of licenses is politically motivated and a form of patronage or is designed to serve a special interest group, for example, agriculture or housing. Where this has occurred, problems and banking insolvency have often followed.

In many countries, commercial and industrial conglomerates attempt to establish banks to ensure their access to preferential or subsidized credit. In others, special purpose banks created outside the banking laws under various government ministries have led to distortions in the financial marketplace caused by credits granted to priority sectors at heavily subsidized interest rates. To eliminate or reduce these distortions and abuses, all decisions concerning licensing and other corporate activities, such as mergers and acquisitions, should require the satisfaction of specific criteria prior to approval by the supervisory authority. For example, for de novo entry, regulations should address the minimum amount of capital, the qualifications of management, the development of a reasonable business plan and projections, and the financial strength of the proposed owners. Failure to meet the minimum criteria or to present reasonable projections should result in the denial of a banking license. The establishment of specific criteria that must be met reduces the potential for political interference in the licensing process. The ease or difficulty of complying with such criteria can be used as a means of regulating new entrants into the marketplace. To further reduce political interference or the influence of special interest groups, decisions regarding licensing should be delegated to the supervisory unit as one of its normal operating functions.

CAPITAL ADEQUACY. Capital is necessary to absorb unusual losses. In most developing countries, financial institutions are significantly undercapitalized and in many cases stated capital is negative even before portfolio and other losses are recognized. The regulatory framework often lacks meaningful minimum capital adequacy guidelines and the ability to impose restrictions on dividend payments when the bank is incurring losses. As a result, capital, as a cushion for unusual losses, is simply not sufficient for the risks that exist both on and off the balance sheet. Lacking adequate capital, the banks' potential for failure is greatly enhanced. Because banks are undercapitalized, management is often forced into hiding losses that would make insolvency apparent. Without appropriate action by bank managements, government officials, and bank supervisors, this unhealthy situation may continue until the banks face a liquidity crisis and the government is forced to act.

In some countries, government-owned banks operating with inadequate or negative capital are particularly vulnerable. Government officials and the public at large may believe that because of government ownership, there is no danger of failure. In such cases, management often lacks the discipline that would otherwise be required in managing a privately owned institution. A common result is that losses multiply at much higher rates than in privately owned banks, with the losses eventually absorbed by the fiscal budget. The ensuing distortions impact both economic development and financial intermediation.

To combat these problems, minimum capital adequacy guidelines should be established. In countries where banks' internal systems are weak, these guidelines may be more easily enforced when expressed as a simple percentage of total assets. A level not less than 5 to 8 percent should be the absolute floor. However, this percentage may need to be increased on a case-by-case basis due to a bank's particular risk profile or where substantial off-balance sheet risks exist. In countries where accounting and management information systems in banks are more sophisticated, it may be appropriate to adopt the risk-based capital adequacy guidelines formulated by the Basle Committee of Bank Supervisors. In either case, the components of what constitutes capital should be clearly defined. Dividends should not be permitted if the minimum capital percentage is not met. Given that the purpose of capital is to absorb unusual losses, the measurement of capital adequacy should be related to the areas of greatest risk, that is, assets and off-balance sheet contingencies. Therefore, a minimum capital adequacy guideline based on assets is to be preferred to one based on deposits.

ASSET DIVERSIFICATION. Banks can increase their returns or reduce their risks or generally achieve a better combination of risk and return by diversifying their operations. Restrictions on geographical expansion or on product diversification often increase the exposure of banks to particular risks. From the prudential point of view, such restrictions should not be condoned. However, lending limits, investment limits, and other exposure limits, which prevent the concentration of risk in a single borrower or a related group of borrowers, are necessary for prudential purposes. Such limits are normally expressed as a percentage of a bank's capital. In high income countries, credit to any one borrower cannot normally exceed 15 or 20 percent of capital. In some developing countries, lending limits do not exist. In others, the limits are established at imprudent levels, in some cases exceeding 100 percent of a bank's capital. In such instances, just one large problem borrower can render the bank insolvent if the borrower's loans become uncollectible. Fearing this eventuality, bank management loses control of the credit relationship to the borrower and may become involved in deception to avoid recognizing a problem situation.

While many developing countries have adopted lending limits, these limits are often circumvented by borrowers who borrow through nominees. Therefore, banking regulations should specify rules for combining loans to the ultimate user of credit. These rules would combine loans extended to a group of related borrowers, to borrowers exhibiting a common source of repayment, or in which the proceeds of loans can be shown to have been used by or for the benefit of one party.

A lending limit of 15 percent of the bank's capital is generally considered reasonable. In no event should the maximum lending limit exceed 25 percent of a bank's capital. To accommodate large borrowers, a mechanism should be in place to syndicate or sell participations in the credit. In such cases, the purchasing bank should conduct its own credit evaluation and must assume the full credit risk for its share. Lending limits should normally apply equally to both unsecured and secured credit, except where readily marketable collateral is obtained and properly pledged. Examples of such collateral include government securities and bank certificates of deposit.

Many argue that lending limits impose an unwarranted constraint on banks in capital-short economies or on indigenous banks in systems where foreign-owned banks are dominant. Notwithstanding these concerns, the failure to abide by reasonable prudential limits frequently results in banking insolvency and systemic distress. The costs of bank failures invariably outweigh the short-term constraints imposed by lending limits. By imposing a reasonable lending limit, bank supervisors will be sending a strong message that banks must have sufficient capital to attain a scale of operations that will permit them to compete effectively and serve their large customers.

LOANS TO INSIDERS AND CONNECTED PARTIES. A frequent cause of loan problems is credit granted to bank insiders and to individuals or firms connected through ownership or with the ability to exert control, whether direct or indirect. Examples of connected parties include a firm's parent, major shareholders, subsidiaries, affiliated companies, directors, and executive officers. Firms are also connected where they are controlled by the same family or group. Such credit may not meet the same standards as that extended to outside borrowers and the amount of credit often exceeds prudent levels. Frequently, the managerial attitudes of the related or subsidiary companies deteriorate because of the easy and systematic access to credit. In addition, banks tend to prop up or support connected companies that are in trouble rather than recognizing them as problem borrowers. Invariably, the close linkages result in losses.

To preclude the problems of connected lending, procedures should be established to ensure that loans to connected parties are granted at arm's length on terms not more favorable than those extended to similarly situated outside borrowers, that proper internal controls and credit limits are in place, and that concentrations of credit are avoided.

PERMISSIBLE OR PROHIBITED ACTIVITIES. Prudential regulations in some countries do not adequately define permissible or prohibited activities. As a result, banks may engage in commercial activities or enter lines of business that are unsuitable for financial institutions because of the risks involved and the specialized expertise required. Abuses can be as subtle as speculating in real estate by purchasing office buildings that far exceed actual banking needs. In other instances, banks engage in activities that are clearly nonfinancial, such as the ownership of manufacturing firms by many Latin American banks. The lack of clear definitions for permissible and prohibited activities increases the risks banks assume in their quest for profits and growth.

Regulations should detail, therefore, permissible and prohibited activities for banks. Such regulations should address whether banks can engage in commercial activities, own equity stakes in firms or enterprises, and participate in nonbanking financial activities.

ASSET CLASSIFICATION AND PROVISIONING. One of the most serious deficiencies in developing countries is the failure to recognize problem assets through classification, provisioning, write-off, and interest suspension. In a majority of cases, banks simply do not identify problem assets, establish realistic provisions for potential losses, write off or fully provide for actual losses, or suspend interest on nonperforming assets. As a result, the balance sheet does not reflect the bank's actual condition and the income statement overstates profits upon which dividends and taxes are paid. In many cases, if all losses were formally recognized, the banks would be insolvent.

Bank supervisors, in the course of their on-site examinations, may identify problem assets but are frequently powerless to require banks to make adequate provisions, direct the write-off of bad assets, and cause the suspension of interest on nonperforming assets for lack of the necessary legal powers. As a result, widespread abuses often continue unchecked and defer the recognition of financial system distress until the level of nonperforming assets gives way to liquidity crisis. Only then may the government be able to mobilize the political support and the resources necessary to deal with the problems that have been allowed to accumulate. If problem assets were appropriately identified and potential losses provided against in a timely manner, actions could be taken to strengthen or collect the problem assets, to prevent additional advances to problem borrowers, and to reflect upon and change lending policies leading to problems with the effect of containing actual losses at a controllable level.

There is a need, therefore, for banks to systematically and realistically identify their problem assets and provide adequate reserves for possible losses. One way to accomplish this is for developing countries to introduce regulations that require banks (1) to classify their assets as to quality according to specific criteria, (2) define nonperforming assets, (3) require the suspension of interest and reversal of previously accrued but uncollected interest on nonperforming assets, (4) preclude the refinancing or capitalization of interest, and (5) mandate minimum provisions to the reserve for possible losses based on the classification of assets.7/,8/ The percentages established for provisions may in some sense be arbitrary. However, on balance, they will establish some discipline in the credit process and force the banks to more accurately reflect their actual state of affairs.

SCOPE, FREQUENCY, AND CONTENT OF THE AUDIT PROGRAM. External audits serve as a means to independently verify and disclose the financial condition of the bank or enterprise audited. However, in some countries, external audits of banks are not required. In others, audits are performed but there are no clear guidelines concerning the standards to be used, the scope and content of the audit program, nor the frequency of audit activities to be carried out. Where audit standards do exist, they may differ substantially from recognized international standards and practices. Frequently, audits are carried out in accordance with local customs, tradition, and practices. This leads to inadequate and misleading financial statements that fail to accurately portray the true condition of the institutions. In point of fact, there are many examples of banks having clean audits even though they are known to be technically insolvent.

The weaknesses in bank auditing standards and practices may require an active role on the part of bank supervisors to establish minimum standards for the scope, frequency, and content of the audit program as well as the form and content of financial disclosures based on such audits.

Regulations should empower bank supervisors to establish auditing standards and minimum disclosure requirements. Key elements of the audit program should include an examination of portfolio quality and standards for valuing assets, establishing reserves for losses, and treatment of interest on nonperforming assets. In addition, supervisors should have the power to appoint or dismiss auditors. Auditors should also be under an affirmative obligation to inform the supervisors of significant findings in a timely manner. This can be done in a manner that respects the bank's right to know, except where criminal acts are involved.

Depositors, investors, and creditors of a bank should have reliable and timely information to make informed decisions when transacting business with a bank. Well-informed investors, depositors, and creditors can be an efficient regulator in an age of technology, information, and free capital flows. Regulations governing the scope and content of financial statements provide a means for disseminating information that is complete, timely, and uniform, thus permitting comparison, informed decisionmaking, and market discipline. However, financial disclosure and market discipline may not be good ideas for developing countries whose financial systems are in disarray until appropriate safeguards are built into the system.

ENFORCEMENT POWERS. Bank supervisors can usually impose fines and penalties for criminal acts and violations of specific statutes. However, there may be very little they can do to address unsafe and unsound banking practices that are not specifically addressed by statute. In such instances, their options very often are to cancel the banking license or to do nothing-neither of which is acceptable. As the result, the lack of intermediate enforcement powers often leads not only to inaction on the part of bank supervisors but to a perpetuation of problems and abuses within a given institution.

In countries where the legal systems are more developed, there are a number of intermediate actions that can be taken. These include a full range of enforcement powers to deal with incompetent or abusive ownership and management, including: (1) the ability to remove management or directors; (2) monetary fines or penalties that can be assessed against individuals, as well as institutions, for criminal acts or violations of the banking regulations; (3) civil money penalties that can be assessed against individuals for engaging in unsound and unsafe banking practices; (4) the right to restrict or suspend dividend payments; (5) the ability to withhold branch or other corporate approvals; (6) cease and desist authority; and (7) the ability to impose financial liability against bank directors for losses incurred due to illegal acts carried out by the bank, for example, violations of the lending limit that result in loss.

Cease and desist orders put the power of the legal system behind the supervisors in requiring changes in unsafe, unsound, or abusive practices. Banking legislation does not need to limit or prohibit the specific activity that is the focus of supervisory concern. However, any willful violation of the cease and desist order is accorded the same legal status as a violation of a specific statute and is subject to civil or criminal remedies in the legal system. Supervisors should also have the authority to issue temporary orders to cease and desist, pending confirmation by the legal system, so that the bank will be forced to stop imprudent or abusive practices immediately.

The ability to impose joint and several personal financial liability upon directors for losses arising from illegal acts committed by the bank is designed to encourage greater involvement by a bank's board of directors in actively supervising the affairs of the bank and to guard against potential abuses committed by the directorate. Directors should take an active interest in the bank's affairs and insist on proper controls and reporting so that they may remain sufficiently informed to carry out their responsibilities in a prudent manner.

TREATMENT OF PROBLEM AND FAILED BANKS. In many developing countries, the laws and regulations governing banking are rooted in the legal systems inherited or borrowed from former colonial governments. One feature of these systems is that banks are incorporated under the provisions of a company's act, subjecting banks to the same bankruptcy proceedings that apply to other corporations. This has caused considerable problems for prudential supervisors since the power to quickly intervene in insolvent banks is lacking. The bank supervisors lack authority to close a bank, appoint a receiver, and liquidate or merge it. Instead, the bank must go through a normal bankruptcy process, initiated by a depositor or creditor. This process may take months or years to complete during which depositors may not have access to their monies. In addition, shareholders may retain an interest in their shares. This effectively prevents any attempt to recapitalize the institution or transfer ownership to the government or new investors.

Legislation is necessary, therefore, to permit supervisors to declare banks insolvent, close banks, and place them in receivership outside the normal corporate bankruptcy process. This is necessary if supervisors are to protect depositors' interests and ensure public confidence in their ability to handle financial distress in an orderly and efficient manner. As part of this process, supervisors will also need broad powers to remove and replace management; eliminate the interests of shareholders; and purchase, sell, or transfer problem assets.

DEPOSIT INSURANCE. Many countries operate deposit insurance or deposit protection schemes as part of their prudential regulatory frameworks. Participation in such schemes is often compulsory. The primary objectives of deposit insurance schemes are to avert bank runs and protect the stability of the banking system. However, such schemes may also serve to protect small depositors, thus promoting competition by small banks. Under certain circumstances, deposit insurance schemes may act as catalysts for improving the system of prudential regulation, strengthening the effectiveness of bank supervision, and streamlining the machinery of bank restructuring.

However, deposit insurance may suffer from the problem of moral hazard affecting bank owners and depositors as well as bank supervisors. In countries with inadequate and ineffective supervision, deposit insurance may provide a false sense of security and lead to the taking of imprudent and unacceptable risks. Therefore, the establishment of deposit insurance schemes should be assessed on a case-by-case basis taking into account the administrative capabilities of different countries, the effectiveness of banking supervision, the structure of the banking system, and the sophistication of depositors.

Commercial Law, Debt Recovery, and Bankruptcy

In addition to prudential regulations designed to ensure the safety and soundness of the banking system, there is another important aspect of the legal framework that affects banks. This is the body of commercial laws and regulations governing a bank's contractual relationship with its customers. A key aspect of this legislation that often causes problems for the banks is that involving debt collection or recovery. In many countries, the commercial law dealing with debt collection and recovery overwhelmingly favors the banks' borrowers. Foreclosure and other legal actions involve a cumbersome legal process that may take years to complete at great expense to the banks. This cumbersome process is a disincentive to banks to take strong action to collect their problem debts. It may also encourage bankers to lend additional funds to carry the problem borrowers in the hope that the borrowers may recover and pay off their debts. All too often, though, the borrowers are unable to recover and the losses incurred by the banks multiply to even greater levels.

If banks are to remain viable, the legal system must be able to balance the rights of banks to foreclose on collateral with the rights of individuals and firms so that debts can be recovered in a timely manner. This may require changes in laws governing commercial transactions and bankruptcy and a wide range of actions to improve the effectiveness of the legal system, for example, hiring more judges and establishing courts specifically designed to hear commercial law and bankruptcy eases.