Bank Supervision Models in the Industrialized Countries

Bank supervision in the industrialized countries developed in response to financial crises, economic events, and political phenomena Very often, the form of bank supervision reflected philosophical and social differences in the role of government and in the organization of society, for example, the "clubby" approach in 19th century Britain, where the Bank of England exerted its moral authority and leadership through "nods and winks," versus the strongly populist and confrontational tradition of the United States, which was based on more or less detailed "rules of the game" and required a more elaborate mechanism for ensuring compliance with these rules. These differences were embodied in two principal models of bank regulation and supervision: an informal approach that relied on consultation and moral suasion; and a formalized approach that required active, "hands-on" verification through on-site inspection. In continental Europe, a legalistic approach was developed that was less "hands-on" than in the United States and delegated much of the verification and inspection of bank records to external auditors.

Bank Supervision in Britain

The informal approach to bank supervision is best exemplified by the approach taken by the Bank of England. In Britain, supervision was traditionally carried out by the Bank of England in consultation with banks. Moral suasion, discretion, and personal contact were the principal tools of bank supervisors. Each bank had an individual relationship with the Bank of England. Banks made prudential returns but, unlike other systems of supervision where examiners conduct onsite examinations to verify and extract information, the responsibility for passing on information to the Bank of England rested solely with the banks.9/ For many years this system worked relatively well in a highly concentrated banking industry. However, the system came under stress when the number of banks increased as a result of the creation of so-called secondary banks and the influx of foreign banks in the late 1960s and early 1970s.

The flaws of the informal system, which relied on information provided by management but without an independent assessment of the quality of bank portfolios and of the adequacy of provisions for possible loan losses, became apparent. Gradually, the British authorities adopted a more legalistic approach to bank regulation and supervision that brought British practice closer to continental European practice. Following the Johnson Matthey affair, which precipitated a reappraisal of the supervisory approach of the Bank of England, the British authorities effectively delegated on-site inspections to external auditors by strengthening the reporting requirements of banks' auditors to the Bank of England.10/ Steps were also taken to improve the off-site surveillance capability of the Bank of England.

For the informal approach to be effective, the U.K. experience would seem to suggest that several key conditions must exist: a small number of banks, a strong central authority, a tradition of close cooperation between government and industry as well as close personal relationships between bankers and supervisors, a highly skilled work force, effective management systems within the banks themselves, strong auditing and accounting practices, and full disclosure to ensure market discipline. Even then, dishonest or fraudulent management could deceive bank supervisors and cause irreparable damage to an institution. This system of informal supervision left a legacy of "hands-off" bank supervision in many former British colonies, which made them ill-prepared for the problems of banking in a developing environment. While this does not appear to have created difficulties in some countries, problems have emerged in many other Commonwealth countries in Africa and Asia where indigenous banks were promoted to compete against the hitherto dominant role of foreign banks.

Bank Supervision in Continental Europe

The model of bank supervision found in continental European countries is based on a legalistic approach that stipulates various ratios that the banks must observe but delegates the on-site examination of banks and the verification of their records to external auditors. In Belgium, special auditors are appointed and paid by the authorities. In Switzerland, the auditors are licensed by the Federal Banking Commission and are subject to special statutory dudes. In Germany, general auditors perform the examinations of banks and must inform the authorities if they discover facts that justify the qualification of an audit. However, supervisors retain the right to examine a bank's books and carry out examinations at any time. In each of these countries, the supervisors have established detailed rules concerning the form and content of the auditors' reports.

Delegating on-site bank examinations to external auditors effectively represents the privatization of the inspection process, although under strict government rules and guidelines. There are several advantages to this approach. Auditing firms may escape the resource and salary constraints that often prevent supervisory authorities, and governments generally, from employing and retaining highly skilled staff. Moreover, auditors may achieve operating economies by combining a prudential inspection with ordinary accounting audits.

However, this approach also raises some concerns. There are risks that if not properly structured and controlled, auditors may be placed in potentially conflicting roles with dual loyalties to both the banks and the government, particularly in cases where the auditors are permitted to undertake other work. In addition, there is a concern that, in their efforts to control costs and maximize profits, auditors may not devote sufficient resources to ensure proper performance of the audit.

The appropriate modality for on-site inspection, that is, supervisors or auditors, for any particular country ultimately depends on an evaluation of which group is best able to perform the on-site verification function. Factors to be evaluated include skills, competence, experience, and independence from political and other influence. This evaluation is best performed on a case-by-case basis.

Bank Supervision in the United States

Bank supervision in the United States exemplifies the formal approach to supervision that requires an active, on-site presence to verify conditions existing within banks. In the U.S. model, periodic onsite examinations have been the cornerstone of the supervisory process. The American approach is justified by the large number of small banks and on unit banking within particular states, both of which result from restrictions on geographic expansion. Whereas the concentrated banking systems of the European countries internalize most of the costs of policing branches and losses are dispersed at the branch level, in the American banking structure, policing costs are incurred to a much greater extent by the regulatory agencies, while bank losses are covered to a greater extent through formal deposit insurance schemes.11/ This creates greater social and political pressures for a hands-on approach to bank supervision.

Unlike countries where the authorities rely on outside experts, bank supervisors in the United States must themselves possess the skills to evaluate asset quality and other areas of a bank's activities. A major disadvantage of this approach is that it can be labor intensive and can be inhibited by budgetary constraints. U.S. supervisory agencies have responded to resource constraints in recent years by targeting on-site examinations, making greater use of off-site surveillance and early warning analysis, and taking advantage of advances in computer technology. These steps have permitted the supervisory agencies to hold the number of examining staff relatively constant despite the growth in assets and growing complexity of the financial system.

The more than 14,000 banks supervised by U.S. regulators is a major reason that a formal approach to supervision has been required. It also explains the adoption of the CAMEL rating system and the use of the Uniform Bank Performance Report. The CAMEL rating quantifies a supervised institution's condition in five critical areas and assigns an overall composite rating, while the Uniform Bank Performance Report (UBPR) is a statistical analysis of bank performance that is based on data from quarterly prudential reports.12/ This report compares and ranks each bank against its peers. There are twenty-five peer groups, bringing together institutions with similar characteristics. These reports are publicly available and the computer tapes are made available to stock analysts and others. By using this technology, supervisors also have the ability to prepare ad hoc reports or to download data into microcomputer models where simulation or forecasting is performed. In the latest stage of technological advance, expert systems are being used to analyze prudential reports and generate written comments.

Harmonization and Convergence of Bank Supervision

Despite the differences in supervisory approaches, there is a growing consensus that bank supervision and regulation should be harmonized across national boundaries due to the ever-increasing global interdependence of financial markets. As developing countries grow and prosper, the integration of domestic financial markets with the larger international financial system will become more and more important so that distortions are minimized. In a world where financial transactions occur around the clock and banks enter into financial transactions with any number of foreign correspondents and counterparties, the global financial system may only be as strong as its weakest links. Differences in regulation can distort the financial markets as well as increase the risks for banking activities performed beyond national borders. There is also a danger that domestic institutions operating abroad may escape supervision.

The failure of the West German Bankhaus Herstatt in 1974 due to foreign exchange and other losses had damaging effects on the international interbank market and focused attention on the need for greater international supervisory cooperation. This led to the formation of the Basle Committee later that year under the auspices of the Bank for International Settlements. This forum comprises banking supervisors from the Group of Ten countries plus Switzerland and Luxembourg.13/ Following its creation, the committee addressed the issue of supervision of financial institutions operating abroad by developing broad guidelines to ensure that no institution escaped supervision. These guidelines are contained in the Basle Concordat," which embodied the following key principles: (1) supervision of foreign banking establishments is the joint responsibility of parent and host authorizes, (2) no foreign banking establishment should escape supervision, (3) supervision of liquidity should be the primary responsibility of the host authorities, (4) supervision of solvency is essentially a matter for the parent authority in the case of foreign branches and primarily the responsibility of the host authority in the case of foreign subsidiaries, and (5) practical cooperation should be promoted by the exchange of information between host and parent authorities and by the authorization of bank inspections by or on behalf of parent authorities on the territory of the host authority.14/

Other important initiatives prompted by the work of the Basle Committee include recommendations that supervision of banks' international business be conducted on a consolidated basis, so that risks can be evaluated globally, and the adoption of risk-asset based capital adequacy standards. Continuing work focuses on banks' exposure to country risk, liquidity and interest rate risk, and offbalance sheet risk.15/

Supervisory Methodologies

The growing integration of financial markets, especially among member states of the European Community, has led to a convergence of systems of bank supervision. It is now widely accepted that an adequate system of bank supervision should allow for both on-site examination and off-site surveillance and that nonprudential concerns, such as tax collection and compliance with currency controls and credit constraints, should be held to a minimum.

Supervisors' tools include on-site examinations of individual institutions and off-site surveillance from both macro and micro perspectives. For most developing countries, on-site examinations are especially important. This is because problems of insolvency in developing countries usually occur due to credit losses, which are best determined while within an institution. Therefore, supervisors must concentrate on assessing asset quality and mandating provisions for bad debts and suspension of interest on nonperforming assets through on-site examination and verification. By determining asset quality and the condition of an institution, bank supervisors provide critical information to government policymakers on the health of the financial system.

ON-SITE EXAMINATIONS. Traditional on-site examination methodologies in many countries frequently focus on compliance with banking regulations and directives. As a result, prudential concerns for safety and soundness are often overlooked. Even in cases where supervisors attempt to address safety and soundness concerns, the examination process may only provide a "snapshot" of the institution's condition as of a given date without addressing potential risks and the management systems needed internally by the bank to control risk in a dynamic, changing environment. For example, examiners may determine the condition of a bank's loan portfolio but fail to evaluate the lending policies and practices that lead to loan problems or that may give rise to future loan problems. Indeed, in many cases, bank examiners fail to identify and quantify the extent and severity of problem assets-a major failure. Even when problems are identified, supervisors may lack the powers to require provisions and write-offs or other necessary actions.

To correct these weaknesses and improve the effectiveness of their on-site examination activities, supervisors need to move away from checking compliance with laws to assessing risk and assisting banks in managing risk. To accomplish this, bank supervisors should embrace a top-down approach that places emphasis on the direction and policies formulated by the board of directors and executive management. It is not enough to quantify problems-although this is certainly a necessary step. The causes of problems must also be understood and preventive action taken to reduce the likelihood of their recurrence.

As part of the examination process, on-site examiners should verify the accuracy of prudential reports submitted to the supervisory agency and analyze those aspects of a bank that cannot be adequately monitored by off-site surveillance. Examiners should focus on the banks' main activities and on the potential problems identified by offsite surveillance. In particular, they should assess the quality of assets, management, earnings, capital, and funds management, as well as the bank's internal control, audit, management information, and accounting systems. In evaluating asset quality, the examiner should review the bank's lending policies, written or implied, to determine whether they are reasonable and complete. Thereafter, he should examine the credit files of large borrowers, problem borrowers, and a sample of files belonging to smaller borrowers, to assess the quality of the loans, management's credit practices, and adherence to credit policies. Minutes of meetings of the credit committee and the board of directors should be reviewed. The examiner should also evaluate the bank's procedures for suspending the accrual of interest, writing off bad debts, and determining an adequate loan loss provision.

Bank supervisors should also review the business and strategic plans of individual banks and assess the capabilities of management to fulfill objectives. They should check that management systems in place are sufficient to ensure compliance with policies and proper functioning. Bank supervisors should also encourage banks to establish and strengthen their own internal management systems as the first lines of defense against unsound, unsafe, or illegal banking practices. Management systems should include written policies and procedures, formalized planning and budgeting, management information systems, internal loan review, compliance systems, internal and external audit activities, and internal controls. The development of management systems should be encouraged in both large and small banks, although their sophistication and complexity may differ.

Since the ongoing task of bank supervisors is typically to ensure the safety and soundness of the financial system-as opposed to individual banks-and to protect depositors, not the shareholders of banks, supervisory activities should focus on the areas of greatest risk to the system, for example, large financial institutions or banks whose activities may lead to contagion within the system. Within individual banks, efficient use of scarce supervisory resources should be made by targeting examination efforts to the areas of greatest risk, for example, asset quality, interest rate risk, foreign exchange activities, and so on. Examination activities should also avoid the examination of each and every branch office or operating subsidiary of an institution. Instead, the examination should focus on the condition of the consolidated institution by examining those units that have a significant impact on the institution's overall position. The remaining units should be evaluated on a sample basis.

The failure to follow up on problems and to enforce corrective action is a common weakness in the supervisory process. This occurs for many reasons including weak leadership, political influence, temerity in dealing with problems, organizational weaknesses, and a lack of appropriate enforcement tools. However, it also occurs because examination results and the type of corrective actions needed are not adequately communicated to the bank's board of directors and senior management. It is extremely important that examination results are clearly communicated to the bank through a written examination report and meetings with the board of directors and executive management. A transmittal letter attached to the written examination report and signed by the head of bank supervision or his designee should highlight the report's major conclusions and recommendations. In addition, the transmittal letter should require a formal response by the bank within a stated time frame. If progress reports concerning corrective actions to be taken by the bank are required, these should be outlined in the transmittal letter. Administrative procedures should be established for monitoring the bank's response and verifying corrective actions.

In most developing countries, written examination procedures are less than adequate, or lacking altogether, so that the examiner must rely totally on his or her experience, knowledge, and skills. This leads to a lack of uniformity and consistency in the conduct of on-site examinations from one examiner to the next. As a result, the head of bank supervision can never be sure which bank functions were reviewed and the manner in which the examination was performed. The lack of written examination procedures also deprives new staff of an essential training tool. Therefore, to ensure consistency and uniformity, and to provide a training tool for new examiners, written examination procedures and questionnaires should be developed for use in on-site examinations. These are not meant to supplant the examiner's judgment. However, they do provide a framework and support for the work to be carried out.

A complementary aspect to written examination procedures is the documentation of work performed and the maintenance of working papers. These are necessary to demonstrate that the actions recommended by the examiner are not arbitrary but are based on valid concerns and criticisms. This documentation may also be necessary to support legal enforcement actions proposed by the supervisors.

Over the long run, bank supervisors can use the on-site examinations process as a catalyst for changing the fundamental ways in which banks operate by recommending actions for financial institutions to upgrade their operations. This usually involves the strengthening of management systems in banks, including written policies and procedures, formalized planning and budgeting, internal controls and audit procedures, management information, and loan review. The rationale for this approach is that supervisors will always face resource constraints. The banks themselves, therefore, must establish the first lines of defense against unsound or unsafe practices. Once management systems are in place, supervisors can determine that the systems are working by testing the systems. If the systems are inadequate, the scope of an examination should be expanded so that risks can be identified and quantified.

OFF-SITE SURVEILLANCE. An off-site surveillance capability provides an important complement to on-site examinations by providing early warning of actual or potential problems and a means for monitoring and comparing financial performance. However, off-site surveillance should not be viewed as a means to replace on-site examination as the primary form of supervision in a developing country. The quality of information and integrity of data provided by banks in all countries must be verified. In developing countries, the quality of information is frequently incomplete and inaccurate. Often, banks do not have the internal accounting and control systems to ensure timely and accurate preparation of information. Therefore, in most cases, it would be inappropriate to rely on off-site surveillance as more than a complement to on-site examinations.

In most developing countries, prudential reports, which form the basis for most off-site surveillance activities, are frequently limited to those concerning liquidity, reserve requirement computations, and credit guidelines. Analysis often consists of simply checking compliance with certain balance sheet ratios. Rarely is information gathered to meaningfully appraise risk.

For off-site surveillance and early warning analysis to be effective, prudential reports must move away from statistical inputs, liquidity and reserve requirement computations, and simple balance sheet calculations to inputs that permit the measurement of risk. This means that supervisors should collect data concerning a bank's loan portfolio, including delinquencies and problem assets, foreign exchange position, off-balance sheet commitments, and other risk areas, as well as balance sheet and profit and loss statements. To ensure uniformity, supervisors should have the ability to prescribe the timing, content, and format of the prudential returns so that comparative data can be prepared and used in a consistent fashion.

It is critical that the off-site surveillance function be fully integrated into the supervisory process so that weaknesses may be corrected. In some cases, it may be sufficient to contact the bank by phone or letter to discuss concerns identified off-site. However, in other cases, it may be necessary to send examiners into a bank to follow up on the weaknesses identified off-site. In any event, information and reports prepared off-site can provide important comparative data on areas of risk and efficiency and should be used by examiners during their onsite examinations.

Organizational Issues

Bank supervision is often placed under the umbrella of a country's central bank. Since the function of bank supervision is to ensure a safe and sound banking system and to prevent financial system instability, the central bank, as manager of a country's monetary policy and lender of last resort, is a logical place to house banking supervision. However, there is no compelling evidence to suggest that operating from within the central bank affords a distinct advantage over the creation of an autonomous supervisory agency provided that bank supervision is insulated from political influences, information derived in the supervisory process is shared with those managing monetary policy, and the agency is adequately funded through assessments or direct budget allocations. In fact, some argue that an agency that is solely responsible for bank supervision will devote greater attention to the fulfillment of its role than one that also has responsibilities for managing the nation's monetary policy. On the other hand, there is an argument that where supervisory responsibility is centered in a central bank, it is likely to be exercised with a wider degree of discretion than where the primary supervisory agency is autonomous and operates within defined statutory limits.16/

In general, in countries that have strong central banks, it would seem inappropriate to dilute their influence and authority by assigning supervisory responsibilities to another institution. If the central bank is weak, then the case for an independent supervisory agency is stronger. In many high income countries, the division of responsibilities reflects historical factors.

Another alternative is to place the supervisory agency within the Ministry of Finance or Treasury. In most countries, this alternative is the least desirable since these ministries tend to be highly politicized and the coordination of policy with other government agencies tends to be problematic. Ultimately, it would seem, therefore, that the effectiveness of a bank supervisory body depends not so much on its organizational location but on its leadership and independence from political influence. If a particular institutional arrangement in a given country permits the bank supervision unit to operate free from inappropriate outside interference, that arrangement is probably the most desirable for the country.

Regardless of where supervision is located within government, there are important organizational steps that can be taken to enhance its effectiveness. The bank supervision unit should possess its own identity on at least a par with other important units within the central bank or ministry or as an independent agency. The director of bank supervision should be a high ranking government official and report directly to the central bank governor or deputy governor or the minister of finance or treasury. This is necessary to establish an appropriate degree of credibility with the banking industry so that directives issued by the supervisor will have effect.

Staffing and Compensation

In most developing countries, bank supervisors face resource and budget constraints. As a result, supervisory units are often understaffed. This affects the supervisor's ability to conduct bank examinations and perform other supervisory duties. The most capable and qualified individuals are frequently employed in the private sector or in other activities where compensation is greater. In some cases, compensation for bank supervisors may not be as great as for other parts of government even though the responsibilities are greater. This affects the supervisor's ability to attract and retain qualified staff.

Needless to say, adequate staffing for bank supervision, both in terms of quantity and skill levels, is a must. To attract and retain qualified staff, compensation should be competitive within government and with the private sector. Governments frequently argue that they cannot afford additional staff or higher salaries. Nor can they justify differentiated salaries within government. However, there is an argument to the contrary that governments cannot afford a banking crisis and its debilitating effects on economic growth and development. It should be noted that there are precedents for banking supervisors to be exempted from normal civil service guidelines and salary scales. The cost of even one bank failure may far exceed the costs incurred in employing and retaining competent staff, a situation clearly demonstrated by the U.S. savings and loan crisis when requests for additional staff were denied by the government administration then in power.

Career Path

In some countries, bank supervision is not viewed as a career, and employees are rotated in and out of the bank supervision unit in only a few years. This contrasts with countries where bank supervisors require four to five years just to learn the skills necessary to examine small, well-managed institutions. If bank supervision is to be effective, it must be considered a full-time career option. Career paths and job descriptions should be developed to provide meaningful and challenging responsibilities as well as upward mobility. This could include career milestones such as promotion from an assistant examiner to a full-fledged examiner to a senior examiner and, ultimately, into the ranks of management. Rotational assignments in other departments could be accommodated as a means of broadening an individual's knowledge and skills. However, it should not mean the end of a career as a bank supervisor.

Training

Training is often conducted solely on the job in a less than systematic manner so that skills are acquired in a hit-or-miss fashion. Inadequacies in training and development affect the supervisor's ability to build a skilled, knowledgeable, and competent staff. Training programs should ensure that each supervisor receives not less than two weeks training per year. This training should combine formal instruction, case study, and seminars. In addition, on-the-job training should be conducted in a systematic fashion. Senior staff should have the opportunity to mix with supervisors from other countries for cross-fertilization of ideas.

Inaction in Restructuring Banks

In the industrialized countries, bank supervisors attempt to minimize potential losses and liability to the government by closing banks near or at the point of reaching technical insolvency. However, in the developing countries, the absence of reliable information, an inadequate legal framework, and the lack of political will often permit banks to remain open and losses to multiply, even though the banks may have lost their reported book capital many times over. Inaction in dealing with insolvency may also occur because the institutional framework for dealing with insolvency is inadequate. Experience indicates that ad hoc approaches to dealing with insolvency generally do not succeed. Because banks are not closed, the effectiveness of bank supervision may be compromised. Bankers may know that supervisors are powerless to take appropriate action. To counter this, a systematic approach and mechanism for dealing with insolvency is necessary.17/