Legal and Institutional Framework for Financial Supervision
The legal framework empowering and governing the regulator and the rules used to regulate the various markets and institutional types form the cornerstone of the orderly functioning and development of the financial system. In this respect, the key laws are the law governing the central bank, banking and financial institutions, capital market laws, and insurance laws, and those laws are backed by adequate provisions on the efficient and reliable payment system infrastructure. The provisions are sometimes embedded in the laws or else are governed by separate legislation. The key elements of sound financial sector laws are already part of the existing international standards on supervision. Effective supervision also requires certain preconditions that are embedded in a broader range of laws such as laws on bankruptcy; company laws; contracts laws; and laws governing accounting, auditing, and disclosure, and so forth.
The legal and institutional framework for financial supervision should cover (a) the identity of the supervisor (central bank or separate agency), terms of reference, powers, and authority of the supervisory agency; (b) the authority and processes for the issuance of regulations and guidance; (c) the authority and tools to monitor and verify compliance with the regulations and principles of safe and sound operations; (d) the authority and actions to remedy, enforce, take control, and restructure; and (e) the procedures to delicense and liquidate problem institutions that cannot be restructured.
The legal framework should clarify the roles and responsibilities of different agencies involved in financial supervision. The central bank laws, banking laws, and other laws governing financial sector supervision need to specify the relationships among the supervisory agency, any deposit insurance agency, and other financial sector supervisors. In addition, the relationship with the Ministry of Finance needs to be clear and to provide sufficient operational autonomy to the supervisor. If a country has put in place a unified financial supervisory agency, then this arrangement needs to be laid down in a law, and its autonomy and powers need to be explicit.
The legal and regulatory basis of financial supervision should also support the core components of all financial supervisory standards. Those components consist of the following categories:
• Regulatory governance, which refers to the objectives, independence, enforcement, and other attributes that provide the capacity to formulate and to implement sound regulatory policies and practices
• Regulatory practices, which refer to the practical application of laws, rules, and procedures
• Prudential framework, which refers to internal controls and governance arrangements to ensure prudent management and operations by financial firms
• Financial integrity and safety net arrangements, which refer to (a) the regulatory policies and instruments designed to promote fairness and integrity in the opera-
a. Includes BCP 1 and 19; ICP 1; IP: 1, 2, 3, 4, 5, 6, and 7.
b. Includes BCP 2, 3, 4, 6, 16, 17, 18, 20, 22, 23, 24, and 25; ICP 2, 3, 4, 5, 12, 13, 15, 16, and 17; IOP 8, 9, 10, 11, 12, 13,
c. Includes BCP 5, 6, 7, 8, 9, 10, 11, 12, 13, and 14; ICP 6, 7, 9, and 10; IOP 17, 18, 20, 21,22, 23, 25, and 27.
d. Includes BCP 15 and 21; ICP 11 and 16; IOP 14, 15, 16, 19, 24, 26, 28, and 30.
BCP—Basel Core Principles
ICP—Insurance Core Principles of International Association of Insurance Supervisors
IOP—International Organization of Securities Commission’s Objectives and Principles of Securities Regulation
Note: This four-component framework is based on the paper “Financial Sector Regulation: Issues and Gaps" (IMF 2004a). The allocation of insurance principles into various components is based on the 2000 IAIS standard. For a discussion of specific core principles under each standard, see chapters 5.3-5.5.
tions of financial institutions and markets and (b) the creation of safeguards for depositors, investors, and policyholders, particularly during times of financial distress and crisis
Those four components are illustrated in figure 5.1. For example, in the area of regulatory governance, Insurance Core Principles (ICPs) relating to supervisory objectives and supervisory authority require that insurance legislation include a clear statement on the mandates of the supervisory authority and give authority to issue and enforce rules by administrative means. Many of the other criteria and core principles—such as those relating to independence and accountability—could be part of primary legislation or part of regulations and bylaws issued pursuant to the legislation.
The institutional framework for supervision—and the laws that support it—needs to reflect the financial market structure and the broader institutional and policy environment. The institutional framework should be flexible enough to adapt to the shifts in market structure and in the broader environment to avoid regulatory gaps and to support financial innovation and development. For example, a poorly structured organizational
framework for supervision could impede financial innovation or cause overregulation that stifles development. Similarly, an inappropriate organizational structure may cause regulatory gaps and regulatory arbitrage that may allow excessive risk taking and financial instability. An institutional framework for financial stability is, however, quite broad and goes beyond the institutions conducting financial supervision (such as the sectoral supervisor or integrated supervisor or central bank with supervision responsibilities). It includes other institutions and policy authorities that have jurisdictions over the broader financial infrastructure and macroeconomic policies. For example, accounting policies, competition policies, and insolvency regimes are matters outside the jurisdiction of supervision but are critical for financial stability. The broader institutional framework also includes the specific coordinating arrangements to ensure information exchange and policy coordination among all these policy components—supervisory, infrastructure, macroeconomic, and macroprudential—that interact to produce financial stability and financial development. In most cases, the Ministry of Finance will have the overall coordinating powers, and in some cases, there could be specific coordinating committees that bring together representatives of different policy authorities.
The appropriate design of the institutional structure of financial regulation and supervision has become a major issue of policy and public debate in several countries. Although many countries have moved in the direction of a unified agency for prudential regulation and supervision, the case for integrating conduct-of-business regulation and prudential supervision within the same agency is less powerful and considerably less common. Also, the issue of how to tailor the structure of regulation to specific features—operational complexities and transaction characteristics—of regulated institutions has become a pressing issue, for example, in the context of expanding access to the poor or in managing large and complex financial institutions (LCFIs). The issues in assessing the institutional structure are taken up in greater detail in appendix F (Institutional Structure of Financial Regulation and Supervision).