Preconditions for Effective Banking Supervision
The BCPs include five preconditions for effective supervision. Although preconditions are not formally part of the BCPs because they are normally beyond the jurisdiction of bank supervisors, “weaknesses or shortcomings in these areas may significantly impair the ability of the supervisory authority to implement effectively the Core Principles” (BCBS 1999), the preconditions are as follows:
• Sound and sustainable macropolicies (the precondition that has the most significant effect on risk exposures and capital adequacy)
• A well-developed public infrastructure that covers contract enforcement, a general insolvency regime, an accounting framework, and a corporate governance (all of which affect supervisory powers and enforcement)
• Effective market discipline that is based on transparency and disclosure (which affects the quality of prudential framework)
• Procedures for effective resolution of problem banks
• Mechanisms for providing either an appropriate level of systemic protection or a public safety net (which, along with the preceding precondition above, affects supervision of market conduct and enforcement of corrective actions)
The 2002 evaluation of the experience with the Financial Sector Assessment Program (FSAP) in 60 countries8 drew attention to the importance of effective preconditions for bank supervision during recent banking crises. In many of the countries experiencing crises, these preconditions were not sufficiently met. It is also noted that “compliance with the BCP is positively correlated to compliance with the preconditions and the stage of development of the financial sector”(IMF and World Bank 2002b). It was stated that developing countries generally are characterized by less favorable preconditions, including unstable macroeconomic conditions, inadequacies of the laws and judicial systems, weak credit culture and accounting systems, low disclosure, and incipient or nonexistent safety nets.
In view of these arguments, the evaluation emphasized the need for assessing the preconditions for effective banking supervision more explicitly in the context of an FSAP process and the BCP assessment. It continued to explain that a more structured approach to their evaluation could improve the analysis of the BCPs. It could furthermore enhance the discussion within an FSAP of linkages between the macroeconomy, the condition of the banking sector and the effectiveness of supervision.
Although an in-depth assessment of some of the preconditions may be beyond the scope of a BCP assessment, an effort should be made to present not only the weaknesses
and shortcomings with respect to those preconditions but also the effect they may have on the effectiveness of supervision and on the soundness of the financial system. Emphasis could be placed on the following issues:
• Although the assessment of macroeconomic policies remains in the purview of the broader surveillance, the assessor can focus on identifying vulnerabilities and risks associated with macroeconomic policies both for the financial system and for the effectiveness of bank supervision. Assessors should note whether supervisors have the capacity to assess those vulnerabilities and risks and to what extent the risks can be controlled by supervisors or by banks.
• To assess the adequacy of public infrastructure, the BCP assessors can draw from the conclusions of assessments of financial infrastructure, where available. Using that information, the assessors could note weaknesses in the credit culture, the level of creditor protection, the effectiveness of the judicial system, the bankruptcy procedures, the accounting standards, the auditing profession, and the level of information disclosure to the public.
• An assessment of the strength of market discipline needs to consider (a) issues of transparency, including quality, timeliness, and clarity of the information available to the public; (b) issues of corporate governance; and (c) the role of the government in the financial system and the set of incentives that may weaken market discipline.
• The adequacy of procedures to address problem banks and the effectiveness of the safety net fall within the scope of the BCP assessment and should be examined while assessing Core Principles 1 and 22. In this regard, the assessor should focus on whether supervisors have a sufficient and flexible range of procedures to achieve the efficient resolution of problems in banks, including the capacity to conduct an orderly resolution with respect to problem banks. For the assessment of the safety net, examiners should focus on the existence and design of the deposit insurance and lender-of-last-resort facilities.
In many cases, assessing the weaknesses and shortcomings in the preconditions for effective bank supervision may be time consuming and difficult, demanding a high degree of coordination of different agencies and branches of the government. Important issues of priorities and sequencing arise when trying to prepare a road map to address weaknesses in prudential aspects and preconditions for effective supervision. The question of whether shortcomings in preconditions should be addressed before addressing prudential weaknesses is not a trivial one. Coordination, prioritization, and sequencing of various reforms of infrastructure, supervision, and market and institutional development require careful consideration of the effect on financial stability and the technical interlinkages among various reform components that affect implementation.9