Experience With Basel Core Principles Assessments

Core Principles Assessments (CPAs) aim to judge the adequacy both of the rules for banking supervision and of the supervisors' ability to monitor and limit major risks run by banks. CPAs have begun to make a significant contribution to the work of the Fund in surveillance, technical assistance (TA), benchmarking in Fund programs, and transparency. The 26 CPAs to date, completed by the Fund and the Bank, have utilized expert assistance from a number of cooperating institutions. The process benefited from improvements to the methodology for assessments, an exercise in which Fund staff actively collaborated with the Basel Committee on Banking Supervision (BCBS).

Results from the 26 CPAs demonstrate serious weaknesses in banking supervision in many countries, especially in risk management, the taking of corrective actions, and consolidated supervision. Implementation and enforcement of laws and regulations were often found to be weak. Defects in many of the necessary pre-conditions for effective banking supervision—such as accounting systems and loan valuation procedures, legal processes, market discipline—were often an additional source of weakness.

The detailed methodology for compliance assessment brings out the weaknesses in the framework for effective supervision, and for the stability of the banking system. CPAs done by the Fund and the Bank have also allowed for sharper identification of weaknesses than have self-assessments. This suggests that considerable attention to supervisory and regulation reforms need to be given in the context of surveillance, particularly Financial Sector Assessment Program (FSAP) and Fund programs. Learning from the experiences of the CPAs, more emphasis might be put on assisting countries to set priorities, implement and thoroughly understand the issues behind observance of the CPs. TA resources need to be devoted for this purpose.

The experience so far has found real advantages in doing CPAs in the context of the much broader FSAPs in order to provide better perspectives on financial vulnerabilities. Accordingly, CPAs will be conducted in FY 2001 by the Fund and the Bank mostly as part of planned FSAP missions. (See also SM/00/54). The use of a detailed assessment methodology will ensure consistency and uniformity of approach across the membership.

These findings have been discussed with, and welcomed by, supervisors, both members and non-members of the BCBS, and will be taken into account in forthcoming work on possible revisions to the Core Principles and to the assessment methodology. The Basel Committee and its Core Principles Liaison Group will hold a workshop in May 2000 to take stock of experiences with the CPs and the CPAs. Fund and Bank staff will participate, and this paper, together with the Boards' conclusions, will be a major input to the discussions.

1.   The two main objectives of Basel Core Principles Assessments (CPAs) are to assess the adequacy of the legislative and regulatory framework, and to determine whether supervisors are capable of, and are, effectively supervising and monitoring all of the important risks taken by the banks. The CPA process, set up to play a key role in strengthening national and international financial systems, are increasingly contributing to the work of the Fund by helping to: (1) strengthen financial system surveillance, in the context of Article IV Consultations, through Financial System Stability Assessments (FSSAs) and Reports on Observance of Standards and Codes; (2) improve the focus of the Fund’s technical assistance work; (3) set structural benchmarks in Fund-supported programs; and (4) support efforts to improve transparency. This paper reviews the experience thus far with CPAs in the context of the Fund’s work, with a view to learning lessons for the future, including the better integration of CPAs into Fund surveillance and Technical Assistance (TA) priorities.¹

2.   CPAs were initially used, in the context of TA in banking supervision, to set priorities for TA as well as structural benchmarks for Fund-supported adjustment programs. The Core Principles and these assessments have been well received by the international community, which has also supported their linkage to Fund surveillance (see Box 1).

3.   Accordingly, an increasing number of CPAs are being carried out as part of Financial Sector Assessment Programs (FSAPs) linked with Article IV Consultations. A CPA is seen as a necessary part of any FSAP: the resilience of the banking system is a central part of all FSAPs, and this, in turn, requires a thorough understanding of the effectiveness of the regulation and banking supervision framework.

4.   The paper draws heavily on the experience thus far with CPAs carried out both by the Fund and the World Bank. The two institutions have rapidly responded to the need for devoting larger resources to the assessments of compliance with the Core Principles for banking supervision (and with principles and standards in other areas). Thus far, 26 CPAs have been completed by the Fund, the Bank or joint teams since the first CPAs were attempted in February 1998.² Of these, 18 were carried out by Fund teams, five by Bank teams, and four jointly. The sample includes only one industrial country (Canada); most CPAs were associated with TA programs in developing countries, and their use in FSAP and Article IV missions is just beginning. Out of the 26 CPAs, 17 were conducted as part of larger TA missions and three on a stand-alone basis. One CPA (Turkey) was conducted in the context of program design, and five as part of FSAP missions (Canada, Colombia, India, Lebanon, and South Africa). The Fund has made use of 24 external experts in banking supervision in its CPA work so far. Ten have come from central banks or financial supervisory authorities, eleven are retired supervisors, and three work on a freelance basis.

5.   The remainder of this paper is organized as follows: The next section examines the background to the CPAs. Chapter II reviews the Fund’s experience with CPAs, as well as reviewing the findings of Fund— and Bank—led CPAs and comparing those findings with a set of self-assessments. Chapter III raises the issues of dissemination and publication. Chapter IV presents the paper’s conclusions and suggests issues for Directors' consideration. Appendix I, on methodological issues, examines the tools and inputs used in carrying out CPAs, and describes how the assessments were reviewed with the authorities, and disagreements handled. Appendix II provides background information on possible amendments to the CPs and the methodology for assessing them.

B. Background

6.   The recognition that weaknesses in national banking systems can threaten both domestic and international financial stability led the G-7 to call for efforts to improve the strength of national financial systems in its Communiqué following the Lyons Summit in June 1996. The Basel Committee on Banking Supervision (BCBS)³ worked with a team of G-10 and non-G-10 countries to define a set of basic elements for an effective system of banking supervision.⁴

7.   The final document, which is generally referred to as the Core Principles (CPs),⁵ was issued by the BCBS in September 1997. The CP document has two main parts. The first part, which has received less attention, covers the preconditions for effective banking supervision (general preconditions). While these preconditions are largely beyond the control of the supervisory authority, strengths and weaknesses in these areas affect the scope and effectiveness of supervision substantially, and influence the ability of the supervisor to implement the CPs effectively. The preconditions cover five broad areas: "(1) sound and sustainable macroeconomic policies; (2) a well-developed public infrastructure; (3) effective market discipline; (4) procedures for the efficient resolution of problem banks; and (5) mechanisms for providing an appropriate level of systemic protection (or public safety net)."⁶

8.  The second part of the document outlines the 25 CPs (see Box 2 for a summary of the CPs). They lay out the minimum requirements for banking supervision to be effective; from the outset the BCBS recognized that "...in many cases [they] may need to be supplemented by other measures designed to address particular conditions and risks in the financial system of individual countries."⁷ The CPs cover seven broad areas: (i) preconditions for effective banking supervision (which differ from the general preconditions, and cover issues such as independence, responsibilities, legal framework, and information sharing); (ii) licensing and structure; (iii) prudential regulations and requirements; (iv) methods of ongoing supervision; (v) information requirements; (vi) the formal powers of supervisors; and (vii) cross-border banking. In addition, the CP document has appendices on state-owned banks and deposit insurance systems, but the appendices are not considered to be CPs, and are not formally assessed.

9.   The Fund has been supportive of the development of international banking standards and best practices for some time and has been strongly supportive of the CPs from the beginning. In this regard, it is worth noting that the BCBS has acknowledged that the Fund’s call for international banking guidelines was an impetus for the development of the Core Principles.

10.   While leaving the primary responsibility for implementation to the national supervisory authorities themselves, the CP document also suggested that "...the IMF, the World Bank and other interested organizations use the Principles in assisting individual countries to strengthen their supervisory arrangements in connection with work aimed at promoting overall macroeconomic and financial stability."⁸

11.   It should be stressed that this paper deals only with the CPs for banking supervision; but a country’s implementation of standards must be seen in a broader context, which affects how standards are implemented. First, good supervision will not and should not insulate financial institutions and markets from innovation, risk-taking or operating problems. Second, the stability of the banking system is closely interlinked with overall macro economic stability, and the strength of the broader financial system and the financial infrastructure.

12.   Fund staff conducted its first CPAs in February 1998. They were based on the relatively short explanatory notes for each CP in the CP document. Since the Principles were not always very explicit and clear, this left considerable room for varying interpretations by individual assessors. Most countries also did self-assessments but these suffered from the additional problem that the assessors had an incentive to show the extent of implementation in the best possible light. As a result it was difficult to draw valid cross-country comparisons.

13.   The experiences of Fund and Bank assessors and also of other assessments using the CP document led the BCBS, in October 1998, to set up a working group with the task of writing a "Core Principles Methodology." The group comprised senior experts from the supervisory authorities represented in the BCBS plus senior supervisory experts from the Fund and the Bank. During the work on the methodology, there was an ongoing and intensive exchange of views, both with the BCBS and with the Basel Core Principles Liaison Group.⁹ A draft version of the methodology was also sent for review to all supervisory agencies around the world. The final version was endorsed, first by the Core Principles Liaison Group, and then by the BCBS in October 1999, and was then published on the BIS website.

14.   The methodology adds to the Core Principles paper in four important ways by:

• making consideration of the general preconditions more explicit;

• clarifying the interpretation of each CP by specifying detailed criteria for assessing compliance (227 criteria covering all 25 CPs);

• specifying a format for the conduct, evaluation and presentation of the Fund and the Bank CPAs (with the implicit aim of setting a standard to be followed by other assessors); and

• including a scheme for assessing compliance with the individual CPs. The assessment uses four grades: (1) compliant, implying full compliance or only insignificant shortcomings; (2) largely compliant, where only minor shortcomings are observed, and which do not raise doubts about the authority’s ability to achieve the objectives of the principle; (3) materially non-compliant, where the shortcomings raise doubts about the ability to achieve compliance, but substantive progress has been made in rectifying the deficiencies; and (4) non-compliant, when, in the judgment of the assessors, no substantive progress toward compliance has been achieved.

15.   The methodology document also called for all CPAs to be based on "essential criteria," which are derived from the internationally accepted norms described in BCBS documents or elsewhere. In addition, countries could be assessed against the "additional criteria," implying a higher level of compliance. Both the methodology and the original CP document recognized that, depending on country circumstances, assessors could take the view that the fulfillment of the essential criteria for one or more CPs may be inadequate to ensure efficient supervision and, therefore, a stable financial system.

16.   Since April 1999, all 12 Fund and Bank CPAs have used the methodology in draft or final form. Because the methodology requires assessments against clearly defined criteria, the objectivity, coverage and cross-country comparability of the CPAs has been greatly improved. Nonetheless, there remain a number of shortcomings which suggest a need to clarify or strengthen the criteria. These are discussed in section II D of the paper.

17.    In the CPAs the Fund and the Bank rely strictly on the agreed methodology. This helps to ensure valid comparisons of results across countries. The importance of this is underscored by the fact that the assessments are conducted worldwide, for countries with widely diverging financial structures and domestic practices. A general conclusion, based on the experiences of assessing compliance with the CPs for banking supervision, is that the methodology also could be extended to assessing compliance with standards in other areas of the financial sector.

18.   The main findings of this study have been discussed by the Basel Core Principles Liaison Group (CPLG). This provided a valuable opportunity for an exchange of views with supervisors from industrial, transition, and developing countries. The Group welcomed the findings, endorsed the value of the methodology, and saw the outcomes as very helpful to countries wishing to improve their standards of supervision. Supervisors from three of the countries that had been assessed were present at the meeting, and all were very positive about the results. The Group thought the CPAs were most useful in the context of broader assessments, particularly under the FSAP although many participants also saw value in stand-alone assessments. Most participants saw the objective of the CPAs as aiding the process of implementation rather than judging the adequacy of supervisory systems; publication of the results could, therefore, delay the implementation process. The Group looked forward to further discussion of CPAs in the context of the forthcoming re-examination and possible revision of the Core Principles.

19.   Looking ahead, a number of CPAs will be conducted in FY 2001 by the Fund and the Bank, mostly as part of planned FSAP missions. (See "Financial Sector Assessment Program—Progress Report—Lessons from the Pilot Exercise and Next Steps" SM/00/54 on Fund experiences to date with FSAPs). The Basel Committee and the CPLG will hold a workshop in May 2000 to take stock of experiences with the CPs and the CPAs. Fund and Bank staff will participate and this paper, together with the Board’s conclusions, will be a major input.

20.   This section presents the main findings from the CPAs conducted so far by the Fund and the Bank. It also compares these findings with self-assessments conducted for the BCBS in 1998. While these data are not robust enough (because they are based on small samples) to present statistically well-founded conclusions, nonetheless, the findings provide some useful indications confirmed by many assessors and officials in assessed countries. The assessors, at least two for each CPA, included in about 80 percent of the cases at least one experienced banking supervisor, drawn from Fund staff or from active or retired staff of various supervisory agencies. All recent CPAs were conducted by at least two supervisors from different supervisory traditions, as recommended by the Basel Committee.

Summary of the findings

21.   In all the 26 CPAs conducted by the Fund and the Bank, each of the CPs was rated according to the four-grade scale of compliance recommended in the Appendix to the Core Principles Methodology paper. The assessments for each CP were then aggregated across all the 26 countries (see Table 1).

Areas in which compliance was most frequently identified as weak

22.   The results of the assessments analyzed show that compliance with the majority of individual CPs is far from satisfactory. Significant resources, at both national and international levels, including those of the Fund and the Bank, will be needed to assist in improving compliance. These resources will be needed for the drafting of legislation and regulations, for improving implementation and, in particular, for building institutional capacity to enable improved and effective supervision.

23.   Useful insights can be gained by examining those CPs in which compliance has tended to be the weakest, as measured by the percentage of countries receiving a compliance rating of 3 or 4 for that particular CP. The following are the main findings:

• CP 7 on credit policies. Since losses from credit exposures remain the largest threat to the financial stability of banks, in particular less complex and smaller banks, the frequently noted lack of comprehensive policies for credit granting and monitoring gives reason for concern. This also points to where the focus of Fund staff should be in its surveillance work.

• CP 11 on country and transfer risk. Due to the increasing extent of cross-border exposures by banks, it is worrisome that many countries do not yet require banks to apply comprehensive systems and procedures for identifying and monitoring those risks, including guidelines for setting aside provisions.

• CPs 12, 13, and 14 on market risks, other risks and internal controls. The weaknesses are generally of two kinds. Either the prudential regulations and rules are too narrowly drawn, in that not all major risks are included, or the regulations focus on the legal formalities and do not take a comprehensive view of the overall risk and control environment. It is crucial that risk management systems and internal control functions are well designed, especially for those banks entering into more sophisticated activities. If there are severe shortcomings in such systems and control functions, the supervisor has no practical means of supervising banks effectively.

• CP 15 on money laundering. Considering the increasing risk of banks being used for improper purposes, such as money laundering and fraud, rules for their prevention must be strengthened.

• CP 20 on consolidated supervision. Since banks, and other financial group structures, are becoming more common and complex in many countries, they need to be supervised on a consolidated basis so that the supervisor can have an understanding of the overall situation of a bank and its affiliates, and so be able to spot potential weaknesses. This may require additional legislative authority and more skilled resources.

• CP 22 on remedial measures. In order to prevent bank problems from escalating, or becoming systemic, it is important that supervisors are given the powers to apply prompt corrective action, and avoid unnecessary forbearance.

• Subpart 2 refers to the crucial need for supervisory authorities to possess substantial operational independence and adequate resources; deficiencies here, including political interference, severely hamper effective supervision.

• Subpart 4 requires the supervisor to have the powers to take remedial action. A related problem is that banks in some countries do not comply with the supervisors' orders or recommendations and supervisory enforcement is weak—for example, because of delays or other shortcomings in the judicial system, political interference, severe supervisory staff shortages, lack of leadership or poor morale).

• Subpart 5 refers to legal protection for supervisors. The CP assessors have noted many cases where legal action against supervisors, or the threat of such actions, have hindered the prompt execution of necessary supervisory measures.

• Subpart 6 refers to the capacity of supervisory authorities to exchange information. In practice, such exchanges seem not to pose major problems even when written or other formal agreements are lacking. However, the willingness to share information has, in many cases, not yet been fully tested--for example, in problem situations. It might also be noted that many developing countries complain that major industrialized countries do not seem to give priority to concluding written agreements on information sharing with them. Such agreements are rare in those countries assessed.

25.   Those CPs for which compliance commonly has been identified as "weak" are especially important for the conduct of effective supervision, and, more generally, for the stability of the banking system. These CPs are also the more comprehensive ones, requiring substantial efforts by supervisors and banks to ensure an adequate degree of compliance. This suggests that considerable attention to recommended supervisory and regulatory reforms needs to be given in FSAP diagnoses and Fund programs, using structural benchmarks to address these deficiencies, taking account of broader macroeconomic and macroprudential considerations. TA resources also need to be devoted to these areas. Learning from the experiences of the CPAs, even more emphasis might be put on assisting countries to set priorities, implement and thoroughly understand the issues behind observance of the CPs.

26.   Individual countries' overall compliance with the CPs (see Table 2) shows large differences in relative compliance. Six countries were assessed as having weak compliance with 14 or more of the 25 CPs; and in the two worst cases compliance was rated as being weak for 19 CPs. Countries in this group also tended to exhibit a higher degree of shortcomings in other CPs and in the preconditions for effective supervision, such as lacking an objective and reliable legal and judicial system and professional accounting and auditing systems with integrity. At the other extreme, five countries largely comply with all but five or fewer CPs.

27.   Based on the CPAs carried out so far, one can conclude that many countries are still far from achieving satisfactory compliance and much remains to be done. This applies not only to the enactment and implementation of laws, regulations and other rules and procedures, but also to the strengthening of the preconditions such as the legal and judicial framework. In addition, improvements in the macroeconomic framework will be necessary in many cases. On the other hand, for those countries closer to achieving adequate compliance, most of the preconditions and regulations are in place. What remains is thorough implementation both by the supervisors and by the banks themselves.

28.   There is no clear pattern as to which types of countries have high, or low degrees of compliance; the sample is too small for statistically verifiable conclusions. In all regions, there are both weak and strong countries. Also, the sample is too small to conclude whether larger, systemically important emerging economies are more compliant than smaller economies. As noted, only one industrialized country is included in the sample.

Implications for financial sector vulnerability

29.   The findings in many cases provide clear indications as to the potential sources of vulnerability within the banking sector. For example, when relevant prompt corrective action is not taken, relatively minor bank problems may grow into systemic crises. Also, when there are shortcomings in the identification and management of risks, vulnerabilities may build up in the banking system, unless prompt countermeasures are taken. As a third example, when control systems—both of a bank’s normal activities and for the avoidance of fraud and money laundering—are weak, problems may develop in banks without being detected. A fourth example may arise when supervision is not carried out on a fully consolidated basis; in such circumstances difficulties or losses in nonbanking affiliates can cause serious problems for the bank.

30.   Deficiencies in the preconditions are also particularly important. Weak accounting rules—especially lack of adequate loan loss provisioning rules and procedures—inefficient judicial and legal systems, or inadequately-skilled auditors may imply that vulnerabilities are less likely to be identified in time, or are not forcefully addressed, even when formal regulations and rules may be in place. For example, weaknesses in accounting, loan valuation and other practices may raise serious questions about bank capital adequacy regardless of how rigorously capital is defined, and how high reported capital ratios. In addition, weak market discipline and underdeveloped markets sometimes reflect the dominant role of government in directing and processing credit, and can constrain the scope and conduct of supervision.

Comparisons with self-assessments¹⁰

31.   Tables 3A and 3B compare the findings of the self-assessments with the CPAs carried out by the Fund and Bank. (The sample is limited to18 countries, as the remaining 8 countries did not respond to the Basel Committee’s self-assessment survey).

32.   The results are clear. Half of the self-assessments were materially different from the Fund/Bank CPAs; and in nearly all of those the Fund/Bank assessments were stricter. Only in 15 percent of the differences did a country take a stricter view. Moreover, in 21 cases the self-assessment judged a CP to be fully implemented but in the Fund/Bank CPA the same CP was graded as non-compliant—the lowest grade. This result suggests that many self-assessments were based on a deficient understanding of the purpose behind the relevant CP and the criteria for judging compliance.

33.   The self-assessments tended to focus more than the CPAs on formal compliance with legislation, regulations and other written material. They did not take fully into account the need for comprehensive implementation, both by the supervisory authority and by the banks.

34.   Self-assessments, it is clear, can rarely be used as a substitute for independent assessments made by the Fund and the Bank. However, countries' self-assessments do provide benefits to countries not only in improving their understanding of the CPs, but also in facilitating the Fund/Bank’s assessment by focusing the discussions on appropriate laws, practices, and other documentation. The BCBS has therefore encouraged all countries to do self-assessments.

35.   It should be noted that some countries have recently made self-assessments based on the methodology paper: these are much more comparable to the Fund and Bank CPAs than the earlier self-assessments. In the Western Hemisphere, the regional organization of bank supervisors has contracted a group of preeminent international experts to conduct CPAs, starting with the major countries.¹¹ Discussions are under way to establish how this effort can feed into the work of the Fund and the Bank and to what extent the Fund could participate in, and support this program for a broader group of countries. There is also an issue whether reliance could be put on CPAs conducted, for example, by large accounting firms reinforced as necessary by supervisory expertise.

Comparison of Fund/Bank CPAs conducted in different contexts

36.   The dozen assessments carried out after the first draft of the CP Methodology paper was issued show a sharp improvement in consistency, completeness, and quality. These include assessments that were carried out as TA assignments as well those conducted as part of broader assessments in the context of the Financial Sector Assessment Program. It seems that the broader the objective of the assessment, the greater attention is the given to the general preconditions. Hence, assessments that focus strictly on TA needs often have little choice but to focus more narrowly on the CPs, while missions made up of larger teams, with broader sets of skills not only tend to provide more complete coverage of the preconditions, but also incorporate more fully the interactions between the preconditions and the CPs in their assessments.¹²

37.   The narrower CPA assessments require considerably less resources than the broader assessments. A narrower assessment will generally be sufficient at the start of a TA program. Such CPAs can then be updated and reviewed in the broader perspective of an FSAP mission, which can also review improvements implemented since an earlier assessment.

38.   Four CPAs have been completed so far as part of the FSAP and FSSA process. These CPAs, together with assessments of financial system risks and other relevant financial system standards, provided an overall picture of financial system stability in these countries. These CPAs benefit from the broader perspective of the FSAP/FSSA. It is usually effective to link CPAs to the FSAP/FSSA process so that risks and vulnerability assessments can be combined with the CPA to produce the overall assessment needed for effective surveillance and thus set appropriate priorities for reforms. Such a procedure ensures that the findings of the CPA is properly interpreted, taking into account the broader institutional and macroeconomic context.

39.   Stand-alone CPAs can also be useful in identifying weaknesses and strengths in banking supervision, and in helping to develop an action plan to address weaknesses. Such cases would include the undertaking of a CPA as part of the preparatory work for an Article IV mission, where special attention to banking and macro-prudential issues are considered important for surveillance, or for the design of Fund programs. Other cases include the preparation of TA programs in banking supervision, or as a basis for specifying components of a Technical Cooperation Action Plan (TCAP). Stand-alone CPAs would typically be done at the request of the area department and/or the country authorities.

40.   Notwithstanding the usefulness of such stand-alone CPAs, there will not be sufficient resources available to do all such assessments, at least in FY 2001. It is envisaged that CPAs normally will be done in the context of the FSAP and restricted to those countries participating in the FSAP. Therefore, to the extent stand-alone CPAs are done, they will be undertaken under the TA program and TA priorities

41.   An important use of CPAs is that they provide a basis for making recommendations on supervisory and regulatory reforms. Fund and Bank CPAs usually list recommended actions, often in order of priority, and provide a good basis for follow-up by the country, and by the Fund and Bank. Indeed, in addition to stimulating countries' own policy priorities, experience has shown that CPAs have already provided the basis for effective TA by both the Fund and the Bank in a number of countries, and have also helped in the design of programs for the use of Fund resources.¹³

Recommendations given priority

42.   A clear tendency in Fund and Bank CPAs is to give priority to reforms relating to those CPs which show a low degree of compliance and where reforms are the most pressing from a macroeconomic and macroprudential perspective. In other cases, priority may also be given to measures which yield major benefits and are relatively easy to implement, even if the country is largely compliant with the CP in question. The time frame for implementing reform measures also needs to take into account the capacity of the national authorities and, often, the availability of external expertise to provide required TA.

43.   Some of the individual CPs that have been given priority in a number of countries include:

• Introducing and implementing consolidated supervision and prudential reporting;
• Introducing and implementing systems for managing and monitoring banking risks;
• Strengthening the supervisor’s powers to take prompt remedial action;
• Introducing methods that mitigate against forbearance; and
• Improving the functioning and independence of the supervisory authority.

Identification of problems beyond laws and regulations

44.   Beyond identification of weaknesses such as inadequate laws, regulation or other written material Bank and Fund assessors have often identified weak implementation and/or understandings by the supervisor in the following areas:

• Systems for managing and monitoring various types of risks, in particular more complicated forms of risks;
• Cross-border supervision and relations with foreign supervisors;
• Relations and information sharing with other domestic supervisory agencies;
• Requirements for the licensing of banks; and
• Weaknesses relating to the supervisory authority itself.

45.   A more general issue is the handling of prudential violations, where the experience from CPAs is that the practice in many countries is not sufficiently transparent. As a result, it may be quite difficult for the assessor to evaluate the degree of enforcement. Unfortunately, assessors have found that forbearance is relatively easy to hide or disguise—sometimes because both the affected bank and the supervisory authority believe that hiding the supervisor’s inaction is in their mutual interest.

46.   Another general issue is that many countries tend to be very strict on formal rules but less strict on their practical application. For instance, rules may require bank managers to have academic degrees approved by the supervisory authority—but without any formal requirement for a thorough understanding of the bank’s business. Another example is that large amounts of data are often collected through the prudential reports, in accordance with closely defined formats, but without sufficient capacity to do the necessary analysis or even determine its relevance. A mass of data makes it difficult for an outside assessor, in the short time available, to evaluate whether all the important information is included and whether the quality of the information is good.

47.   Based on the CPAs conducted so far, a number of areas for improvement have been identified. These refer both to the CPs themselves and to the assessments process:

Areas in which CPs can/should be improved or expanded

48.   The CPA process is one of the instruments available to address an important goal of the Fund, namely to identify and help member countries address weaknesses in their financial institutions and infrastructure in order to strengthen their financial systems. In the banking and bank supervision area, the CPs can contribute to this goal, provided that they are explicit and comprehensive enough and that the criteria for fulfillment reflects what is needed for sound regulation, supervision and banking practice. However, the CPs, and the criteria for their assessment can never be detailed and comprehensive enough to cover all possible ramifications. The assessor must be left sufficient room for judgment—for instance to take into account specific domestic circumstances and the evolutionary nature of international supervisory and regulatory minimum standards and best practices.

49.   In general, the CPs, as presently drafted meet these objectives. However, during Fund and Bank CPAs, assessors and the assessed countries themselves have identified some shortcomings in the CPs, while there remain differences over interpretation and measurement. Moreover, CPs need to be broad enough to cover all relevant aspects of the banking system. There are some gaps, where new CPs need to be added. However, it should be noted that the shortcomings do not always lie in the CPs themselves, but in the lack of broadly accepted international standards in some areas, for instance in accounting and loan valuation practices.

50.   The responsibility for amending the CPs belongs to the Basel Committee on Banking Supervision and to the related Core Principles Liaison Group, in which the Fund is represented. Fund staff have pointed out to the Basel Secretariat the need for possible changes in the CPs. Appendix II describes in greater detail some of these findings.

51.   The problems of weak accounting standards and implementation of legislation have already been mentioned. Often many countries may seem to be in compliance with particular CPs, but in reality are not. For example, the 8 percent capital adequacy ratio is often not met because the valuation of assets, liabilities and own funds do not reflect actual values and as a result the reported capital adequacy ratio is misleading, and needed corrective actions are delayed. The same applies to CP 8 on loan evaluation and loan loss provisioning. When evaluation and provisioning rules do not reflect actual realizable values, the financial strength of the bank, as reported, will be overestimated. Such weaknesses also have systemic and macroeconomic importance. If the loss situation is generally underestimated and the banks' financial strength is overestimated, the analysis of the overall economic situation may be misleading.

52.   Consequently, the area of accounting issues needs further consideration. In many countries, although not in all, supervisors have an influence in the rule-making process for setting accounting standards and practices for financial institutions. However, what is needed is not so much an amendment of the CPs relating to accounting but rather a strengthening, harmonization and elaboration of international accounting principles and standards, especially when it comes to valuation of bank loans. The relevance of true compliance with many CPs depends on reliable accounting and valuation practices, and an independent and competent external audit profession.

53.   With minor exceptions, the CPs do not address the issue of exit procedures for banks. This issue is important for financial sector stability and also for supervision. There is a need for clear rules to be applied in exit cases (such as voluntary or forced liquidation and bankruptcy), thereby strengthening incentives for banks to apply sound policies. Experience with bank problems in many countries is that the exit process is often drawn out and cumbersome, often leading to increasing losses to the banks and costs to the public sector.

54.   The CPs also need to address disclosure issues. Increased disclosure of relevant and informative bank data, for example, quantitative measures of credit and market risk, would enhance market discipline on banks, help financial markets work better and thereby assist the supervisory process.

55.   In addition, the two appendices to the present CP document—on state-owned banks and on deposit protection systems—should be included in the CPs, and be assessed alongside the others. Both refer to important aspects of the financial system. For state-owned banks the main criterion would be that such banks operate on the same conditions and terms as other banks. For deposit protection systems, international best practices should apply. Since the CPs were written there has been a convergence of views internationally as to the minimum norms to be applied for such schemes.¹⁴

Areas where CPAs may not accomplish envisaged objectives

56.   This section discusses situations where the Fund and Bank CPAs for various reasons may not be able to fulfill their objectives of objectivity and completeness. It should be noted that the conclusions refer to the present situation, after the introduction of the methodology paper.

57.   Due to lack of manpower and time, the assessments are not always as in-depth as warranted to identify all the underlying weaknesses. It is also difficult to obtain a thorough understanding of the adequacy of supervisory staff numbers and skills, as well as the skills of commercial bankers. A genuine assessment of bank supervision requires in-depth on-site review—including interviews with supervisors and bankers—resulting in well-researched judgments on institutional capacity and supervisors' concrete achievements. Further, assessors require a deep understanding of the "functioning" of a country’s banking system to be able to evaluate comprehensively whether the supervisory authority has full autonomy in all practical aspects. In some obvious cases, it is easy to spot forbearance but often there is no hard proof, and the assessor must depend largely on anecdotal information.

58.   In light of the these considerations, the Fund might need to exercise greater flexibility when deciding on the extent of resources to allocate to specific assessments. For example, more resources and time might be devoted to a country that has systemic importance, or to a country with a more complex banking and financial structure, or to one where the financial sector is particularly vulnerable. This is envisaged under the FSAP.

59.   In many countries, supervision of banks is more sophisticated than the supervision of other financial institutions and markets, and can run ahead of the financial infrastructure, particularly the legal and judicial framework which can sometimes hinder effective banking supervision and prudential enforcement. In other cases, criteria governing CPs may be too sophisticated relative to the state of development of a country’s financial markets and infrastructure. When conducting a CPA, these features may be identified in the overall context of a particular country, but may be difficult to relate to the state of compliance with individual CP.

III. Dissemination and Publication

60.   CPAs often contain information and judgments that are sensitive in relation both to individual institutions and to public policy agencies. Information which relates, for example, to a particular bank can, in general, remain strictly confidential. More general assessments and information about the banking sector as a whole, raise issues of disclosure similar to those in FSAPs and related Fund surveillance documents. In addition, the newness of the compliance assessment process and the selectivity of countries assessed raise additional concerns.

61.   While many CPAs have been done separately for TA purposes, CPAs have been increasingly accepted as part of the Fund’s Article IV surveillance process. CPAs have been an integral part of the joint Fund/Bank FSAP and of the Fund’s Financial System Stability Assessments (see "Financial Sector Assessment Program-Progress Report-Lessons from the Pilot Exercise and the Next Steps" SM/00/54). Summary versions of CPAs have thus far been made available for Article IV Board discussion in the context of four FSSAs; the detailed CPAs contained in FSAPs have been made available only to the authorities in the country concerned. The summary version of the CPA will also be included as the financial system module of the experimental Reports on Standards and Codes (ROSC). In all these cases, CPAs were done without any presumption of publication. Moreover, there is a view in the supervisory community and the Basel Committee that countries which are assessed would need time to introduce the recommended reforms and corrective measures before being subjected to assessments that are publicized. Presumption of publication may also result in countries being less frank in the discussion of supervisory weaknesses.

62.   Therefore, while publication would provide market participants with information which they could not otherwise obtain—leading to better market discipline and better informed judgments—any presumption toward publication at this stage, could discourage countries in undertaking assessments and affect the confidential nature of the Fund’s advisory role.

63.   Notwithstanding this need for the confidentiality of CPAs at this stage, some countries which have been assessed by Fund or Bank staff may wish to forward the assessment to a limited group of recipients, for example to supervisors in countries where the assessed country’s banks have foreign branches or affiliates, or to a regional supervisory organization, or to publish the results so as to allow market discipline to work in a more informed manner. Where this national prerogative to release the CPA is exercised, the Fund staff would have no grounds for objecting to the wider circulation of these findings, and in the interest of international cooperation and transparency, their circulation or publication would be encouraged.

64.   This paper has reviewed the limited experience thus far in conducting CPAs. The reactions from the authorities in the countries surveyed have been positive, most recently at the CPLG in February 2000 where an early draft of this paper was discussed and many supervisors welcomed the findings. In most cases, the country authorities have cooperated fully in the work of the assessors and have accepted their evaluation. Not surprisingly, the assessments of compliance found a wide variety of results, both between and within countries, as well as more general weaknesses. Some of the major areas where supervisory and prudential deficiencies have been identified include: (i) systems for managing and monitoring bank risks; (ii) the taking of prompt corrective action in problem situations; and (iii) the implementing of consolidated supervision. An important general weakness lies in the implementation and enforcement of existing laws and regulations. Apart from the CPs themselves, frequent weaknesses have been found in some of the preconditions for effective banking supervision, such as in accounting (and loan valuation) systems, and in the legal and judicial framework. These need to be addressed with priority, and with the support of TA from the Fund, Bank and others.

65.   This study found significant benefits from carrying out broad-based assessments as part of the Fund’s general surveillance operations, especially in the context of an FSAP. While such broad-based assessments are more resource-intensive, they provide more usable indications of macroeconomic and financial vulnerabilities, as well as a more complete assessment of the strengths and weaknesses of systems of bank supervision. At the same time, stand-alone CPAs are less resource-intensive and, as has already been shown in a number of countries, can produce valuable inputs for designing a reform agenda and technical assistance programs.

66.   A comparison of CPAs made by the Fund and the Bank with self-assessments made in 1998 in accordance with a survey by the BCBS suggests that self-assessments have tended to be much more optimistic about compliance than the CPAs made by the Fund and the Bank. This notwithstanding, self-assessments are useful and strongly encouraged by the BCBS; self-assessments made with the help of the new methodology are proving to be more consistent.

67.   Particular attention is being given in the CPA reports to reforms in areas with low compliance, in areas where reforms are most pressing in light of identified vulnerabilities and where governments are most interested to make progress, taking account of realistic timeframes and the capacity of the authorities.

68.   Difficulties in carrying out compliance assessments include: going beyond the existence of formal rules to the much more difficult issue of the extent of implementation and enforcement (forbearance); resource constraints for the assessors; major measurement problems (due to the lack of international accounting standards) in asset valuation and loan loss provisioning; and gaps in the Core Principles themselves as elaborated in Appendix II.

The views of the Executive Directors are sought on the following issues:

• Do Directors agree that the CPAs have proved useful to countries concerned in identifying weaknesses in banking supervision, and hence in helping countries strengthen their financial infrastructure?

• In the light of the areas of weak compliance, do Directors feel that the Fund should increase its focus on promoting reforms, for example, through TA targeted to a greater extent on those areas?

• Do Directors agree that assessments of compliance with the Core Principles as an input in Fund surveillance are best undertaken as an integral part of the FSAP and FSSA process in order to provide input on the broader preconditions for the assessment and on the vulnerabilities and risks that need to be managed?

• Do Directors agree that self-assessments or assessments by external parties such as large accounting firms can be useful, provided they are based on the agreed methodology?

• What are Director’s views on encouraging the wider disclosure of CPAs, or of summaries or extracts from them? Do Directors support the BCBS view that countries be given the opportunity to implement reforms before assessments are publicized, and that any decision to publish CPAs in full or summary form should be a national prerogative.

• Do Directors feel that there is a need to have more incentives for countries to participate in CPAs, or should the gains from a more robust financial system be sufficient incentive?

Appendix 1

Tools used

69.    Fund and Bank assessments have, with experience gained, become more standardized and comprehensive. In the assessment process, the most intense discussions are with the bank supervisory authority, regardless of whether it is an independent agency or the central bank. Meetings are also held with the Ministry of Finance, the Deposit Insurance Agency (where one exists), and other supervisory authorities. Assessors meet with bankers representing different categories of banks (private and state-owned; domestic and foreign-owned; savings banks and commercial banks), with accountants and auditors; and independent persons, including former officials or bankers.

70.   The assessments are based on reviews of a large amount of relevant legislation, regulations, guidelines, reports, and other information. The documentation is reviewed with supervisors and others. As noted above, implementation, understanding and enforcement are to some extent judged by examining written material. However, discussions with various parties also play a major role. The assessment may involve limited use of confidential material, such as examination reports of a sample of individual banks. Such reports provide important information about the efficacy of the supervisory process.

71.   In most countries the amount of information to be digested is very large. Time constraints limit more in-depth assessment. However, the time available is normally enough to conduct an adequate assessment for the stated purpose: to identify major weaknesses and strengths, and to compile a list of measures needed for improved compliance.

How were the assessments used

72.   Besides being used for measuring the progress of implementing banking supervision, the CPAs conducted by the Fund as part of TA programs and Article IV missions have been used to provide priorities for TA programs and structural benchmarks for Fund-supported programs. This have proved to be effective in facilitating changes in laws and regulations and improvements in supervisory practices needed to create a comprehensive framework for more effective banking supervision. The CPAs conducted in the context of traditional Article IV consultations and as a part of a FSAPs help provide a better understanding of financial sector vulnerabilities more generally.

How disagreements were handled

73.   Almost all assessors have acknowledged a positive attitude from their counterparts. In most cases, the country assessed has accepted (either verbally or in written comments) the evaluation of the assessor. Also, misunderstandings resulting from the interpretation of written material or from evaluations reached during the discussions have been promptly corrected after they were pointed out by the authorities during missions or in their written comments on the assessment. When more substantive disagreements have occurred they have, normally, related to the specific circumstances peculiar to the country concerned. .

74.   Differences in interpretation may also occur when a country is close to enacting new legislation or implementing measures leading to improved compliance. Since the assessments are made "as of the date of the assessment" (this is not defined, but is generally taken to mean the final day of the assessors' visit to the country) no measures to be implemented after that date will be taken into account in the rating of compliance, regardless of the likelihood of such implementation. However, the assessments will contain information, for example timetable and contents, on all plans for improving compliance.

75.   In sum, no country has yet made any substantive complaint about the assessment procedure or objected to the overall assessment. In accordance with the methodology, all countries have the right to comment on the final assessment and to have their views included in the assessment report.

Improvements to the methodology

76.    The methodology is based on criteria designed to ensure an adequate regulatory and supervisory framework, but is not specific on how the institutional capacity and the willingness to carry out proper supervision should be assessed. As noted above, evidence from the review of CPAs carried out so far suggests that the latter is crucial for effective supervision. Hence, the methodology may need to be examined and strengthened on this point.

77.   As mentioned above, a number of assessment criteria may need to be clarified. In addition, any review of the CPs themselves will lead to a necessary modification of the criteria. For practical reasons, amendments to the CPs and to the assessment criteria should be discussed and implemented simultaneously.

78.   Apart from those considerations, no major shortcomings in the methodology paper have been found.

Appendix 2

79.   The Fund participates in the Basel Core Principles Liaison Group’s (CPLG) work on reviewing the CPs and the methodology for assessing them. The information in this Appendix is intended to be presented to this group.

80.   An overriding issue is the coverage of a CPA. The Core Principles apply to "banking supervision." Principle 2 states that "the activity of taking a proper bank deposit from the public would typically be reserved for institutions that are licensed and subject to supervision as banks." However, in practice there is no strict definition of a "proper bank deposit." Most countries have financial institutions that perform bank-like activities, including some kind of deposit-taking—for example, credit unions/cooperatives; development financial institutions; and finance companies. Most of these institutions are regulated and supervised, although sometimes by different authorities and with different rules. In some countries, nonbank financial institutions have a significant market share in bank-like activities.

81.   The methodology states that when bank-like institutions form a significant part of the market, these should also be included in the assessment. However, conducting full assessments for all different groups of institutions would greatly expand and complicate the assessment and there are no guidelines on how to proceed, for example should there be multiple assessments or just an aggregate? So far, this issue has been solved by including in the assessment the core banking categories (the systematically important ones) for which the main laws, regulation and supervision are intended. Other categories are summarily described in a section on "the financial structure," which describes how these institutions are regulated and supervised and the main differences from the regulations and supervision applicable to the core bank category.

82.    Given that nonbank financial institutions may be systemically important for financial stability, there is a need for further guidance on the treatment of these institutions in the assessments. More generally, the implementation of standards would be enhanced if the international standard-setting bodies for various categories of financial institutions and markets could harmonize their respective "Core Principles." On the specific issue of "proper bank deposits," there is a need for a more precise definition.

83.   It is important that the CPs are clear and comprehensive so that a country can see what needs to be done for full compliance. It is also important that the CPs, individually and taken together, are detailed enough to contribute to a reasonable degree of financial stability. As a result of the Fund/Bank CPAs, some areas have been identified where there is room for further improvements of the CPs.

• CP 1, dealing with the overall legislation, regulation and supervision of banks, is crucial to the fulfillment of the other CPs. For instance, if the supervisory authority is not independent, it is of only limited use if other prudential regulations are in place. In the area of defining a truly independent supervisory authority, adequately staffed and equipped, more needs to be done (e.g., how should an independent supervisory authority be financed, what should be the minimum level of staff numbers and qualifications in relation to their tasks, to what extent shall the head of supervision, and the staff, be legally protected?).

• CP 2, dealing with the definition of "bank" is also highly important in order to ring-fence the systemically important area for the bank supervisor. As noted, the definition of "a proper bank deposit" needs clarification.

• CP 3, dealing with licensing of banks also needs clarification to better cover more complex banks and bank groups coming into the market. For instance, it is increasingly important that bank managers do not only have the formal qualifications for their work, such as academic degrees, but also have proven expertise in their bank’s activities. It is also increasingly important that the organization of the bank is commensurate with its intended activities.

• CP 7 and other CPs referring to the various risks (credit, market, country and transfer, and "other" risks) should more explicitly require specific policies for each type of risk, and an overall risk policy framework, taking a comprehensive approach to the bank’s risk management. A similar recommendation applies to CP 14 on internal controls. It is not enough to audit and monitor transactions and operations; the internal control function must be integrated into the ongoing and planned activities of the whole bank on a comprehensive basis.

• CP 8, on loan evaluation, is somewhat formalist and at the same time too lenient. CPAs show that international practices on classifying loans are widely divergent, both as to the time of nonpayment of interest and amortization, and to the amount (percentage) of provisioning. More precise guidance should be included in this CP. The classification should also explicitly include exposures where payment has not yet been overdue for the specified number of days, but where the expectations of nonpayment for various reasons are large. Also, the treatment of collateral when classifying loans and making provisions should be clarified.

• The present formulation of CP 9, on large exposures, and CP 10, on connected lending, allows for rather wide differences in definitions of "related groups of borrowers" when dealing with risk concentrations, and "connected or related borrowers" for the purpose of limiting insider borrowing. Some countries apply broad definitions and others are much more restrictive. More precision in the assessment criteria is warranted.

• CP 11 on country risk and transfer risks is the weakest of all CPs regarding overall compliance. When countries attempt to implement international standards in this area, they find little up-to-date guidance, for example, in written documents from the BCBS. Hence, there is a need to make the criteria of the CP more explicit and/or to produce a policy document for guidance. This is an area where several authorities falsely thought they were in compliance because they misinterpreted the objectives and requirements of the CP.

• CP 20 and other CPs dealing with consolidated supervision, consolidated prudential reporting or consolidated financial accounts need clarification of the extent of consolidation required.

• CP 22, dealing with remedial action, should be more explicit and clear. While not necessarily (at least not in the essential criteria) requiring a detailed "prompt corrective action" template, it should clearly spell out types of timely and appropriate action to be taken at defined situations, such as when a bank falls below the statutory capital adequacy ratio or when it falls below even lower levels, including going into a net negative capital position. In relation to this, the CPs should also be more explicit on "exit processes" for banks, such as going into liquidation or bankruptcy.

• CPs 23 to 25 dealing with cross-border supervision, should be more precise, for example as to the duties of home and host country supervisors and the content of the agreements between the supervisors. There is also a need to define the criterion of "the home country supervisor establishes informal or formal arrangements (such as memoranda of understanding) with host country supervisors..." This criterion has proven to be difficult to interpret, e.g., whether an informal relation not based on any written agreements may be regarded as adequate compliance.

• The two appendices to the CPs, dealing with state-owned banks and deposit protection systems should be upgraded to become, and be assessed as, CPs. The experiences of the CPAs conducted has confirmed that these two areas are of major importance for the effectiveness of banking supervision and for financial stability in general. In addition, it may be noted that on deposit protection schemes, there has, since the CP paper was issued, been a convergence of the views relating to international best practices.

• There is no grade "not applicable" in the CP methodology but in cases when a CP is clearly not applicable (such as compliance with CPs for cross-border establishments when there are no such cases) no grade is given. In all other situations a grade is given, even when the application of the CP is very limited—for example, when there is only one bank with an overseas branch. Some assessed countries have found this overly strict. However, the Fund/Bank argument is that it is reasonable to assess a grade as soon as there is any relevance to this CP for the country concerned, otherwise it will be difficult to define when the CP becomes sufficiently relevant. In addition, the occurrence of one case — for example, of one bank’s branch abroad—can signify a new trend. So the definition of "not applicable" should be confirmed.