## PALAU: Banking Supervision, Prudential Regulation, and AML/CFT — Mission Findings and TA Recommendations

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### MAE-led mission and scope
- An MAE-led mission visited Koror during April 3–16, 2002, to conduct a Module 2 assessment under the IMF’s Offshore Financial Centers initiative.
- Assessment focus:
  - Compliance with international supervisory standards (Basel Core Principles).
  - Anti-money laundering arrangements in the banking sector using the IMF and World Bank expanded AML methodology dated February 7, 2002.
- Mission team: Mr. Luca Errico (Mission Chief, MAE, IMF), Ms. Cecilia Marian (Legal Department, IMF), Mr. Tuomo Malin (Financial Supervision Authority of Finland); assisted by Mr. John Vaught, MAE Banking Supervision Advisor assigned peripatetically to the Financial Institutions Commission of Palau.
- Meetings held with: the President of the Republic of Palau; the Minister of Finance; the Minister of Justice; the Attorney General; the Chair and members of the Financial Institutions Commission (FIC); the Acting Executive Commissioner of the FIC; the Coordinator of the Financial Intelligence Unit (FIU); senior members of the Olbiil Era Kelulau (OEK); representatives from the Chamber of Commerce; the National Development Bank of Palau (NDBP); and foreign and domestic private commercial banks.

### Key background facts and immediate outcomes
- The Financial Institutions Act (FIA) and four anti-money laundering laws were enacted in June 2001.
- Of the "30 plus financial institutions known to be active in Palau", only 12 applied for a banking license under the FIA “grandfathering” provisions.
- Around September 2001, authorities revoked the licenses of 10 shell corporations registered as banks.
- The Offshore Banking Act was repealed in 1982; company service providers and International Business Companies (IBCs) were non-existent, leaving offshore business virtually absent.
- Authorities volunteered to participate in a Forum Secretariat and Asia/Pacific Group on Money Laundering initiative funded by LEG and indicated intention to join the Asia/Pacific Group on Money Laundering.

### Major findings — Banking supervision and prudential regulation
- Overall observance of the Basel Core Principles (BCPs): assessed as modest given the newness of prudential supervision and lack of implementation capabilities.
- Compliance categorization (mission counts):
  - Compliant with 1 Core Principle (CP)
  - Largely compliant with 6 CPs
  - Materially non-compliant with 7 CPs
  - Non-compliant with 11 CPs
- Major legal and institutional weaknesses jeopardizing effective supervision:
  - Excessive influence of banking industry representatives on the FIC’s Governing Board (GB).
  - Lack of legal protection for the FIC’s GB and staff.
  - Constraints on lawful exercise of FIC regulatory and supervisory powers, including Sections 79(a), 62(b)(3), and 33(b) of the FIA.
  - Limitations on FIC operational autonomy and inability to fully recover financing and budget needs from supervised entities (Sections 34 and 79).
  - “Grandfathering” provisions limit FIC’s ability to ensure solvency, liquidity, and proper management of the 12 applicant institutions prior to licensing.
  - Overly-extended transition periods for coming into compliance with prudential requirements (Section 77(b)).
  - Insufficient requirements for timely preparation, certification, and disclosure of balance sheets and income and expense statements.
  - Use of the FIC to pursue government community reinvestment policy (Section 55) in a potentially undue manner.
  - Technical shortcomings in prudential requirements (detailed in Volume II).

### Major recommendations — Banking supervision and prudential regulation
- Governance and legal amendments (timing indicated by mission):
  - Designate and Senate-confirm the missing fifth voting member of the FIC’s GB as soon as possible; this individual should be from outside the Palauan banking industry. (Recommendation: Immediately.)
  - Amend Section 16 of the FIA to remove the ineligibility of government employees to serve on the GB. (Recommendation: Immediately.)
  - Amend the FIA to grant legal protection to the FIC’s GB and staff when acting in good faith within their authority. (Recommendation: Immediately.)
  - Remove Sections 79(a), 62(b)(3), and 33(b) of the FIA to eliminate undue limits on the FIC’s powers. (Recommendation: As soon as possible.)
  - Amend Sections 34 and 79 to allow the FIC to set by regulation the level of fees applied to supervised entities based on its funding and budget requirements. (Recommendation: As soon as possible.)
- Licensing, transition, and reporting:
  - Allow the FIC, at a minimum, to assess solvency and “fit-and-proper” criteria for the 12 applicants under “grandfathering” prior to granting banking licenses. (Recommendation: Immediately.)
  - Amend Section 77(b) to reduce the transition period for coming into compliance with all prudential requirements under the FIA to 12 months from the date the FIC was established, i.e., by February 21, 2003. (Recommendation: As soon as possible.)
  - Require that by the end of the transition period all licensed banks prepare annual consolidated balance sheets and income and expense statements following GAAP; have them audited by a reputable external auditor; and make them available to the public and the FIC. (Recommendation: As soon as possible / by end of transition period.)
  - Amend Section 55 to remove the requirement that the FIC propose regulatory and legislative measures to implement the government’s community reinvestment policy. (Recommendation: As soon as possible.)
- Staffing, implementation, and technical fixes:
  - Hire permanent staff for the FIC, including the Executive Commissioner, by and not later than the end of the current fiscal year (September 30, 2002). (Recommendation: By and not later than September 30, 2002.)
  - Implement the mission’s detailed technical recommendations to address prudential shortcomings as specified in Volume II. (Recommendation: As soon as possible.)
- Specific prudential amendments recommended:
  - Amend Section 53 to increase the CAR minimum to the international minimum of 8 percent.
  - Amend Section 31 to allow the FIC to set minimum absolute capital by regulation (current FIA reduced the absolute minimum from $1,000,000 to $500,000 and the CAR from 10 percent to 5 percent).
  - Include a risk management provision in the FIA enabling the FIC to make qualitative judgments and take timely corrective action.
  - Clarify rules on investment approvals and corporate affiliations and which investments require supervisory approval versus notification.

### Major findings — AML/CFT legal, institutional, and supervisory aspects
- Methodology used: “Fund and Bank Methodology for Assessing Legal, Institutional, and Supervisory Aspects of Anti-Money Laundering and Combating the Financing of Terrorism” dated February 7, 2002.
- Assessment results (12 broad criteria):
  - Compliant with 2 criteria
  - Largely compliant with 5 criteria
  - Materially non-compliant with 3 criteria
  - Non-compliant with 2 criteria
- Overall assessment: Largely satisfactory legal and institutional framework for preventing and detecting money laundering in the banking sector, but implementation capabilities need strengthening.
- Key gaps and weaknesses:
  - Supervisory responsibility for AML implementation and audit compliance not clearly identified.
  - If the FIC is assigned AML supervisory responsibility, some reporting entities (e.g., exchange offices and money transmitters) would remain unregulated and unsupervised by the FIC.
  - The FIU is established by legislation but lacks clear enforcement powers in the AML laws.
  - The FIU is understaffed and lacks expertise, especially in suspicious transaction analysis.
  - Banks lack clear guidelines and recommendations from the FIU for day-to-day AML implementation.

### Major recommendations — AML/CFT implementation
- Clarify supervisory responsibilities:
  - Assign the FIC responsibility for establishing AML policies and procedures for banks.
  - Give the FIU responsibility for day-to-day implementation (including on-site inspection) and enforcement of AML requirements for all reporting entities, including banks. (Recommendation: As soon as possible.)
- Strengthen FIU capacity and powers:
  - Provide the FIU with sufficient staff resources to fulfill duties under the AML legislation. (Recommendation: As soon as possible.)
  - Amend AML legislation to provide clear enforcement powers to the FIU and other technical amendments as specified in Volume II. (Recommendation: As soon as possible.)
  - Remove prohibition on FIU staff concurrently holding other public employment or elective office in Palau.
  - Provide the FIU with powers to issue regulations for effective AML implementation without parliamentary approval.
- Legal and operational amendments recommended to the AML law:
  - Specific record-keeping requirements and lower threshold for identifying casual clients.
  - Removal of the threshold of US$10,000 for the record-keeping requirement for customer identification.
  - Prohibition of anonymous accounts.
  - Clarification of suspicious transaction reporting requirements and extension of overriding secrecy/tipping off provisions.
  - Redefinition of money laundering to clearly set out the mens rea element and specification of predicate offenses (including extraterritorial similar offenses).
  - Extension of powers to confiscate proceeds, instrumentalities, and subject matter of offenses, with provisions allowing courts to order confiscation of property of equivalent value or a penalty sum when direct confiscation is unavailable.
  - Inclusion of adequate procedures to protect innocent and bona fide third-party interests.
  - Require customer identification for wire transfers.
  - Vest FIU with powers to disseminate information to relevant law enforcement agencies (foreign and local) with confidentiality safeguards; conduct on-site inspections and audit compliance; facilitate advisory activities, research, training, and public education; protect FIU, employees, and information from suit and compulsory legal process; and access sources of public information.
- Implementation and training:
  - Begin implementation of existing AML provisions immediately.
  - Provide banks with clear operational guidance from the FIU and deliver training to FIU staff and banks on practical AML/CFT implementation.
  - Establish a training program for the FIU, financial intermediaries, and the Attorney General’s office; technical assistance from MAE and LEG is envisaged.
  - Enact anti-terrorism legislation and issue regulations for registration of over-the-counter exchange dealers as soon as possible.

### Technical assistance needs, priorities, and program schedule
- Priority: Banking supervision and regulation should receive first priority for technical assistance (TA).
- Emphasis: Distinguish TA for drafting regulations and reporting forms from TA to develop implementation capabilities; prioritize intensive on-the-job, hands-on training for the FIC’s GB and staff.
- Timing: Hands-on training to begin as soon as the FIC’s budget is approved and permanent staff are hired.
- MAE and LEG are already providing TA, including this mission and peripatetic expert assignments; additional MAE & LEG TA would be considered favorably depending on authorities’ reform commitment and implementation record and subject to IMF TA budgetary constraints.
- AML/CFT TA needs: review and assist in drafting amendments to AML/CFT legislation; assist drafting AML/CFT regulations; assist establishment of a well-functioning FIU; provide training to FIU staff and banks.
- Planned TA visit durations by quarter (calendar year 2002 and subsequent periods):
  - 2nd Quarter 2002: 40 days
  - 3rd Quarter 2002: 60 days
  - 4th Quarter 2002: 40 days
  - 1st Quarter 2003: 60 days
- Selected TA activities include drafting regulatory reports and statistical data requirements; establishing off-site monitoring procedures and key ratios; analyzing condition and FIA compliance of existing banks; developing licensing criteria and pro forma business-plan requirements; prudential regulations on regulatory capital, risk-based capital and risk-weighted assets; asset classification and provisioning; and assistance in funding the FIC through fees and staffing/budget planning.

### Macroeconomic and banking-sector context (key statistics)
- Population: some 19,200 individuals.
- Per capita GDP: $6,180.
- Share of active workforce in public sector: 36 percent.
- Public sector wages share of all wages (1999): almost 50 percent.
- Legal tender: U.S. dollar.
- Real GDP growth: around 1 percent in the past two years.
- Overall fiscal deficit (FY2001): 15 percent of GDP, financed primarily by draw down of assets from U.S. Compact grant receipts.
- FY2002 Budget deficit target: reduction to 7 ½ percent of GDP.
- Price inflation (FY2001): 2 ½ percent.
- Current account deficit (including official grants) FY2001: around 13 percent of GDP; projected to increase to 14.8 percent of GDP in FY2002.
- Financial system composition:
  - 12 commercial banks (including 3 branches of U.S.-based banks),
  - 1 development bank (National Development Bank of Palau, NDBP),
  - 11 nonbank financial institutions,
  - a number of small credit unions.
- Offshore banking: not allowed since 1982.
- NDBP portfolio size: about $7 million, of which one-third is in residential housing.
- NDBP loans in arrears ("judgment loans"): about $0.7 million, or 10 percent of total loans.
- Deposit and lending rate ranges (1997–2000):
  - 30-day time savings accounts: 2 ¼-5 percent;
  - certificates of deposit: 4-8 percent;
  - consumer loans: 10-18 percent;
  - commercial loans: 9 ¼-13 percent.
- Three largest U.S.-based banks account for approximately 84 percent of total deposits; Bank of Hawaii alone accounts for nearly 57 percent of total deposits.

### Supervisory capacity, reporting, and training program priorities
- Key supervisory and regulatory areas identified for TA and drafting:
  - Statistical data and regulatory reporting requirements and forms (including reporting on related-party transactions and loans in excess of 10 percent of capital).
  - Off-site monitoring procedures and key ratios for capital adequacy, asset quality, earnings performance and liquidity, and establishment of a data base for automated ratio calculations.
  - Analysis of condition, operating performance, and FIA compliance of existing banking institutions.
  - Licensing criteria for new banking institutions, identification of beneficial owners, and forms/pro forma business-plan requirements.
  - Minimum criteria for entry of new significant shareholders (including change-of-control) and notification time frames.
  - Prudential regulations per FIA: regulatory capital, risk-based capital and risk-weighted assets; aggregation and attribution for credit exposure to single borrowers and related groups; asset classification and minimum provisioning; placement of nonperforming loans on nonaccrual.
  - Guidance on credit policies, asset quality, and other prudential practices adapted to local conditions.
  - Amendment to provide increased funding of the FIC by recovering supervisory expenses through assessment of fees for on-site examinations and fees for ongoing FIC operations, and assistance in staffing and budget planning.
- Hands-on training and assistance (selected priority activities):
  - Off-site monitoring training: review of regulatory reports, calculation and analysis of key ratios, checks for FIA compliance, and preparation of off-site monitoring reports.
  - Training in evaluation of banking license applications: review of financial statements of proposed principal shareholders, assessment of business plans and pro forma statements, and use of license conditions.
  - Training and assistance to the FIC Governing Board and Executive Commissioner on roles, reporting formats, delegation of duties, and proper use of discretion.
  - Development of on-site safety and soundness examination guidelines, standardized examination report formats, and procedures for enforcement actions and monetary penalties.
  - Training on GAAP and regulatory accounting practices.

_International Monetary Fund MAE-led mission to Palau, April 3–16, 2002._

### Preface.................................................................................................................

### Preface

### MAE-led mission and scope
- An MAE-led mission visited Koror during April 3–16, 2002, to conduct a Module 2 assessment under the IMF’s Offshore Financial Centers initiative.
- The assessment focused on compliance with international supervisory standards (Basel Core Principles) and anti-money laundering arrangements in the banking sector, using the IMF and World Bank expanded AML methodology issued February 7, 2002.
- Mission team: Mr. Luca Errico (Mission Chief, Monetary and Exchange Affairs Department, IMF), Ms. Cecilia Marian (Legal Department, IMF), and Mr. Tuomo Malin (Financial Supervision Authority of Finland). Assisted in the field by Mr. John Vaught, MAE Banking Supervision Advisor assigned to the Financial Institutions Commission of Palau on a peripatetic basis.
- Meetings were held with the President of the Republic of Palau, the Minister of Finance, the Minister of Justice, the Attorney General, the Chair and members of the Financial Institutions Commission (FIC), the Acting Executive Commissioner of the FIC, the Coordinator of the Financial Intelligence Unit (FIU), senior members of the Olbiil Era Kelulau (OEK), representatives from the Chamber of Commerce, the National Development Bank of Palau, and foreign and domestic private commercial banks.

### Key background facts and immediate outcomes
- The Financial Institutions Act (FIA) and four anti-money laundering laws were enacted in June 2001.
- Of the "30 plus financial institutions known to be active in Palau", only 12 applied for a banking license under the FIA “grandfathering” provisions.
- Around September 2001, the authorities revoked the licenses of 10 shell corporations registered as banks.
- The Offshore Banking Act was repealed in 1982; company service providers and International Business Companies (IBCs) were non-existent, resulting in offshore business being virtually absent in Palau at the time of writing.
- The authorities volunteered to participate in a Forum Secretariat and Asia/Pacific Group on Money Laundering initiative funded by LEG, and indicated intention to join the Asia/Pacific Group on Money Laundering.

### Major findings — Banking supervision and prudential regulation
- Overall observance of the Basel Core Principles for Effective Banking Supervision (BCPs) was assessed as modest given the newness of prudential supervision and lack of implementation capabilities.
- Major legal and institutional weaknesses identified that could jeopardize effective supervision:
  - Excessive influence of banking industry representatives on the FIC’s Governing Board (GB).
  - Lack of legal protection for the FIC’s GB and staff.
  - Constraints on lawful exercise of the FIC’s regulatory and supervisory powers, including Sections 79(a), 62(b)(3), and 33(b) of the FIA.
  - Limitations on the FIC’s operational autonomy and inability to fully recover financing and budget needs from supervised entities (Sections 34 and 79).
  - “Grandfathering” provisions that limit the FIC’s ability to ensure solvency, liquidity, and proper management of the 12 applicant institutions prior to licensing.
  - Overly-extended and unclear transition periods for coming into compliance with prudential requirements (Section 77(b)).
  - Insufficient requirements for timely preparation, certification, and disclosure of balance sheets and income and expense statements for licensed banks.
  - Use of the FIC to pursue government community reinvestment policy (Section 55) in a manner that may be undue.
  - Technical shortcomings in prudential requirements detailed in Volume II.

### Major recommendations — Banking supervision and prudential regulation
- Urgent governance and legal amendments:
  - Achieve designation and Senate confirmation of the missing fifth voting member of the FIC’s GB as soon as possible; this individual should be from outside the Palauan banking industry.
  - Amend Section 16 of the FIA to remove the ineligibility of government employees to serve on the GB. (Recommendation: Immediately.)
  - Amend the FIA to grant legal protection to the FIC’s GB and staff when acting in good faith within their authority. (Recommendation: Immediately.)
  - Remove Sections 79(a), 62(b)(3), and 33(b) of the FIA to eliminate undue limits on the FIC’s powers. (Recommendation: As soon as possible.)
  - Amend Sections 34 and 79 to allow the FIC to set by regulation the level of fees applied to supervised entities based on its funding and budget requirements. (Recommendation: As soon as possible.)
- Licensing, transition, and reporting:
  - Allow the FIC, at a minimum, to assess solvency and “fit-and-proper” criteria for the 12 applicants under “grandfathering” prior to granting banking licenses. (Recommendation: Immediately.)
  - Amend Section 77(b) to reduce the transition period for coming into compliance with all prudential requirements under the FIA to 12 months from the date the FIC was established, i.e., by February 21, 2003. (Recommendation: As soon as possible.)
  - Require that by the end of the transition period all licensed banks prepare annual consolidated balance sheets and income and expense statements following GAAP; have them audited by a reputable external auditor; and make them available to the public and the FIC. (Recommendation: As soon as possible / by end of transition period.)
  - Amend Section 55 to remove the requirement that the FIC propose regulatory and legislative measures to implement the government’s community reinvestment policy. (Recommendation: As soon as possible.)
- Staffing, implementation, and technical fixes:
  - Hire permanent staff for the FIC, including the Executive Commissioner, by and not later than the end of the current fiscal year (September 30, 2002). (Recommendation: By and not later than September 30, 2002.)
  - Implement the mission’s detailed technical recommendations to address shortcomings in the prudential requirements of the FIA as specified in Volume II. (Recommendation: As soon as possible.)

### Major findings — AML/CFT legal, institutional, and supervisory aspects
- Overall assessment: Palau has a largely satisfactory legal and institutional framework for preventing and detecting money laundering in the banking sector, but implementation capabilities need strengthening.
- Key gaps and weaknesses:
  - Supervisory responsibility for AML implementation and audit compliance is not clearly identified.
  - If the FIC is assigned AML supervisory responsibility, some reporting entities (e.g., exchange offices and money transmitters) would remain unregulated and not supervised by the FIC.
  - The FIU is established by legislation but lacks clear enforcement powers in the AML laws.
  - The FIU is understaffed and lacks expertise, especially in suspicious transaction analysis.
  - Banks lack clear guidelines and recommendations from the FIU for day-to-day AML implementation.

### Major recommendations — AML/CFT implementation
- Clarify supervisory responsibilities:
  - Assign the FIC responsibility for establishing AML policies and procedures for banks.
  - Give the FIU responsibility for day-to-day implementation (including on-site inspection) and enforcement of AML requirements for all reporting entities, including banks. (Recommendation: As soon as possible.)
- Strengthen FIU capacity:
  - Provide the FIU with sufficient staff resources to fulfill duties under the AML legislation. (Recommendation: As soon as possible.)
  - Amend AML legislation to provide clear enforcement powers to the FIU and other technical amendments as specified in Volume II. (Recommendation: As soon as possible.)
- Implementation and training:
  - Begin implementation of existing AML provisions immediately.
  - Provide banks with clear operational guidance from the FIU and deliver training to FIU staff and banks on practical AML/CFT implementation. (Recommendation: As soon as possible.)

### Technical assistance needs and program priorities
- Priority: Banking supervision and regulation should receive first priority for technical assistance (TA).
- Emphasis: Distinguish TA for drafting regulations and reporting forms from TA to develop implementation capabilities; prioritize intensive on-the-job, hands-on training for the FIC’s GB and staff.
- Timing: Hands-on training to begin as soon as the FIC’s budget is approved and permanent staff are hired.
- MAE and LEG are already providing TA, including this mission and peripatetic expert assignments; additional MAE & LEG TA would be considered favorably depending on authorities’ reform commitment and implementation record and subject to IMF TA budgetary constraints.
- AML/CFT TA needs: review and assist in drafting amendments to AML/CFT legislation; assist drafting AML/CFT regulations; assist establishment of a well-functioning FIU; provide training to FIU staff and banks.

_International Monetary Fund MAE-led mission to Palau, April 3–16, 2002._

### 1.      The mission assessed Palau’s observance of the Basel Core Principles for Effective

### cr04169 - 1.      The mission assessed Palau’s observance of the Basel Core Principles for Effective

### Overall assessment of observance of the BCPs
- The mission assessed Palau’s observance of the Basel Core Principles for Effective Banking Supervision (BCPs).
- Overall degree of compliance: modest, given the newness of prudential supervision and lack of implementation capabilities.
- Compliance categorization (counts as assessed by the mission):
  - Compliant with 1 Core Principle (CP)
  - Largely compliant with 6 CPs
  - Materially non-compliant with 7 CPs
  - Non-compliant with 11 CPs
- Detailed assessment included in Volume II of the report.

### Major outstanding issues in the Financial Institutions Act (FIA) and FIC structure
- The mission identified a number of major issues in the FIA that may jeopardize or impede effective banking regulation and supervision if left unaddressed.

A. Composition of the FIC’s Governing Board (GB)
- FIC established on February 21, 2002; four of five voting members were confirmed by the Senate.
- Current GB composition: Chair and Vice-Chair are business community representatives; two voting members are bankers (one domestic, one foreign commercial bank); President of the National Development Bank of Palau is ex-officio sixth non-voting member.
- Concerns:
  - Excessive influence of the banking industry on FIC operations.
  - Potential conflicts of interest and risk of operational paralysis.
- Recommendations:
  - Designate and confirm the missing fifth voting member as soon as possible; the individual should be from outside the Palauan banking industry.
  - Amend Section 16 of the FIA to remove the ineligibility of government employees to serve on the GB to enlarge the candidate pool, while preserving the Chamber of Commerce’s right to choose nominees for the President’s list.

B. Legal protection for the FIC’s Governing Board and staff
- The FIA lacks a provision granting legal protection to the FIC’s GB and staff when acting in good faith within the scope of their authority.
- Consequences: FIC has refrained from adjudicatory action, including deciding on 12 banking license applications under grandfathering provisions; current Tax Office licenses expired on April 30th and are expected to be renewed only for limited periods.
- Recommendation: Amend the FIA to include legal protection for the FIC’s GB and staff. The mission welcomes the President’s submission of an ad-hoc Bill to Congress and supports its approval.

C. Regulatory and supervisory powers of the FIC
- Section 78(a) provides full regulatory and supervisory powers, but other FIA provisions constrain those powers:
  - Section 79(a): all regulations issued by the FIC shall take effect upon approval by the OEK by joint resolution.
  - Section 62(b)(3): requires FIC to seek Supreme Court approval for issuance of Cease and Desist Orders.
  - Section 33(b): limits conditions the FIC may impose on a financial institution’s license.
- Combined effect: these provisions severely impede the FIC’s autonomy and timely exercise of regulatory and supervisory powers.
- Recommendation: Amend the FIA to remove provisions that unduly limit the FIC’s ability to conduct effective banking regulation and supervision.

D. Financing, budget, and staffing of the FIC
- Section 34 limits fees for investigation of new applications to only $500.
- Section 79 limits fees that can be charged to financial institutions for routine operations; Section 79(b) states FIC expenses are to be funded by fees assessed against supervised institutions.
- Consequences: fee caps may prevent FIC from recovering investigative expenses and limit thoroughness of background checks and analysis.
- Recommendations:
  - Amend Sections 34 and 79 to allow the FIC to determine and set by regulation the level of fees for new applications and routine expenses based on funding/budget requirements.
  - In the interim, government funds may be needed to cover the funding gap.
  - Hire permanent FIC staff, including the Executive Commissioner, as soon as possible and by not later than September 30, 2002.
- Administrative notes:
  - The Acting Executive Commissioner prepared a draft FIC budget for 2002/03 expected to be finalized by September 30, 2002.
  - The fiscal year in Palau is October 1st–September 30th.
- Clarification sought on Section 12(a)(2) requiring the FIC to “propose and submit” its budget to the OEK; mission believes budget should be submitted for informational purposes only to protect FIC autonomy.

E. Licensed banks under “grandfathering” provisions
- FIA allowed existing financial institutions to be licensed without applying “fit and proper” criteria.
- Recommendation: At minimum, allow the FIC to require the twelve grandfathered institutions to:
  1. Submit a plan acceptable to the FIC for increasing capital to the FIA minimum levels (both absolute and risk-based). Any capital-deficient bank should inject additional cash to correct deficit and increase capital to a level sufficient to support operating expenses until profitability is reasonably assured, as shown in an acceptable business plan.
  2. Provide necessary information enabling the FIC to assess “fit-and-proper” criteria for controlling shareholders and management.

F. Transition period
- Section 77(b) provides transition periods from the date “all of the positions of the Governing Board of the FIC are filled”: 24 months for organization and administration; 48 months for accounting, auditing, and reporting.
- Issues:
  - Clock has not started because the fifth voting position is vacant.
  - Mission considers transition periods overly extended given straightforward prudential requirements.
- Recommendation:
  - Amend Section 77(b) to reduce transition periods to 12 months from the date the FIC was established (i.e., by February 21, 2003).
  - Give the FIC power to extend the transition period for up to 12 months based on prudent judgment of individual circumstances.

G. Preparation, certification, and disclosure of balance sheets and financial statements
- Recommendation: By the end of the transition period, require all banks licensed to operate in Palau to:
  - Prepare an annual consolidated balance sheet and income and expense statements following Generally Accepted Accounting Principles (GAAP).
  - Have financial statements audited by a reputable external auditor.
  - Make financial statements available to the public through publication or upon request, and submit them to the FIC.

H. Community reinvestment provision
- Section 55 requires the FIC to propose within 12 months regulatory and legislative measures to improve implementation of Palau’s community reinvestment policy and to monitor and report annually.
- Mission view: The FIC is improperly being tasked with actively pursuing government reinvestment policy.
- Recommendation: Delete the portion of Section 55 that directs the Commission to promulgate regulations, monitor implementation, report annually, and propose measures to improve implementation of the Republic’s reinvestment policy.

I. Other regulatory issues
- Capital adequacy:
  - Section 53 reduced minimum capital to risk-weighted assets (CAR) requirement from 10 percent to 5 percent; Basle minimum is 8 percent.
  - Section 31 reduced minimum absolute capital from $1 million to $500,000 (note: $1 million was already below the $5 million international norm).
  - Recommendations:
    - Amend Section 53 to increase CAR minimum to the international minimum of 8 percent.
    - Amend Section 31 to allow the FIC to set minimum absolute capital by regulation, considering current economic conditions.
- Examinations and risk management:
  - Section 66(c) states primary purpose of FIC examinations is disclosure of irregularities and malfeasance, curtailing FIC powers to address safety and soundness.
  - Recommendation: Include a risk management provision in the FIA to enable the FIC to make qualitative judgments on a bank’s general risk situation and take timely corrective action.
- Investment approvals and corporate affiliations:
  - FIA should include clear rules on which bank investments need supervisory approval versus notification, with consideration of whether corporate affiliations (domestic/overseas) might jeopardize effective supervision.

### AML/CFT legal, institutional, and supervisory assessment
- Methodology used: “Fund and Bank Methodology for Assessing Legal, Institutional, and Supervisory Aspects of Anti-Money Laundering and Combating the Financing of Terrorism” dated February 7, 2002.
- Assessment results (12 broad criteria):
  - Compliant with 2 criteria
  - Largely compliant with 5 criteria
  - Materially non-compliant with 3 criteria
  - Non-compliant with 2 criteria
- Political commitment and recent actions:
  - Government enacted four AML laws in June 2001 and is a signatory to the Honiara Declaration.
  - Palau volunteered to participate in a Forum Secretariat / Asia/Pacific Group initiative funded by LEG to assist Pacific countries in AML/CFT and financial sector fraud measures.
  - Government agreed that LEG undertake an assessment of the FIU’s operations and AML framework.
  - Palau intends to join the Asia/Pacific Group on Money Laundering.
  - On November 19, 2001, a Coordinator for the FIU was appointed to initiate AML legislation implementation.
- Anti-terrorism measures:
  - Palau is drafting anti-terrorism legislation and has set up a Task Force on Anti-Terrorism and Homeland Security; enactment expected shortly.
- Overall assessment:
  - Largely satisfactory legal and institutional framework for preventing and detecting money laundering in the banking sector.
  - Implementation capabilities need strengthening due to:
    1. FIU established but AML legislation does not provide clear enforcement powers.
    2. FIU understaffed and lacks sufficient expertise, especially for suspicious transaction analysis.
    3. Banks need clear guidelines and recommendations from the FIU for day-to-day implementation.
  - FIU should undertake on-site AML inspections of all reporting entities on a regular basis.
- Supervisory regime gap:
  - Authority for AML implementation is not clearly identified.
  - Initial thinking: FIC should have responsibility, but many reporting entities (exchange offices, money transmitters) are unregulated by FIC.
  - Given resource constraints and FIC workload, mission’s recommended division of responsibilities:
    - FIC: responsible for establishing AML policies and procedures for banks.
    - FIU: responsible for day-to-day implementation, on-site inspection, and enforcement of AML requirements for all reporting entities, including banks.
  - Mission also recommends technical amendments to the legal framework to ensure effective AML implementation.

### AML/CFT recommendations (summarized)
- Begin implementation of existing AML provisions immediately.
- Amend the AML law to include:
  - Specific record-keeping requirements.
  - Lower threshold for identifying casual clients.
  - Removal of the threshold of US$10,000 for the record-keeping requirement for customer identification.
  - Prohibition of anonymous accounts.
  - Clarification of suspicious transaction reporting requirements.
  - Extension of the scope of overriding secrecy and tipping off provisions.
  - Redefinition of money laundering to clearly set out the mens rea element.
  - Specification of predicate offenses to which money laundering relates, including extraterritorial similar offenses, taking into account authorities’ view that all crimes would be predicate offenses.
  - Extension of powers to confiscate proceeds, instrumentalities, and subject matter of offenses, and, where unavailable, allow courts to order confiscation of property of equivalent value or a penalty sum equivalent to the value of property.
  - Inclusion of adequate procedures to protect innocent and bona fide third-party interests.
  - Require customer identification for wire transfers.
- Amend AML law to vest the FIU with powers to:
  - Disseminate information to relevant law enforcement agencies (foreign and local) where money laundering is suspected, with adequate confidentiality safeguards.
  - Conduct on-site inspections and audit compliance of reporting entities and have sufficient enforcement authority.
  - Facilitate advisory activities, research, training, and public education.
  - Protect the FIU, its employees, and information received from suit and compulsory legal process.
  - Have access to sources of public information.
- Remove prohibition on FIU staff concurrently holding other public employment or elective office in Palau.
- Provide FIU with adequate staffing and expertise.
- Provide FIU with powers to issue regulations for effective AML implementation without parliamentary approval.
- Establish a training program for the FIU, financial intermediaries, and the Attorney General’s office; technical assistance from MAE and LEG is envisaged.
- FIC to issue regulations for “fit-and-proper” criteria for controlling shareholders and management; consider applying fit-and-proper tests to controlling shareholders and management of the 12 grandfathered institutions.
- Enact anti-terrorism legislation and issue regulations for registration of over-the-counter exchange dealers as soon as possible.

### Technical assistance needs
- The mission identifies a need for an intensive technical assistance program to develop implementation capabilities for prudential supervision and AML/CFT (details and priorities implied throughout recommendations).

*Source: The mission's assessment of Palau’s observance of the Basel Core Principles for Effective Banking Supervision and the legal, institutional, and supervisory aspects of AML/CFT.*

### 22.      Based on its findings, the mission is of the view that banking supervision and

### PALAU: Banking Supervision, Prudential Regulation, and AML/CFT — Mission Findings and TA Recommendations

### Mission priority and staffing recommendations
- The mission concluded that banking supervision and regulation should receive first priority in Palau’s technical assistance (TA) needs.
- The mission reviewed and revised the work program for the MAE Banking Supervision Advisor assigned on a peripatetic basis to the FIC (originally prepared with assistance from PFTAC) to distinguish:
  - TA to strengthen the regulatory and supervisory framework (e.g., drafting regulations and reporting forms), and
  - TA to develop and foster implementation capabilities — the mission emphasized the latter.
- The mission recommends an intensive on-the-job, hands-on training program for the FIC’s Governing Board and staff, to begin as soon as the FIC’s budget is approved and permanent staff are hired.
- The mission urges that hiring of the FIC’s permanent staff, including the Executive Commissioner, be done as soon as possible and in any case by and not later than September 30, 2002.
- The mission’s recommended TA work program on banking supervision and prudential regulation is included in Appendix II of Volume I of the report.

### AML/CFT TA needs and commitments
- Authorities indicated need for TA to:
  - review and assist in drafting amendments to AML/CFT legislation as needed;
  - assist in drafting necessary AML/CFT regulations;
  - assist in establishment of a well-functioning FIU; and
  - provide training to FIU staff and banks in practical aspects of AML/CFT implementation.
- MAE and LEG have already provided some TA, including through the mission and peripatetic expert assignments.
- The IMF (MAE & LEG) indicated it would consider additional TA requests favorably, depending on the authorities’ reform commitment and implementation record, and subject to IMF TA budgetary constraints.

### Macroeconomic and banking-sector context (key statistics)
- Population: some 19,200 individuals.
- Per capita GDP: $6,180.
- Share of active workforce in public sector: 36 percent.
- Public sector wages share of all wages (1999): almost 50 percent.
- Legal tender: U.S. dollar.
- Real GDP growth: around 1 percent in the past two years.
- Overall fiscal deficit (FY2001): 15 percent of GDP, financed primarily by draw down of assets from U.S. Compact grant receipts.
- FY2002 Budget deficit target: reduction to 7 ½ percent of GDP.
- Price inflation (FY2001): 2 ½ percent.
- Current account deficit (including official grants) FY2001: around 13 percent of GDP; projected to increase to 14.8 percent of GDP in FY2002.
- Financial system composition:
  - 12 commercial banks (including 3 branches of U.S.-based banks),
  - 1 development bank (National Development Bank of Palau, NDBP),
  - 11 nonbank financial institutions,
  - a number of small credit unions.
- Offshore banking: not allowed since 1982.
- NDBP portfolio size: about $7 million, of which one-third is in residential housing.
- NDBP loans in arrears ("judgment loans"): about $0.7 million, or 10 percent of total loans.
- Deposit and lending rate ranges (1997–2000):
  - 30-day time savings accounts: 2 ¼-5 percent;
  - certificates of deposit: 4-8 percent;
  - consumer loans: 10-18 percent;
  - commercial loans: 9 ¼-13 percent.
- Three largest U.S.-based banks account for approximately 84 percent of total deposits; Bank of Hawaii alone accounts for nearly 57 percent of total deposits.

### Legal and supervisory framework developments
- Five key pieces of financial legislation enacted in June 2001 (with assistance from PFTAC and LEG): the Financial Institutions Act (FIA) and four AML laws.
- In approving the FIA, Parliament diluted prudential supervision provisions drafted with LEG assistance to secure passage.
- FIA provisions included a deadline for existing banks to apply for a banking license under "grandfathering" provisions by December 17, 2001; that deadline was subsequently extended to February 15, 2002.
- Delays in constituting the Financial Institutions Commission (FIC), including appointing an Executive Commissioner and permanent staff, required the President to appoint, by Executive Order, an Interim Financial Institutions Regulatory Panel to implement the FIA and enforce the "grandfathering" deadline.
- The FIA did not establish full prudential evaluation of existing banks and granted exemptions to statutory capital requirements under "grandfathering."
- The FIC was established on February 21, 2002, when four of the five voting members of its Governing Board were confirmed by the Senate.
  - The Chair and Vice-Chair are representatives from the business community.
  - Two other voting members are bankers (one domestic, one foreign).
  - The President of the NDBP is, ex-officio, the sixth non-voting member.

### AML implementation measures and international engagement
- Office of the Attorney General (AG) implemented measures after enactment of four AML laws (June 2001), including:
  - Establishment of a Financial Intelligence Unit (FIU) under the AG; and
  - Notification to banks and other financial institutions mandating submission of "Suspicious Transactions Report" under specific circumstances.
- Licenses of 10 shell corporations registered as banks were revoked around September 2001; notices were sent to the U.S. Office of the Comptroller of the Currency and the FDIC.
- Palau is a signatory to Pacific Island Forum anti-money laundering initiatives, including the Honiara Declaration, committing to implement the FATF 40 Recommendations.
- Palau is not on FATF’s NCCT list following a FATF mission review of legislation in September 2001.

### Findings on supervisory capacity, reporting, and prudential rules
- The mission emphasized strengthening implementation capabilities through hands-on training of the FIC Governing Board and staff.
- Key supervisory and regulatory areas identified for TA and drafting include:
  - statistical data and regulatory reporting requirements and forms (including reporting on related-party transactions and loans in excess of 10% of capital);
  - off-site monitoring procedures and key ratios for capital adequacy, asset quality, earnings performance and liquidity, and establishment of a data base for automated ratio calculations;
  - analysis of condition, operating performance, and FIA compliance of existing banking institutions;
  - licensing criteria for new banking institutions, identification of beneficial owners, and forms/pro forma business-plan requirements;
  - minimum criteria for entry of new significant shareholders (including change-of-control) and notification time frames;
  - prudential regulations per FIA (regulatory capital, risk-based capital and risk-weighted assets; aggregation and attribution for credit exposure to single borrowers and related groups; asset classification and minimum provisioning; placement of nonperforming loans on nonaccrual);
  - guidance on credit policies, asset quality, and other prudential practices adapted to local conditions;
  - an amendment to provide increased funding of the FIC by recovering supervisory expenses through assessment of fees for on-site examinations and fees for ongoing FIC operations, and assistance in staffing and budget planning.

### Appendix II: TA program schedule and selected activities (calendar year 2002 and subsequent periods)
- Planned visit durations by quarter:
  - 2nd Quarter 2002: 40 days
  - 3rd Quarter 2002: 60 days
  - 4th Quarter 2002: 40 days
  - 1st Quarter 2003: 60 days
- Selected TA activities and timing (checkmarks indicate scheduled coverage in the table):
  1. Draft and issue regulation establishing statistical data and other information (regulatory reports) to be submitted by banks to FIC — ✔ (timing indicated in Appendix II)
  2. Establish off-site monitoring procedures, identify key ratios, and develop/establish a data base for statistical data and automated calculation of key ratios — ✔
  3. Conduct analysis to determine condition, operating performance, and compliance with FIA requirements of existing banking institutions — ✔ ✔
  4. Develop and issue guidelines establishing licensing criteria for new banking institutions (including identification of beneficial owners), procedures and necessary forms; regulation on business plan and pro forma statements — ✔ ✔
  5. Develop and issue regulation on minimum criteria for entry of new significant shareholders (including change-of-control) and minimum time frame for notifying and submitting necessary information to FIC staff — ✔
  6. Develop and issue prudential regulations as specifically provided in FIA: definition and computation of regulatory capital, risk-based capital, risk-weighted assets; calculation of credit exposure to single borrowers and related groups; asset classification, minimum provisions, and nonaccrual placement — ✔
  7. Develop and issue guidelines on prudential practices on credit policies, asset quality, and other requirements based on local practices, conditions and legal constraints — ✔ ✔ ✔ ✔ ✔
  8. Develop amendment providing for increased funding of FIC (recover supervision expenses through fees for on-site examinations and ongoing operations) and assist in staffing requirements/plan and budgetary process — ✔

*Source: IMF mission report and associated technical assistance program for the Republic of Palau.*

### 9. Develop regulations as necessary to clarify application or

### 9. Develop regulations as necessary to clarify application or to properly implement FIA

### Regulatory clarifications and requirements
- Require existing banks to provide information as to beneficial owners; ✔
- “Loans” on books of existing banks includes “credit” as defined in FIA for purposes of determining compliance with limit on credit extended to single and related borrowers; ✔
- Establish minimum time frame for notifying FIC staff of pending change-of-control, merger, or sale of substantially all assets of a bank; ✔
- Establish procedures for compliance with conflict of interests by banks; ✔
- Clarify applicability of FIA to other corporations undertaking financial activities (other than deposit taking activity). ✔

### 10. Develop and issue guidelines on minimum criteria to evaluate adequacy of internal audit procedures of banking institutions
- Develop and issue guidelines on minimum criteria to evaluate adequacy of internal audit procedures of banking institutions. ✔ ✔

### 11. Review anti-money laundering laws and regulations
- Review anti-money laundering laws and regulations and assist in promulgation of necessary regulations for banks, including “know your customer” requirements. ✔

### On-site safety and soundness examinations (FIC)
12. Develop guidelines for use by FIC for conducting on-site safety and soundness examinations of banks, including:
- Establishing operating policy for FIC on minimum examination frequency and prioritization; ✔ ✔
- Examination procedures for functional areas, compliance with requirements of FIA, and assessment of performance of administrators; ✔ ✔
- Develop standardized examination report format, supporting schedules and key ratios. ✔ ✔

13. Develop guidelines/procedures for assessing adequacy of administrators and their performance and criteria for acceptability of persons appointed as administrators.
- Removal of administrators to be addressed and included in regulation for enforcement actions. ✔ ✔

14. Develop guideline for use by FIC on uniform bank rating (internal assessment tool for use by FIC staff for rating the performance and condition of the CAMELS components and overall condition of a bank), including establishing benchmarks for ratings of each component. ✔ ✔

15. Develop and issue guideline/regulation on enforcement actions, identifying types of enforcement measures (written agreements, orders, suspension of administrators and officers and suspension/revocation of banking license), procedures for preparation, issuance and appeal process.
- Develop separate regulation on calculation and assessment of monetary penalties including criteria to determine appropriateness and amount of penalty. ✔ ✔

16. Develop regulation specifying nature and type of information that may be released as “public information” and minimum public disclosure of financial information of banks:
- Formulate formal written agreement for sharing of information with other bank supervisory authorities to assure confidentiality of information. ✔ ✔

### DEVELOPING IMPLEMENTATION CAPABILITIES: Training and hands-on assistance

17. Provide hands-on training in off-site monitoring, including:
- Review of regulatory reports for completeness and identification of suspicious changes; ✔
- Calculation and analysis (meaning) of key ratios, and use of levels and trends analysis techniques for each of CAMELS components (capital, asset quality, management, earnings, liquidity and sensitivity to market risk); ✔
- Checks for compliance with FIA and regulations; and ✔
- Preparation of off-site monitoring/summary reports. ✔

18. Assist with and provide hands-on training in evaluation of applications for banking licenses – including the review of financial statements on proposed principal shareholders, adequacy of business plans and pro forma statements (assumptions), and proper use of conditions on the license of a bank. ✔ ✔ ✔

19. Provide assistance/training to Governing Board of FIC as needed, including:
- Role of Governing Board versus Executive Commissioner and staff in day-to-day activities; ✔ ✔ ✔ ✔ ✔
- Format and content of reports required to be submitted by the Executive Commissioner to the Governing Board; ✔ ✔ ✔ ✔ ✔
- Identification of duties which the Executive Commissioner may assign to FIC staff; ✔ ✔ ✔ ✔ ✔
- Attend meeting of Governing Board when available; ✔ ✔ ✔ ✔ ✔
- Other areas as requested or identified. ✔ ✔ ✔ ✔ ✔

20. Conduct briefing sessions with Governing Board, Executive Commissioner, FIC staff and representatives of banking industry as necessary or requested to assure proper implementation of provisions of FIA and regulations or guidelines (proposed or issued) by FIC:
- Provide training to Executive Commissioner and staff regarding proper use of “discretion” in enforcing provisions of the FIA and regulations. ✔ ✔ ✔ ✔ ✔

21. Provide training to Governing Board, Executive Commissioner, FIC staff as needed regarding functional areas of bank operations to facilitate thorough and efficient examinations (both on and off-site). ✔ ✔ ✔ ✔ ✔

22. Provide training/assistance in the examination of banks (both on and off-site) and analysis and preparation of examination reports, including:
- Assessment of CAMELS components and relevant key ratios; and ✔ ✔ ✔ ✔
- Loan portfolio analysis techniques, including use and analysis of financial statement ratios, structuring and other considerations for different types of loans, and techniques to assess the adequacy of provisions for bad loans. ✔ ✔ ✔ ✔

23. Provide training on proper use of enforcement actions (written agreements, cease and desist orders, suspension of administrators and officers and suspension/revocation of banking license), including:
- Content of enforcement action to address weaknesses or concerns; ✔ ✔ ✔ ✔
- Issuance of enforcement action; and ✔ ✔ ✔ ✔
- Monitoring of compliance with enforcement action. ✔ ✔ ✔ ✔

24. Provide training on GAAP and regulatory accounting practices in accounting for assets, liabilities and income and expense items. ✔ ✔ ✔ ✔ ✔

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_Source: https://www.imf.org/-/media/files/publications/ofca/english/cr04169.pdf_