## 1.  Reco

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---

### I. Key recommendations / Introduction
- Purpose:
  - Targeted review and follow up on implementation of recommendations of the 2002 assessment of Lithuania’s compliance with the Basel Core Principles for Effective Banking Supervision (BCP) undertaken in the context of the 2002 FSAP.
  - Analysis does not constitute a full or formal reassessment of the initial BCP Assessment.
- Basis of the note:
  - A self-assessment prepared by the Bank of Lithuania (BoL).
  - Interviews with staff of the BoL, industry, and professional associations.
  - Various legal and other background documents.
- Methodology:
  - Note follows the revised BCP (published by the Basel Committee in October 2006).
  - No full verification of all Essential and Additional Criteria; no specific ratings for individual Core Principles assigned.
- Outstanding initiatives:
  - Regulatory initiatives not yet fully implemented or final, including application of Basel II and the draft new Law on Anti-money laundering, combating the financing of terrorism (AML/CFT).

### II. Overview — structure and market context
- Financial system structure and ownership:
  - Banking sector comprises nine banks—of which six are subsidiaries of foreign banks—and two branches of foreign banks.
  - Foreign entities account for around 93 percent of the sector’s assets; Swedish banks together account for around 62 percent of the sector’s assets.
  - The three largest banks (SEB Vilniaus Bankas, Hansabankas, and DnB NORD Bankas) account for around 69 percent of banking sector assets and generated three quarters of the 2006 credit growth.
  - All three largest banks are owned by foreign banks with A+ Standard and Poor’s credit ratings.
- Regulatory alignment and initiatives:
  - Laws and regulations affecting banking supervision changed to conform to EU Directives.
  - Basel II regulations finalized and will become effective as of January 1, 2008.
  - New draft law on AML/CFT presented to the Parliament and expected to become effective as of January 1, 2008.
- BoL governance, resources, and cooperation:
  - BoL Board comprises its Governor, two Deputy Governors and two other Members.
  - Governor appointed by Parliament on the recommendation of the President; Deputy Governors and other Members appointed by the President on the recommendation of the Governor.
  - Law on the BoL explicitly provides that the Government and institutions of the State must respect the independence of the BoL and must not seek to influence it or its staff in the discharge of their duties.
  - BoL’s Credit Institutions Supervision Department (CISD) comprises six Divisions; CISD employs about 65 persons including specialists such as auditors, econometricians, operational risk experts and a real estate valuator.
  - BoL established a Financial Stability Department.
  - BoL concluded Memoranda of Understanding (MoUs) with supervisory authorities in countries of parents and neighboring states, is party to the EU-wide multilateral MoU, and actively participates in EU supervisory bodies.

### III. BCP assessment — progress and remaining issues
- General:
  - BoL has addressed most Recommended Actions from the 2002 FSAP assessment.
  - Mission commends the BoL for many important measures adopted since 2002.
  - Discussion divided into seven broad categories of the revised BCP.

- Principle 1 — Objectives, independence, powers, transparency and cooperation:
  - Law on the BoL amended to reflect the Statutes of the European Central Bank (ECB), further strengthening BoL independence as part of preparations for adopting the euro.
  - Specific objectives of banking supervision have not been incorporated in the Law on the BoL; authorities argue objectives are defined in the Law on Banks and as a task of the BoL in the Law on the Bank of Lithuania; mission notes ECB’s Statutes do not prohibit national central banks from having tasks the ECB itself does not have.
  - Law on the BoL amended to include Article 46(1) providing explicit legal protection to BoL Board members and supervision staff, protecting them in carrying out duties unless it is proven they undertook an illegal action with the intent to cause damage. This protection is additional to existing Civil Code protection.

- Principles 2–5 — Licensing and structure:
  - No major changes since 2002 in permissible activities, ownership requirements, or BoL’s licensing regime, but some changes reflect prior recommendations.
  - Licensing and entry progress:
    - List of licensing criteria in the Law on Banks expanded to include matters subject to ongoing supervision; Article 9 requires applicants to supply information on risk management systems, internal controls, and accounting organization.
    - Minimum capital for new banks maintained at 5 million euros in conformity with the EU Banking Directive.
    - Threshold for BoL approval of acquisitions of bank shares maintained at 10 percent of share capital per the EU Banking Directive; banks must notify BoL when 5 percent or more of authorized capital is acquired.
    - BoL can appeal to courts to request forced sale of shares by shareholders failing fitness and propriety requirements.
    - Article 49 of the Law on Banks specifies limits on a bank’s holdings of the capital of other legal persons.

- Principles 6–18 — Prudential regulation and requirements:
  - New or revised regulations and letters issued on operational risk, large exposures, internal audit, loan accounting, public disclosure, anti money laundering, and capital.
  - New regulations implementing Basel II will enter into force on January 1, 2008, covering credit, market, and operational risk, capital adequacy, public disclosure and large exposures.
  - Capital adequacy and prudential measures:
    - Minimum capital adequacy ratio reduced from 10 to 8 percent in 2005 following EU accession.
    - Mitigating measures by BoL include:
      - redefinition of residential mortgages (eligible collateral limited to registered buildings for living);
      - limitation on inclusion of current year’s profits in capital;
      - BoL urged banks to retain all profits made in 2005 and 2006, and intends to do so again with respect to profits made in 2007.
    - Stress tests and estimates of economic capital indicate cushions above regulatory minimum may not be sufficient under severe circumstances; banks’ capital base needs strengthening.
    - Where the Capital Requirements Directive allows national discretions, BoL chose conservative options, for example:
      - applying a 100-percent risk weight for commercial real estate loans (where a 50-percent risk weight would have been possible);
      - setting the maximum amount of a retail exposure at 1 million litas (about 290,000 euros) instead of 1 million euros, limiting assets eligible for a 75-percent risk weight.
  - Credit risk specifics:
    - About 90 percent of residential mortgage loans is concluded at variable interest rates (most commonly with 6 months intervals) and a substantial part is denominated in euros.
    - These features expose banks to indirect credit risk from rising interest rates or euro exchange rate changes and to valuation risks if real estate prices reverse.
    - Limited historical banking and macroeconomic time series in Lithuania create significant risk that banks’ IRB models would not capture Lithuanian loan portfolio risk characteristics, potentially underestimating regulatory capital needs.
    - Risks not adequately covered under Pillar 1 should be captured in Pillar 2 under Basel II.
  - Validation and model approval:
    - Banks applying IRB must validate internal rating systems; those applying advanced operational risk approaches must validate essential elements.
    - BoL issued Regulations on Validation and its Assessment; will carry out regular reviews of banks’ validation processes.
    - For Lithuanian banks with foreign parent, BoL approval for IRB and AMA is required, but final decision rests with home country supervisor; BoL cooperates closely with home supervisors.
    - It is expected most Lithuanian banks will not be allowed to use IRB and AMA approaches before 2009. One Lithuanian bank plans to apply IRB and AMA approaches in 2008 and has performed test calculations verified by the BoL; BoL emphasized preliminary character and noted a floor specified for the new capital requirement in the EU Directive.
  - Foreign exchange and open position rules:
    - Regulatory limit on open positions in euros abolished in 2004.
    - BoL maintains requirement that open euro positions be included in calculation of required capital for foreign exchange risk; mission found some confusion among banks about this issue.
    - BoL clarified inclusion of capital charges on euro positions to banks after the FSAP mission.
    - Authorities reaffirm commitment to maintain the currency peg under the CBA and not re-impose restrictions on banks’ net open positions in euro; mission encourages BoL to continue close monitoring of related risks.
  - Enforcement and insolvency triggers:
    - Authorities considered specifying triggers for enforcement actions when a bank’s capital falls below certain levels but do not see merit given small number of banks and BoL’s oversight capabilities.
    - Banks’ individual minimum capital requirements will be kept under review via the Internal Capital Adequacy Assessment Process and Supervisory Review and Evaluation Process.
    - Mission recommends that, at a minimum, a balance sheet insolvency condition (zero net worth) should be included in the Law as a trigger for compulsory license withdrawal.
  - Loan loss provisioning and disclosures:
    - In 2005 BoL adopted a new regulation setting minimum requirements for loan assessment and formation of specific reserves implementing IAS 39:
      - Specific reserves must be calculated if there is objective evidence a loan is impaired.
      - Senior management is responsible for establishing principles and procedures for assessing impairment, recognizing loss events, and calculating loss from impairment.
      - All significant loans and loans with objective evidence of impairment are subject to individual assessment; unimpaired loans are grouped for collective assessment.
      - Under the old regulations loans were classified into five risk groups with set provision levels.
      - BoL does not have exact data on how the new regulation affected the level of specific reserves.
      - Following 2006 Basel Committee guidelines, BoL does not intend to set additional loan loss provisioning requirements beyond IAS 39.
    - In 2006 a BoL resolution requires banks to publish information on the risks assumed and their risk management and internal control processes in annual reports; the bank’s board is responsible for accuracy and timeliness.
  - Large exposures and intra-group lending:
    - BoL revised large exposure rules in 2004:
      - Interbank loans with maturity up to 30 days were formerly excluded; exclusion reduced to 14 days provided loans are not automatically rolled over.
      - Large exposure rules apply to intra-group lending including lending to the parent bank.
      - Article 53 of the Law on Banks requires terms and procedure for intra-group lending to be approved by the bank’s supervisory board and specific intra-group loans to be approved by the managing board.
      - Law requires lending terms to natural persons related to the bank not be more favorable than terms to other clients.

### Internal control, risk management, and IT risk
- BoL regulations require that banks have an effective internal control system that ensures that all material risks are being recognized and continually assessed.
- BoL provided specific guidance on operational risk and (separately) on information technology (IT) risk.
- Management bodies of a bank are held responsible by the BoL for the proper management of all material risks.

### Anti–money laundering (AML) framework
- BoL’s Resolution on Money Laundering Prevention Guidelines requires banks to organize training for managers and staff, including those (but not limited to) who directly deal with customers, to ensure proper implementation of measures for the prevention of money laundering.
- Anti money laundering measures must be properly integrated into the bank’s system of internal control.
- Bank managers are held responsible by the BoL for the implementation of adequate anti money laundering measures, including “know your customer” procedures.
- Government’s Financial Crime Investigation Service is responsible for coordination of anti money laundering measures and measures taken against perpetrators.
- New law on money laundering transposing the 2005 EU Directive on anti money laundering and countering the financing of terrorism is pending with the Parliament and is expected to come into force on 1 January 2008.
  - Law will refine procedures for cooperation among institutions involved in preventing and detecting financial crime and will include measures to counter the financing of terrorism.

### Methods of ongoing banking supervision (Principles 19–21)
- Findings on supervision and monitoring:
  - BoL conducts effective on-site and off-site supervision on all banks operating in Lithuania.
  - Regular reports submitted by banks on balance sheets, capital adequacy, liquidity, concentrations on lending and funding sides, loan impairment, and various other aspects.
  - BoL has direct access to the management information systems of some of the larger banks.
  - Off-site information analyzed and used as input to BoL’s Early Warning System (EWS), which is based on a large number of financial ratios.
  - If the EWS indicates that a bank is high risk, BoL can require daily reports on liquidity, increase capital requirements, meet with bank management, or conduct additional on-site inspections.
- On-site inspection practices:
  - Full-scope on-site inspection once a year in normal circumstances (for small banks scope may be limited).
  - Additional inspections may target particular risk areas or specific problems.
  - Main focus: internal governance, including risk management and internal control systems.
  - Credit files examined on a sample basis.
  - Compliance with laws and regulations and accuracy of supervisory reports verified.
  - On-site inspections produce a report with recommendations included in a time-specific action plan; implementation is monitored off-site and verified in the next on-site inspection.
- Loan classification, provisioning, and sanctions:
  - On-site inspectors assess compliance of internal rules and procedures for doubtful assets evaluation, classification and provisioning.
  - Banks required to improve loan assessment methodology if shortcomings found.
  - Additional specific provisions may be required based on loan portfolio quality.
  - Sanctions, including fines and removal of board members, may be imposed if a bank does not form sufficient provisions.
- Supervisory approach and communication:
  - BoL increasingly following a principle-based approach towards banking regulation (endorsed by the Committee of European Banking Supervisors).
  - Some banks requested more guidance on Internal Capital Adequacy Assessment Process and stress testing; suggested solution: differentiate guidance by bank needs and increase contacts between banks and on-site supervisors between annual inspections.
- Interaction between Financial Stability and Supervision:
  - Scope exists to enhance interaction between the Financial Stability Department and the CISD.
  - Current interaction largely focused on data sharing.
  - Potential benefits: Financial Stability Department could suggest macroeconomic stress scenarios for Supervision Department, and its stress testing model could help determine capital surcharges under Pillar 2.

### Accounting and disclosure (Principle 22)
- Law on Banks requires Lithuanian banks to keep accounts and prepare reports according to BoL rules.
- Banks must publish quarterly and annual reports; annual financial statements must be audited.
- Audits performed in accordance with the International Standards on Auditing.
- All Lithuanian banks are audited by large and internationally active auditing firms.
- Progress and disclosure improvements:
  - A 2002 Resolution prescribes accounting principles in line with the IAS/IFRS; senior management responsible for correctness and timely presentation.
  - BoL established requirements for publicly disclosed information in 2006 to improve transparency and market discipline:
    - Public disclosures must provide timely, consistent and material information about activities, financial condition, risk types, and risk management mechanisms, including for any subsidiaries.
    - Materiality: information is material if omission, insufficient detail or misstatement would result in wrong decisions by users.
  - Recommendation: banks should issue simplified statements comprehensible and accessible to the wide public (e.g., at branches and on the internet).

### Corrective and remedial powers (Principle 23)
- BoL has a comprehensive range of supervisory tools from instructions to sanctions.
- Article 72 of the Law on Banks includes the possibility for the BoL to withdraw a bank’s license.
- Tools and sanctions are hierarchical and proportionate to severity.
- Progress on sanctions:
  - Law on Banks amended to empower the BoL to levy fines on banks.
  - Possible fines listed in Article 74 range from 0.1 percent to 2 percent of a bank’s gross annual income.

### Consolidated and cross-border supervision (Principles 24–25)
- Cross-border cooperation and MoUs:
  - Lithuanian authorities enhancing cross-border cooperation and the financial crisis management framework.
  - BoL policy: written MoUs with all countries with banking establishments in Lithuania and countries where Lithuanian banks are established, as well as all bordering countries.
  - BoL concluded bilateral MoUs with a number of foreign financial supervisory authorities, including those supervising parent banks of Lithuanian subsidiaries or branches.
  - Signed multilateral agreements include the EU-wide trilateral MoU of 2005 on crisis management cooperation.
  - Most recently BoL signed a MoU with the central banks of Estonia, Latvia, and Sweden on management of a financial crisis in banks with cross-border subsidiaries or branches.
  - BoL and the Swedish Financial Supervisory Authority are drafting a separate MoU on supervision of financial conglomerates and procedures for SREP.
- Application of home country supervisory standards:
  - Home country supervisors apply Lithuanian prudential requirements to local subsidiaries in consolidated supervision where Lithuanian requirements are higher for certain assets; higher requirements enter into consolidated capital adequacy calculations.
  - BoL regularly provided by home supervisors with information on the financial condition of parent banks.
  - Formal information exchange supplemented by frequent meetings; foreign-owned banks operate within exposure limits set by their parents.

### Key recommendations (selected)
- Objectives, independence, powers, transparency, and cooperation (BCP 1):
  - Consider incorporating the objectives of banking supervision in the Law on the BoL on a basis consistent with the Law on Banks.
  - Continue to advance the depth of staff expertise and skills.
- Prudential regulation and requirements (BCPs 6–18):
  - Ensure credit risk from variable interest rate borrowing or euro-denominated loans is fully captured in Pillar 1 and/or Pillar 2.
  - Clarify that open positions in euros enter into capital adequacy calculations and closely monitor banks’ open positions in euros.
  - Include, at a minimum, a balance sheet insolvency condition (zero net wroth) in the Law as a trigger for compulsory license withdrawal.
- Methods of ongoing banking supervision (BCPs 19–21):
  - Consider giving more guidance to banks on an individual basis using more frequent contacts with on-site supervisors.
  - Enhance interaction between the Financial Stability Department and the Credit Institutions Supervision Department.
- Accounting and disclosure (BCP 22):
  - Encourage banks to make public simplified information comprehensible and accessible to a wide public alongside obligatory disclosures.
- Consolidated and cross-border supervision (BCPs 24–25):
  - Continue close cooperation with home country supervisory authorities of Lithuanian banks with foreign parents.

### Authorities’ response and recent actions
- Capital under Pillar 2 and ICAAP:
  - BoL intends to assess each bank’s additional capital needs under Pillar 2 from 2008 and to establish additional capital requirements as needed, based on the General Provisions for the Internal Capital Adequacy Assessment Process and the General Provisions for the Supervisory Review and Evaluation Process issued by the BoL.
  - This should result in capital surcharges for banks’ individual risk not captured under Pillar 1.
  - Banks are required to submit their first ICAAP report to the BoL at the end of the first quarter of 2008.
- Open euro positions:
  - In December 2007 BoL organized meetings with banks to clarify that open euro positions are to be included in the capital adequacy calculation for market risks.
  - All banks specified to the BoL at that time that they now include open euro positions in the calculations in the required manner.
- Cooperation between Banking Supervision and Financial Stability Departments:
  - Cooperation is “constantly increasing,” including joint banking sector stress testing and a cross-departmental committee that monitors market developments and reassesses cooperation needs annually.
- Loan assessment methodology adopted in 2005:
  - Losses regarding loan value reduction are accounted for only when actually incurred; expected future losses are not accounted for even if very likely, in compliance with IFRS.
  - BoL considers additional reporting to measure the effect of the change on reserves an unjustified burden.
  - Regarding simplified public disclosures, the BoL notes banks have leeway to decide what information should be publicly disclosed.

*Source: _cr08246*

### 1.  Reco

### 1.  Reco

### I. Key recommendations / Introduction
- This note presents a targeted review and follow up on the implementation of the recommendations of the 2002 assessment of Lithuania’s compliance with the Basel Core Principles for Effective Banking Supervision (BCP) undertaken in the context of the 2002 FSAP.
- The analysis does not constitute a full or formal reassessment of the initial BCP Assessment.
- The note is based on:
  - a self-assessment prepared by the Bank of Lithuania (BoL);
  - interviews with staff of the BoL, industry, and professional associations;
  - various legal and other background documents.
- The note follows the revised BCP (published by the Basel Committee in October 2006). A full verification of the implementation of all the Essential and Additional Criteria in the revised BCP Methodology was not undertaken; no specific ratings for individual Core Principles have been assigned.
- The mission noted regulatory initiatives not yet fully implemented or final, including the application of Basel II and the draft new Law on Anti-money laundering, combating the financing of terrorism (AML/CFT).

### II. Overview — structure and market context
- Financial system structure and ownership:
  - Banking sector comprises nine banks—of which six are subsidiaries of foreign banks—and two branches of foreign banks.
  - Foreign entities account for around 93 percent of the sector’s assets; Swedish banks together account for around 62 percent of the sector’s assets.
  - The three largest banks (SEB Vilniaus Bankas, Hansabankas, and DnB NORD Bankas) account for around 69 percent of banking sector assets and generated three quarters of the 2006 credit growth.
  - All three largest banks are owned by foreign banks with A+ Standard and Poor’s credit ratings.
- Regulatory alignment and initiatives:
  - Laws and regulations affecting banking supervision have been changed to conform to EU Directives.
  - Basel II regulations have been finalized and will become effective as of January 1, 2008.
  - A new draft law on AML/CFT has been presented to the Parliament and is expected to become effective as of January 1, 2008.
- BoL governance, resources, and cooperation:
  - BoL is headed by a Board comprising its Governor, two Deputy Governors and two other Members.
  - Governor is appointed by Parliament on the recommendation of the President; Deputy Governors and other Members are appointed by the President on the recommendation of the Governor.
  - The Law on the BoL explicitly provides that the Government and institutions of the State must respect the independence of the BoL and must not seek to influence it or its staff in the discharge of their duties.
  - The BoL’s Credit Institutions Supervision Department (CISD) comprises six Divisions; CISD employs about 65 persons including specialists such as auditors, econometricians, operational risk experts and a real estate valuator.
  - The BoL established a Financial Stability Department.
  - The BoL has concluded Memoranda of Understanding (MoUs) with supervisory authorities in countries of parents and neighboring states, is party to the EU-wide multilateral MoU, and actively participates in EU supervisory bodies.

### III. BCP assessment — progress and remaining issues
- General:
  - The BoL has addressed most Recommended Actions from the 2002 FSAP assessment. The mission commends the BoL for many important measures adopted since 2002.
  - The discussion below is divided into the seven broad categories of the revised BCP.

- Principle 1 — Objectives, independence, powers, transparency and cooperation:
  - As part of preparations for adopting the euro, the Law on the BoL has been amended to reflect the Statutes of the European Central Bank (ECB), further strengthening BoL independence.
  - Specific objectives of banking supervision have not been incorporated in the Law on the BoL. Authorities argue objectives are defined in the Law on Banks and as a task of the BoL in the Law on the Bank of Lithuania, and that incorporating such objectives in the Law on the BoL would not conform with the ECB’s Statutes. The mission notes the ECB’s Statutes do not prohibit national central banks from having tasks the ECB itself does not have.
  - The Law on the BoL has been amended to include a new Article 46(1) providing explicit legal protection to BoL Board members and supervision staff, protecting them in carrying out duties unless it is proven they undertook an illegal action with the intent to cause damage. This protection is additional to existing Civil Code protection.

- Principles 2–5 — Licensing and structure:
  - No major changes since 2002 in permissible activities, ownership requirements, or BoL’s licensing regime, but some changes reflect prior recommendations.
  - Progress on licensing and entry:
    - The list of licensing criteria in the Law on Banks expanded to include matters subject to ongoing supervision; Article 9 requires applicants to supply information on risk management systems, internal controls, and accounting organization.
    - Minimum capital for new banks maintained at 5 million euros in conformity with the EU Banking Directive.
    - Threshold for BoL approval of acquisitions of bank shares maintained at 10 percent of share capital per the EU Banking Directive; banks must notify BoL when 5 percent or more of authorized capital is acquired.
    - BoL can appeal to courts to request forced sale of shares by shareholders failing fitness and propriety requirements.
    - Article 49 of the Law on Banks specifies limits on a bank’s holdings of the capital of other legal persons.

- Principles 6–18 — Prudential regulation and requirements:
  - New or revised regulations and letters issued on operational risk, large exposures, internal audit, loan accounting, public disclosure, anti money laundering, and capital.
  - New regulations implementing Basel II will enter into force on January 1, 2008, covering credit, market, and operational risk, capital adequacy, public disclosure and large exposures.
  - Capital adequacy and prudential measures:
    - Minimum capital adequacy ratio reduced from 10 to 8 percent in 2005 following EU accession.
    - Mitigating measures by BoL include:
      - redefinition of residential mortgages (eligible collateral limited to registered buildings for living);
      - limitation on inclusion of current year’s profits in capital;
      - BoL urged banks to retain all profits made in 2005 and 2006, and intends to do so again with respect to profits made in 2007.
    - Stress tests and estimates of economic capital indicate cushions above regulatory minimum may not be sufficient under severe circumstances; banks’ capital base needs strengthening.
    - Where the Capital Requirements Directive allows national discretions, BoL chose conservative options, for example:
      - applying a 100-percent risk weight for commercial real estate loans (where a 50-percent risk weight would have been possible);
      - setting the maximum amount of a retail exposure at 1 million litas (about 290,000 euros) instead of 1 million euros, limiting assets eligible for a 75-percent risk weight.
  - Credit risk specifics:
    - About 90 percent of residential mortgage loans is concluded at variable interest rates (most commonly with 6 months intervals) and a substantial part is denominated in euros.
    - These features expose banks to indirect credit risk from rising interest rates or euro exchange rate changes and to valuation risks if real estate prices reverse.
    - Limited historical banking and macroeconomic time series in Lithuania create significant risk that banks’ IRB models would not capture Lithuanian loan portfolio risk characteristics, potentially underestimating regulatory capital needs.
    - Risks not adequately covered under Pillar 1 should be captured in Pillar 2 under Basel II.
  - Validation and model approval:
    - Banks applying IRB must validate internal rating systems; those applying advanced operational risk approaches must validate essential elements.
    - BoL issued Regulations on Validation and its Assessment; will carry out regular reviews of banks’ validation processes.
    - For Lithuanian banks with foreign parent, BoL approval for IRB and AMA is required, but final decision rests with home country supervisor; BoL cooperates closely with home supervisors.
    - It is expected most Lithuanian banks will not be allowed to use IRB and AMA approaches before 2009. One Lithuanian bank plans to apply IRB and AMA approaches in 2008 and has performed test calculations verified by the BoL; BoL emphasized preliminary character and noted a floor specified for the new capital requirement in the EU Directive.
  - Foreign exchange and open position rules:
    - Regulatory limit on open positions in euros abolished in 2004.
    - BoL maintains requirement that open euro positions be included in calculation of required capital for foreign exchange risk; mission found some confusion among banks about this issue.
    - BoL clarified inclusion of capital charges on euro positions to banks after the FSAP mission.
    - Authorities reaffirm commitment to maintain the currency peg under the CBA and not re-impose restrictions on banks’ net open positions in euro; mission encourages BoL to continue close monitoring of related risks.
  - Enforcement and insolvency triggers:
    - Authorities considered specifying triggers for enforcement actions when a bank’s capital falls below certain levels but do not see merit given small number of banks and BoL’s oversight capabilities.
    - Banks’ individual minimum capital requirements will be kept under review via the Internal Capital Adequacy Assessment Process and Supervisory Review and Evaluation Process.
    - The mission recommends that, at a minimum, a balance sheet insolvency condition (zero net worth) should be included in the Law as a trigger for compulsory license withdrawal.
  - Loan loss provisioning and disclosures:
    - In 2005 BoL adopted a new regulation setting minimum requirements for loan assessment and formation of specific reserves implementing IAS 39:
      - Specific reserves must be calculated if there is objective evidence a loan is impaired.
      - Senior management is responsible for establishing principles and procedures for assessing impairment, recognizing loss events, and calculating loss from impairment.
      - All significant loans and loans with objective evidence of impairment are subject to individual assessment; unimpaired loans are grouped for collective assessment.
      - Under the old regulations loans were classified into five risk groups with set provision levels.
      - BoL does not have exact data on how the new regulation affected the level of specific reserves.
      - Following 2006 Basel Committee guidelines, BoL does not intend to set additional loan loss provisioning requirements beyond IAS 39.
    - In 2006 a BoL resolution requires banks to publish information on the risks assumed and their risk management and internal control processes in annual reports; the bank’s board is responsible for accuracy and timeliness.
  - Large exposures and intra-group lending:
    - BoL revised large exposure rules in 2004:
      - Interbank loans with maturity up to 30 days were formerly excluded; exclusion reduced to 14 days provided loans are not automatically rolled over.
      - Large exposure rules apply to intra-group lending including lending to the parent bank.
      - Article 53 of the Law on Banks requires terms and procedure for intra-group lending to be approved by the bank’s supervisory board and specific intra-group loans to be approved by the managing board.
      - Law requires lending terms to natural persons related to the bank not be more favorable than terms to other clients.

*Source: _cr08246 - 1.  Reco*

### 27.      The BoL regulations on internal control require that banks have an effective

### _cr08246 - 27.      The BoL regulations on internal control require that banks have an effective

### Internal control, risk management, and IT risk
- The BoL regulations require that banks have an effective internal control system that ensures that all material risks are being recognized and continually assessed.
- The BoL has provided specific guidance on the management of operational risk and (separately) on information technology (IT) risk.
- The management bodies of a bank are held responsible by the BoL for the proper management of all material risks.

### Anti–money laundering (AML) framework
- The BoL’s Resolution on Money Laundering Prevention Guidelines requires banks to organize training for managers and staff, including those (but not limited to) who directly deal with customers, to ensure proper implementation of measures for the prevention of money laundering.
- Anti money laundering measures must be properly integrated into the bank’s system of internal control.
- Bank managers are held responsible by the BoL for the implementation of adequate anti money laundering measures, including “know your customer” procedures.
- The government’s Financial Crime Investigation Service is responsible for the coordination of anti money laundering measures and the measures taken against perpetrators.
- A new law on money laundering transposing the 2005 EU Directive on anti money laundering and countering the financing of terrorism is pending with the Parliament and is expected to come into force on 1 January 2008.
  - This law will inter alia refine the procedures for cooperation among the institutions involved in preventing and detecting financial crime and will include measures to counter the financing of terrorism.

### Methods of ongoing banking supervision (Principles 19–21)
Findings on supervision and monitoring
- The BoL conducts effective on-site and off-site supervision on all banks operating in Lithuania.
- Regular reports are submitted by banks on balance sheets, capital adequacy, liquidity, concentrations on lending and funding sides, loan impairment, and various other aspects.
- The BoL has direct access to the management information systems of some of the larger banks.
- Off-site information is analyzed and used as input to the BoL’s Early Warning System (EWS), which is based on a large number of financial ratios.
- If the EWS indicates that a bank is high risk, the BoL can require daily reports on liquidity, increase capital requirements, meet with bank management, or conduct additional on-site inspections.

On-site inspection practices
- In normal circumstances, all banks are subject to a full-scope on-site inspection once a year (for small banks the scope may be limited to exclude irrelevant aspects).
- Additional inspections may target particular risk areas or specific problems.
- Main focus: internal governance, including risk management and internal control systems.
- Credit files are examined on a sample basis.
- Compliance with laws and regulations and accuracy of supervisory reports are verified.
- On-site inspections produce a report with recommendations included in a time-specific action plan presented to the bank; implementation is monitored off-site and verified in the next on-site inspection.

Loan classification, provisioning, and sanctions
- On-site inspectors assess whether internal rules and procedures for doubtful assets evaluation, classification and provisioning comply with requirements.
- Banks required to improve loan assessment methodology if shortcomings are found.
- Additional specific provisions may be required based on loan portfolio quality.
- Sanctions, including fines and removal of board members, may be imposed if a bank does not form sufficient provisions.

Supervisory approach and communication
- The BoL is increasingly following a principle-based approach towards banking regulation (endorsed by the Committee of European Banking Supervisors).
- Some banks requested more guidance on Internal Capital Adequacy Assessment Process and stress testing; suggested solution: differentiate guidance by bank needs and increase contacts between banks and on-site supervisors between annual inspections.

Interaction between Financial Stability and Supervision
- Scope exists to enhance interaction between the Financial Stability Department and the CISD.
- Current interaction appears largely focused on data sharing.
- Potential benefits: Financial Stability Department could suggest macroeconomic stress scenarios for Supervision Department, and its stress testing model could help determine capital surcharges under Pillar 2.

### Accounting and disclosure (Principle 22)
- The Law on Banks requires Lithuanian banks to keep accounts and prepare reports according to BoL rules.
- Banks must publish quarterly and annual reports; annual financial statements must be audited.
- Audits performed in accordance with the International Standards on Auditing.
- All Lithuanian banks are audited by large and internationally active auditing firms.
Progress and disclosure improvements
- A 2002 Resolution prescribes accounting principles in line with the IAS/IFRS; senior management is responsible for correctness and timely presentation.
- The BoL established requirements for publicly disclosed information in 2006 to improve transparency and market discipline.
  - Public disclosures must provide timely, consistent and material information about activities, financial condition, risk types, and risk management mechanisms, including for any subsidiaries.
  - Materiality: information is material if omission, insufficient detail or misstatement would result in wrong decisions by users.
- Recommendation: banks should issue simplified statements comprehensible and accessible to the wide public (e.g., at branches and on the internet).

### Corrective and remedial powers (Principle 23)
- The BoL has a comprehensive range of supervisory tools from instructions to sanctions.
- Article 72 of the Law on Banks includes the possibility for the BoL to withdraw a bank’s license.
- Tools and sanctions are hierarchical and proportionate to severity.
Progress on sanctions
- The Law on Banks amended to empower the BoL to levy fines on banks.
- Possible fines listed in Article 74 range from 0.1 percent to 2 percent of a bank’s gross annual income.

### Consolidated and cross-border supervision (Principles 24–25)
Cross-border cooperation and MoUs
- Lithuanian authorities have been enhancing cross-border cooperation and the financial crisis management framework.
- BoL policy: written MoUs with all countries with banking establishments in Lithuania and countries where Lithuanian banks are established, as well as all bordering countries.
- The BoL has concluded bilateral MoUs with a number of foreign financial supervisory authorities, including those supervising parent banks of Lithuanian subsidiaries or branches.
- Signed multilateral agreements include the EU-wide trilateral MoU of 2005 on crisis management cooperation.
- Most recently the BoL signed a MoU with the central banks of Estonia, Latvia, and Sweden on management of a financial crisis in banks with cross-border subsidiaries or branches.
- The BoL and the Swedish Financial Supervisory Authority are drafting a separate MoU on supervision of financial conglomerates and procedures for SREP.

Application of home country supervisory standards
- Home country supervisors apply Lithuanian prudential requirements to local subsidiaries in consolidated supervision where Lithuanian requirements are higher for certain assets; higher requirements enter into consolidated capital adequacy calculations.
- The BoL is regularly provided by home supervisors with information on the financial condition of parent banks.
- Formal information exchange is supplemented by frequent meetings; foreign-owned banks operate within exposure limits set by their parents.

### Key recommendations (from Table 1 and BCPs)
Selected recommended actions (by theme)
- Objectives, independence, powers, transparency, and cooperation (BCP 1)
  - Consider incorporating the objectives of banking supervision in the Law on the BoL on a basis consistent with the Law on Banks.
  - Continue to advance the depth of staff expertise and skills.
- Prudential regulation and requirements (BCPs 6–18)
  - Ensure credit risk from variable interest rate borrowing or euro-denominated loans is fully captured in Pillar 1 and/or Pillar 2.
  - Clarify that open positions in euros enter into capital adequacy calculations and closely monitor banks’ open positions in euros.
  - Include, at a minimum, a balance sheet insolvency condition (zero net wroth) in the Law as a trigger for compulsory license withdrawal.
- Methods of ongoing banking supervision (BCPs 19–21)
  - Consider giving more guidance to banks on an individual basis using more frequent contacts with on-site supervisors.
  - Enhance interaction between the Financial Stability Department and the Credit Institutions Supervision Department.
- Accounting and disclosure (BCP 22)
  - Encourage banks to make public simplified information comprehensible and accessible to a wide public alongside obligatory disclosures.
- Consolidated and cross-border supervision (BCPs 24–25)
  - Continue close cooperation with home country supervisory authorities of Lithuanian banks with foreign parents.

### Authorities’ response and recent actions
- The BoL noted that as from 2008 it intends to assess each bank’s additional capital needs under Pillar 2 and to establish additional capital requirements as needed, based on the General Provisions for the Internal Capital Adequacy Assessment Process and the General Provisions for the Supervisory Review and Evaluation Process issued by the BoL.
  - This should result in capital surcharges for banks’ individual risk not captured under Pillar 1.
  - Banks are required to submit their first ICAAP report to the BoL at the end of the first quarter of 2008.
- In December 2007 the BoL organized meetings with banks to clarify that open euro positions are to be included in the capital adequacy calculation for market risks.
  - All banks specified to the BoL at that time that they now include open euro positions in the calculations in the required manner.
- Cooperation between Banking Supervision and Financial Stability Departments is “constantly increasing,” including joint banking sector stress testing and a cross-departmental committee that monitors market developments and reassesses cooperation needs annually.
- On loan assessment methodology adopted in 2005:
  - Losses regarding loan value reduction are accounted for only when actually incurred; expected future losses are not accounted for even if very likely, in compliance with IFRS.
  - The BoL considers additional reporting to measure the effect of the change on reserves an unjustified burden.
  - Regarding simplified public disclosures, the BoL notes banks have leeway to decide what information should be publicly disclosed.

*Source: _cr08246 - 27.      The BoL regulations on internal control require that banks have an effective*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08246.pdf_