1. Evaluating the Effectiveness of Financial Supervision Paul J.van Sluijs World Bank Nairobi, 15-17 May 2006

2. 2 Contents 1. Some observations 2. FSAP background 3. Main components of regulatory standards 4. Reviews 2003 and 2006 5. Gaps in financial sector regulation 6. Strengthening standards

3. 3 1 Some observations FSAP: interesting experience for the country to be assessed as well as for the assessing experts FSAP: interesting experience for the country to be assessed as well as for the assessing experts Self assessments should be critically reviewed Self assessments should be critically reviewed Assessment includes practical application of supervisory standards: rule- or principle based Assessment includes practical application of supervisory standards: rule- or principle based Application in practice of supervisory rules and regulations is difficult to assess Application in practice of supervisory rules and regulations is difficult to assess Stress testing important addition to assessment Stress testing important addition to assessment EU used similar approach for new entrants EU used similar approach for new entrants

4. 4 Relative security 1.Not even “perfect” formal implementation of the existing principles or standards and codes will ensure financial system stability. 2.Not even the most thorough financial supervision regime can fully protect against risks to the financial system.

5. 5 2 FSAP Background Start in 1999 as voluntary program Start in 1999 as voluntary program Joint effort World Bank and IMF Joint effort World Bank and IMF 75 central banks, supervisory agencies etc cooperated 75 central banks, supervisory agencies etc cooperated Based on review in 2003 decision for continuation Based on review in 2003 decision for continuation Further evaluation in 2006 Further evaluation in 2006

6. 6 FSAP characteristics Financial sector coverage Financial sector coverage Analytical tools: Analytical tools:  FSIs  Stress testing  Assessment of standards and codes:  BCP/CPSIPS/IAISCP/IOSCO principles/MFP code

7. 7 3 Main components of regulatory standards Introduction Introduction (Regulatory preconditions) (Regulatory preconditions) Regulatory governance Regulatory governance Regulatory practices Regulatory practices Supervisory practices Supervisory practices Financial Integrity and Safety Nets Financial Integrity and Safety Nets

8. 8 Introduction Financial sector regulatory standards comprise essential, but minimum standards Financial sector regulatory standards comprise essential, but minimum standards Good quality regulation is a key element of financial stability Good quality regulation is a key element of financial stability Regulatory standards are internationally adopted and locally implemented Regulatory standards are internationally adopted and locally implemented Cross sector review contributes to review of standards Cross sector review contributes to review of standards

9. 9 Introduction (continued) Regulatory standards: BCP (1997 + 1999; draft revision 2006 ) BCP (1997 + 1999; draft revision 2006 ) IOSCO (1998 + 2003) IOSCO (1998 + 2003) IAIS (2003) IAIS (2003) Common ground Common ground Some variations in similar risks (e.g. capital/risk treatment) Some variations in similar risks (e.g. capital/risk treatment) Some variations arising from intrinsic differences Some variations arising from intrinsic differences

10. 10 Introduction (continued) Main regulatory issues from financial stability viewpoint: Regulatory governance: capacity and ability of regulatory bodies for sound policies and practices Regulatory governance: capacity and ability of regulatory bodies for sound policies and practices Prudential framework: rules, directives etc to govern operations of financial firms Prudential framework: rules, directives etc to govern operations of financial firms Regulatory practices: practical application of regulatory framework Regulatory practices: practical application of regulatory framework Financial integrity and safety net arrangements: instruments to promote fairness and integrity in operations Financial integrity and safety net arrangements: instruments to promote fairness and integrity in operations

11. 11 (Regulatory preconditions) BCP (1997) Sound and sustainable macro-economic policies Sound and sustainable macro-economic policies Well developed public infrastructure Well developed public infrastructure Effective market discipline Effective market discipline Procedure for efficient resolution of problems in banks Procedure for efficient resolution of problems in banks Mechanisms for providing an appropriate level of systemic protection (public safety net) Mechanisms for providing an appropriate level of systemic protection (public safety net) (Similar preconditions in IAIS CP)

12. 12 (Regulatory preconditions) Preconditions are basis for standards Preconditions are basis for standards Linkages between preconditions and regulations, for instance: Linkages between preconditions and regulations, for instance:  “well developed public infrastructure” links with asset valuation, supervisory powers, enforcement, collateral, licensing, accounting framework

13. 13 Regulatory governance Objectives of regulation Objectives of regulation Independence and adequate resources Independence and adequate resources Enforcement powers and capabilities Enforcement powers and capabilities Clarity and transparency of regulatory process Clarity and transparency of regulatory process External participation External participation

14. 14 Prudential framework Risk management Risk management Risk concentration Risk concentration Capital requirements Capital requirements Corporate governance Corporate governance Internal controls Internal controls

15. 15 Regulatory practices Group-wide supervision Group-wide supervision Monitoring and on-site supervision Monitoring and on-site supervision Reporting to supervisors Reporting to supervisors Enforcement Enforcement Cooperation and information sharing Cooperation and information sharing Confidentiality Confidentiality Licensing, ownership transfer and corporate control Licensing, ownership transfer and corporate control Qualifications Qualifications

16. 16 Financial Integrity and Safety Net Markets (integrity and financial crime) Markets (integrity and financial crime) Customer protection Customer protection Information, disclosure and transparency Information, disclosure and transparency

17. 17 4 Review in 2003 and 2006 Comprehensive and system wide approach to analyzing the financial sector Comprehensive and system wide approach to analyzing the financial sector  Independent review by objective outsiders  Discuss supervisory matters with experts from other countries  Compare practices  Benchmarking against international practices  Testing vulnerabilities in the financial system  Selection of key issues and priorities for improvements

18. 18 Review in 2003 and 2006 Points of attention (2003): Points of attention (2003):  Faster and more thorough understanding necessary of legal and regulatory traditions  Limitations of data availability for stress testing  Large resource costs for authorities  Reduction of lag between assessment and report

19. 19 Review in 2003 and 2006 FSAP increased depth and breath of coverage of financial issues: FSAP increased depth and breath of coverage of financial issues:  Developing countries: strengthening medium term financial system and supervision  Address legal and regulatory framework  Emerging countries: non bank sector deficiencies in supervision and regulation; enforcement and prompt corrective action  Industrial countries: large and complex financial institutions

20. 20 FSAP review recommendations (2003) Updates necessary for: Updates necessary for:  systematically important countries  Countries evolving at a rapid pace Selection of key topics per update Selection of key topics per update For developing countries: focus on medium term and structural issues For developing countries: focus on medium term and structural issues AML/CFT issues to be included AML/CFT issues to be included Possible basis for TA Possible basis for TA Promote publication on a voluntary basis Promote publication on a voluntary basis

21. 21 FSAP findings: areas for improvement (2003) For BCP: Credit policies and connected lending Credit policies and connected lending Provisioning practices in practice weaker than on paper Provisioning practices in practice weaker than on paper Increase attention for country, market, fc and interest rate risk Increase attention for country, market, fc and interest rate risk Remedial action Remedial action Large and complex financial institutions Large and complex financial institutions Consolidation of accounts and supervision on a consolidated basis Consolidation of accounts and supervision on a consolidated basis AML/CFT issues AML/CFT issues

22. 22 FSAP evaluation 2006 Some issues: Better understanding key linkages Better understanding key linkages Discussions with authorities and support institutional changes Discussions with authorities and support institutional changes Not all systemic countries assessed Not all systemic countries assessed FSIs generally not used in a meaningful manner FSIs generally not used in a meaningful manner Quality of data needs to be emphasised Quality of data needs to be emphasised Stress testing needs further development Stress testing needs further development Cross border issues need more attention Cross border issues need more attention Surveillance and technical assistance Surveillance and technical assistance

23. 23 6 Gaps in financial sector regulation

24. 24 Conclusions (2004) Average level of implementation of regulatory components across sectors broadly satisfactory Average level of implementation of regulatory components across sectors broadly satisfactory Implementation in industrial countries better than in emerging and developing countries Implementation in industrial countries better than in emerging and developing countries Level of implementation across sectors is correlated Level of implementation across sectors is correlated

25. 25 Conclusions (2004) High level of implementation in particular for legal foundation of regulator High level of implementation in particular for legal foundation of regulator Prudential area: capital, solvency and margin requirements prescribed across sectors Prudential area: capital, solvency and margin requirements prescribed across sectors Licensing process and entry standards largely adequate in most countries Licensing process and entry standards largely adequate in most countries

26. 26 Where are the Gaps? A. Regulatory Governance B. Regulatory practices C. Prudential framework D. Financial Integrity and Safety Net

27. 27 A. Regulatory governance Lack of formal and informal independence Lack of formal and informal independence Ill-defined accountability arrangements Ill-defined accountability arrangements Different categories of deposit taking institutions under different laws and regulators Different categories of deposit taking institutions under different laws and regulators Regulatory forbearance is a problem in some countries Regulatory forbearance is a problem in some countries Ill-defined oversight responsibilities in case of regulators and SRO”s Ill-defined oversight responsibilities in case of regulators and SRO”s Lacking legal protection of supervisors and clarity of regulatory powers Lacking legal protection of supervisors and clarity of regulatory powers

28. 28 B. Regulatory practices In many cases robust regulatory standards but weaker regulatory practices In many cases robust regulatory standards but weaker regulatory practices Consolidated supervision and – regulation needs more attention Consolidated supervision and – regulation needs more attention Shortcomings in regulatory data and reporting, including consolidated reporting Shortcomings in regulatory data and reporting, including consolidated reporting

29. 29 B. Regulatory practices (continued) Limited powers to enforce regulations and impose sanctions Limited powers to enforce regulations and impose sanctions Inadequate cooperation between home and host supervisors Inadequate cooperation between home and host supervisors Lack of clear definition of “control” Lack of clear definition of “control” (Quality of management, administration and internal control??) (Quality of management, administration and internal control??)

30. 30 C. Prudential framework Strong focus on prudential regulation, but: Strong focus on prudential regulation, but:  Deficiencies in oversight and monitoring of country risk  Insufficient requirements for connected lending  Weaknesses corporate governance in particular in banking and insurance

31. 31 C. Prudential framework (continued) Sector specific issues: Banking: Credit risk management, loan classification and provisioning, large exposures, country and transfer risk Banking: Credit risk management, loan classification and provisioning, large exposures, country and transfer risk Asset quality regulation in insurance Asset quality regulation in insurance Monitoring and inspection systems ensuring compliance with capital and prudential requirements Monitoring and inspection systems ensuring compliance with capital and prudential requirements Collective investment schemes: improvement needed of information, asset valuation and pricing of units Collective investment schemes: improvement needed of information, asset valuation and pricing of units

32. 32 D. Financial integrity and safety net In general differences along sectoral lines: Content and timeliness of disclosure Content and timeliness of disclosure Protection of minority shareholders Protection of minority shareholders Accounting and auditing issues Accounting and auditing issues Procedures for winding up insurers and securities forms missing Procedures for winding up insurers and securities forms missing Weak AML efforts Weak AML efforts

33. Strengthening regulatory standards

34. 34 Strengthening regulatory standards Challenges from three factors: Diversity of financial systems a.o. Diversity of financial systems a.o.  Ownership  Role government  Competition  Intermediation patterns

35. 35 Strengthening regulatory standards Cross-sectoral and cross border issues a.o. Cross-sectoral and cross border issues a.o.  Linkages in financial sector growing  Role of international financial centers  Role of off-shore centers  Cross-sector and cross-border financial groups  Arbitrage possibilities across sectors  Different cross-sector and cross-border capital calculations  Cross country differences in preconditions and governance

36. 36 Strengthening regulatory standards Objectives and design of regulatory standards a.o. Objectives and design of regulatory standards a.o.  Regulatory issues and components more linked to system-wide financial stability  Interrelationships among key components of regulatory standards more explicit  Improve standards on information disclosure

37. 37 Issues for standards setters Diversity in financial systems require diversity in regulatory standards? Diversity in financial systems require diversity in regulatory standards? More focus on preconditions More focus on preconditions Cross-sectoral and cross-border issues Cross-sectoral and cross-border issues Guidance on regulatory governance issues Guidance on regulatory governance issues Information exchange arrangements Information exchange arrangements

38. 38 Issues for country authorities Greater attention to preconditions Greater attention to preconditions Periodic review of governance in regulatory bodies Periodic review of governance in regulatory bodies Periodic self assessment of regulatory standards Periodic self assessment of regulatory standards Attention for cross-sector and cross-border issues Attention for cross-sector and cross-border issues Attention for system-wide issues Attention for system-wide issues

39. 39 Sources: * Financial Sector Assessment Program – Review, lessons and issues going forward IMF/World Bank February 2003 * Report on the evaluation of the Financial Sector Assessment Program IMF January 2006 * Financial Sector Regulation: Issues and Gaps IMF August 2004