Case study: the Basle Committee on Banking Supervision and supervisory practices

Established in 1974, the Basle Committee on Banking Supervision follows the general Basle process. It does not possess any formal supranational supervisory authority as its conclusions do not have legal force. For this reason, central banks are neither compelled, nor required by law, to subject themselves to the decisions of the Committee. It formulates broad supervisory standards and guidelines and recommends statements of best practices in the expectation that individual authorities from different countries will take steps to implement them through arrangements suited to their corresponding national systems. Thus, the Committee encourages convergence towards common standards without detailed uniformity or harmonization of countries' techniques of supervision.

The standard-setting process starts with the identification of the salient issues by the Committee, such as capital requirements, credit risk, market risk or cross-border banking. The Committee seeks the endorsement and commitment for its major initiatives and projects from the central bank governors of the G-10 countries. A working group is then formed, which normally consists of supervisory authorities from the Committee members and selected non-G-10 countries, to formulate the principles and standards with regard to the issue at hand. The drafting of the document is done through a series of meetings of the working group, as well as consultations with a wider group of individual supervisors and regional supervisory groups. Usually, international institutions such as IMF and the World Bank are invited to comment on the work at various intermediate stages. After amendment and finalization of the document, endorsement by the central bank governors of the G-10 countries is sought.¹⁶ Once this has been completed, IMF and the World Bank, together with other institutions and central bank groups, aid in the communication of the document to countries around the world, including non-members of G-10, for implementation. The next step is the assessment of compliance with the principles by the Committee through various methods, such as questionnaires. The process may start over again with the identification of other issues, which may eventually lead to additional papers or amendments of the current document - all with extensive consultation with supervisory groups and international institutions. Among the significant outputs of this Committee are the Basle Capital Accord (1988) and the Basle Core Principles for Effective Banking Supervision (1997).

IMF and the World Bank play an active role in the implementation and assessment of compliance. These two institutions encourage member countries to comply with such best practices, and work with them in assessing compliance. Furthermore, they seek to have countries remedy the identified weakness in their respective banking systems as a result of the assessment. Finally, both IMF and the World Bank, as well as the Financial Stability Institute recently established at BIS, provide technical assistance and training in order to address such weaknesses.

Technical aspects in BIS monitoring: the case of banking supervision

The choice of the variables to be monitored follows from the particular framework for analysis. Thus the variables used by the Committee to monitor banks correspond to the different types of risks identified by the Committee. These variables are described below.

Credit risk. This pertains to the risk of default of a borrower. Credit risk concentration owing to large exposures to a single borrower or to a group of related borrowers is a common cause of banking problems.  The Core Principles recommend that banking supervisors set prudential limits to restrict bank exposures to single borrowers, groups of related borrowers and other significant risk concentrations. These limits are usually expressed in terms of the lending bank's capital and, although they may vary from one bank to another, 25 per cent of capital is usually the most that a bank may extend to a private sector non-bank borrower, or a group of closely related borrowers, without specific supervisory approval. In addition, supervisors are encouraged to monitor the banks' handling of concentrations of risk, wherein banks would report to them if any exposure exceeded a specified limit.

Country risk. A wide variety of factors, such as the economic, social and political environment of the home country, may prevent borrowers of that country from fulfilling their foreign obligations. In a published document,¹⁷ the Committee called for an assessment of these risks, involving the analysis of statistical information of the borrower country. The objective of this analysis would be to project a path for countries' external debt and to forecast their ability to service and repay. This entails examination of the outlook for official reserves and other balance-of-payments items, terms of trade, exchange rates, inflation, record in servicing and repaying external debt, and other relevant factors. Second, there is also a need for proper measurement of country exposure. For this, the Committee recommends a framework within which banks' measurement systems should be set. Finally, banks are also advised to review their appropriate weighting or limits applied to their individual country exposures. Although the Committee does not impose a specific limit or percentage as to the exposure on an individual country, it maintains that banks' limits to exposures must be in relation to the degree of perceived risk. One data set that is of help is the BIS semi-annual report of the maturity distribution of international bank lending.

Market risk and foreign exchange risk. Market risk is defined as the risk of experiencing losses from the on-and-off-balance-sheet positions arising from movements in market prices.¹⁸ In this category are the risks pertaining to interest rate-related instruments and equities in the trading book of a bank; and foreign exchange risk and commodities risk throughout the bank. Hence, in a report on supervision of banks' foreign exchange positions,¹⁹ the Committee states that supervisory authorities must seek to ensure that the risks assumed by banks in their foreign exchange operations are never so large as to constitute a significant threat to either the solvency or liquidity of individual banks. The role of bank management and the establishment of internal control procedures covering foreign exchange business are considered pivotal in ensuring the safety of banks with regard to foreign exchange operations. The Committee leaves the setting of standards of limitation to national supervisors, but stresses the desirability of distinguishing between a bank's total uncovered position in foreign currencies and its open position in individual foreign currencies. In addition, in order to avoid the risk of overtrading, it is suggested that banks keep their foreign exchange turnover approximately in line with the size of their balance sheet. In several major countries, the standard used is the size of the bank's capital base. Finally, in monitoring banks' foreign exchange business, the Committee proposes that the authorities look into two types of information flows: statistical reports from the banks about their foreign exchange operations, and information about events and developments in the foreign exchange market.

Interest rate risk. The exposure of a bank's financial condition to adverse movement in interest rates can have a strong impact on a bank's earnings and capital base, and the economic value of its assets, liabilities and off-balance-sheet instruments. Thus, the Committee recognizes the need for an accurate, informative and timely management information system for measuring and managing interest rate risk exposure, both to inform management and to support compliance with policy. The reports that the Committee recommends should, at a minimum, include the following: (a) summaries of the bank's aggregate exposures; (b) reports demonstrating the bank's compliance with policies and limits; (c) results of stress tests, including those assessing breakdowns in key assumptions and parameters; and (d) summaries of the findings of reviews of interest rate risk policies, procedures, and the adequacy of the interest rate risk measurement systems, including any findings of internal and external auditors.²⁰ Moreover, the bank is asked to submit sufficient and timely information to its supervisors on the range of maturities and currencies in its portfolio.

Liquidity risk. Liquidity risk arises when a bank cannot obtain sufficient funds to meet demand, either by increasing liabilities or by converting assets promptly. When a bank has inadequate liquidity, its profitability can be affected and, in some cases, insufficient liquidity can lead to the insolvency of a bank.²¹ The purpose of liquidity management is thus to ensure that a bank is able to meet its contractual commitments fully. The Committee maintains that the elements of strong liquidity management include good management information systems, central liquidity control, analysis of net funding requirements, diversification of funding sources, and contingency planning. The analysis of net funding requirements involves the construction of a maturity ladder and the calculation of cumulative net excess or deficit of funds at selected maturity dates. A bank's net funding requirements are determined by analysing its future cash flows based on assumptions of the future behaviour of assets, liabilities and off-balance-sheet items, and then calculating the cumulative net excess over the time frame for the liquidity assessment. Banks are advised by the Committee to construct a maturity ladder that will be used to compare a bank's future cash inflows with its future cash outflows over a series of specified time periods.

Capital adequacy. Pursuant to the Basle Capital Accord, the Committee also focuses on another important channel for monitoring banks, capital adequacy. The variable associated with this is the capital adequacy ratio, which the Accord has set at 8 per cent capital in relation to risk-weighted assets as the minimum capital adequacy ratio requirement for internationally active banks. One principle in the Basle Core Principles states that banking supervisors ought to set minimum capital requirements for banks and, for international banks, this ratio must meet the minimum standard indicated in the Accord. This figure is perhaps the most widely quoted benchmark of BIS used in assessing the fragility of the financial systems of individual countries. As there were questions about the role of this standard in the run-up to the Asian crisis, the Accord is currently under review and amendments are likely to be adopted in the near future.

The above discussion illustrates the role of the Basle Committee on Banking Supervision with regard to surveillance and the development of early warning systems for banking crises. The Committee has one document focusing on each type of risk, discussing the different ways of managing from which one can gather the variables to be monitored. The documents also highlight the role of the banking supervisors in the development of risk management systems. The setting of standard or benchmark levels with regard to variables such as levels of foreign exchange exposure, levels of liquidity, country exposure etc. are all left to banking supervisors. The exceptions are the minimum capital adequacy ratio requirement (8 per cent), and the risk concentration ratio (25 per cent of capital). The Committee gives only the general framework of the management and procedures of risk assessment to be followed by each banking supervisor. By doing so, BIS is recognizing the autonomy of central banks and other banking supervisors, as well as taking into account the fact that, given the diversity of banks worldwide, the imposition of uniform standards could prove to be ineffective.

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Footnotes:

¹⁶ In some papers, there is no indication as to whether there is endorsement by the Governors of G-10, but important documents containing major principles and standards do state such endorsement.

¹⁷ See BIS, Management of Bank's International Lending, available at <http://www.bis.org/publ/bcbsc002.htm#v1d5> (21 January 2000).

¹⁸ See BIS, Core Principles for Effective Banking Supervision (Basle Core Principles), available at <http://www.bis.org/publ/bcbsc102.pdf> (18 January 2000).

¹⁹ See BIS, Supervision of Banks' Foreign Exchange Positions, available at <http://www.bis.org/publ/bcbsc117.pdf> (21 January 2000).

²⁰ See BIS, Principles for the Management of Interest Rate Risk, available at <http://www.bis.org/publ/bcbs29a.htm> (21 January 2000).

²¹ See BIS, Core Principles for Effective Banking Supervision...