Banking: Need For Effective Supervision

Haritha Sharma, Interim Editor

I believe that banking institutions are more dangerous to our liberties than standing armies. Already they have raised up a monied aristocracy that has set the government at defiance. The issuing power (of money) should be taken away from the banks and restored to the people to whom it properly belongs.”–Thomas Jefferson, U.S. President.

 Photo: BigStockVector Flat Line Art Modern Money And Finance Icons Set

We have come a long way from the stage where we looked at banks as dangerous to the stage where the entire economy of a country rests its functioning on the funding from banks. The World Bank is a prime example of this. It provides assistance by way of giving guidance, funds and vast resources to developing as well as developed countries for their economic development and for encouraging international investment.

Irrespective of how organized we have become, banks are still given a look of censure, and this is so because we still fear the complexities of banking.

We fear that the bank next door with its customer friendly policies and smiling manager might actually be cheating us. Embezzlement of funds in banks by employees, bank fraud in the form of cheque kiting[†] etc. are common occurrences. With opening up of economies of countries, the threat which supervisory authorities face is handling financial globalization.

In order to ensure effective banking supervision, most of the countries strive to put in place a system of check and balance. In this endeavor, the Basel Committee on Banking Supervision  (BCBS) has proved to be invaluable.

The BCBS is   a committee on Banking Supervision, which was established by the central bank governors of the G10 counties in 1975. It is made up of senior representatives of banking supervisory authorities and the central banks of these countries.

The committee in 1997 released the Core principles for Effective Banking Supervision, more commonly known as the Basel I. It was designed to enable the countries to have a foundation for establishing and carrying out supervisory activities by a nodal authority .It further helps in self-assessment of the countries so as to identify any regulatory and/or supervisory shortcomings and means of devise of addressing them

The Basel I had two parts, the first laid down a set of external elements, which must prevail in a country in order to ensure effective supervision. These are:

  • Sound and sustainable macroeconomic policies.
  • A well-developed public infrastructure.
  • Effective market discipline, and
  • Mechanisms for providing an appropriate level of systematic protection (for public safety net).

The committee prescribed these conditions as the very foundation of effective supervision. Though these are out of the reach of supervisors, yet they impact the supervisory system in place for banks.

The committee had urged the supervisors in this regard to make their governments aware of the need for these factors to be in place and to address any defect in them.

The second part deals with the 25 core principles, which the committee laid down. These principles are voluntary, for a country may or may not adopt them. They however, have been flexibly designed, to suite the needs of different countries. The 25 core principles had been bifurcated by the committee into the following groups:

  • Clear responsibilities and objectives for each agency involved in the supervisory system .A legal framework is also necessary.
  • Licensing and structure.
  • Prudential regulations and requirements.
  • Methods of ongoing banking Supervision.
  • Information requirements.
  • Formal powers of supervisors.
  • Cross-border banking.

Many countries have adopted these principles in their supervisory system. In Australia, The Australian Prudential Regulation Authority, which is its nodal agency for banking supervision, stated in a press release in May 2001[‡] that measured against the 25 core principles, Australia’s supervisory system scores a high level of compliance.

In India, The Banking Regulation Act, 1949 empowers the Reserve Bank of India to inspect and supervise commercial banks. A detailed study was carried out so as to ascertain gaps, in implementing the 25 core principles of effective banking supervision and to take necessary steps to make the regulatory as well as supervisory system sound and comparable to international standards.

However, over the years with the increasing financial awareness, the need for banking and consequently for banking supervision has increased. Basel I is now viewed as outmoded as it is risk insensitive and can easily be circumvented by regulatory arbitrage.[§]

BCBS in June 2004 introduced a framework to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks. Commonly known as Basel II, a comprehensive framework on The International Convergence of Capital Measurement and Capital Standards was issued by the BCBS in June 2006.

“The objective of the Committee has been to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency so that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks. The Committee believes that the revised framework will promote the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits. The revised framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and their financial market infrastructure. In addition, the framework also allows for a limited degree of national discretion in the way in which each of these options may be applied, to adapt the standards to different conditions of national markets. These features, however, will necessitate substantial efforts by national authorities to ensure sufficient consistency in application”[**]

Basel II uses a “three pillars” concept – (1) minimum capital requirements; (2) supervisory review; and (3) market discipline – to promote greater system. Basel I only dealt with parts of each of these pillars. For example: of the key pillar one risk, credit risk, was dealt with in a simple manner and market risk was an afterthought. Operational risk was not dealt with at all.

However, the committee acknowledges,  “that moving toward its adoption in the near future may not be a first priority for all non-G10 supervisory authorities in terms of what is needed to strengthen their supervision”[††].

Another hurdle in Basel II is that countries where the banking system is already very advanced and a basic supervisory system is functioning effectively can only follow the sophisticated risk measures that have been enunciated. Countries still trying to establish a rudimentary supervisory authority cannot possibly adopt this model. This model can only be implemented to strengthen an existing supervisory framework and not as the basic starting point of it.

The committee realizing the fast paced developments and significant changes in the banking system particularly and the world generally, decided to update the Core Principles. The committee has designed a revised version of Basel I itself. Although the revised version is yet to be finalized[‡‡], the committee has designed this new version with close consultation with the G-10 countries, non-G10 supervisory authorities, the IMF and the World Bank.

The 25 core principles relate to the following:

  1. Objectives, independence, powers, transparency and co-operation.
  2. Permissible activities.
  3. Licensing criteria.
  4. Transfer of significant ownership.
  5. Major acquisitions.
  6. Capital adequacy.
  7. Risk management process.
  8. Credit risk.
  9. Problem assets, provisions and reserves.
  10. Large exposure limits.
  11. Exposures to related parties.
  12. Country and transfer risks.
  13. Market risk.
  14. Liquidity risk.
  15. Operational risk.
  16. Interest rate risk.
  17. Internal control and audit.
  18. Abuse of financial services.
  19. Supervisory approach.
  20. Supervisory techniques.
  21. Supervisory reporting.
  22. Accounting and disclosure.
  23. Corrective and remedial powers of supervisors.
  24. Consolidated Supervision.
  25. Home-host relationships.

The committee thus in this draft document has strived to built upon the original core principles. Core principles have been designed to focus on key risk areas and supervisory priorities. The committee has covered not only the capital adequacy aspects but the risk aspect also in great depth while maintaining the simplistic approach adopted in the original Core principles.

The Committee has thus provided a yardstick for the countries to put in place supervisory authorities, where they do not exist and where they do exist either to revamp them or to provide for their more efficient functioning.

Banking is becoming a part of the daily lives of every person from all strata’s of society be it a fruit vendor or the chairman of a multi-national company. The increasingly important role of the banks cannot be de-emphasized.

The remarks of Chairman, Alan Greenspan, before the Annual Meeting and Conference of the Conference of State Bank Supervisors, Nashville, Tennessee in May 2, 1998 aptly summed up the need for banking and even more importantly for banking supervision as follows:

“No matter how regulated and supervised, throughout our history many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times–certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. But it is also that very same leverage that makes banks so sensitive to the risk they take and aligns the stability of the economy with the critical role of supervision, both by supervisors and by the market……….”

[†] Cheque kiting is when in-transit or non-existent cash is recorded in more than one bank account. The crime usually occurs when a bank pays on an unfunded deposit.  Example, a bum check is deposited into an account. Before the bank collects the cash, a check is written against the same account and deposited into a second account, or cashed. The increased use of wire transfers allows this type of scheme to be perpetrated very quickly

[‡] Source:

[§] Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position

[**] Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards, A Revised Framework. Comprehensive Version June 2006: on pp 2 of the compiled document.

[††] Ibid, at pp1

[‡‡] The Bank of International Settlement which serves as the secretariat for BCBS on their website have not intimated of the draft being approved. The draft was to be approved by 23 June 2006. The writer has assumed that the draft has not been finalized as yet.