Core Principles for Effective Banking Supervision

Effective banking supervision has become the cornerstone of financial supervision in recent years resulting from the recognition that weaknesses in banking systems have been at the core of financial crises in many countries over the past several decades. As banking crises have affected many countries, both developed and emerging economies, the monitoring of banking systems have become both more critical and more challenging for supervisors. In comparison to traditional methods of banking supervision that primarily involved the assessment of banks’ loan quality, the modern methods of banking supervision includes better management of risks through internal controls, on-and-off site supervision, and early warning systems — tools that allow for the better detection and prevention of bank failures. Risk management and capital adequacy, therefore, have now become crucial to effective banking supervision.

The Basel Committee and Its 25 Basel Core Principles for Effective Banking Supervision

The Basel Committee on Banking Supervision (BCBS) was created in 1974 by the central bank governors of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States, collectively called the G10 nations. Luxembourg and Spain are also current members of the BCBS and the Secretariat for the BCBS is located at the Bank for International Settlements in Basel, Switzerland. The Basel Core Principles for Effective Banking Supervision (henceforth referred to as BCPs) were issued by the BCBS in September 1997 and endorsed by the international financial community during the annual meeting of the International Monetary Fund (IMF) and World Bank in October 1997. The BCPs serve only as a benchmark against which the effectiveness of banking supervision regimes can be assessed and is not binding or enforceable. The BCPs comprise twenty five basic Principles for effective supervisory system. According to the BCBS, they fall under the following categories: (1) objectives, autonomy, powers, and resources of the supervisory body; (2) licensing and structure of banks; (3) prudential regulations and requirements for banks; (4) methods of ongoing banking supervision; (5) information requirements for banks; (6) remedial measures; and (7) cross-border banking.

According to the Basel Committee, since 1997 significant changes have occurred in banking regulation and new regulatory issues and insights and gaps in regulation have become apparent, often resulting in new Committee publications. These developments have made it necessary to update the BCPs and the associated assessment methodology. New and updated BCPs were issued in October 2006.

Applicability of the 25 Basel Core Principles for Effective Banking Supervision

The BCPs provide a benchmark against which the effectiveness of bank supervisory regimes can be assessed. The assessments identify areas that need strengthening and that contribute to the stability of the financial system. In other words, the BCP assessments provide useful qualitative information on the risk environment, the responsiveness of the supervisor, and the overall effectiveness of risk management in banks. The 25 BCPs formulated in 1997 and its accompanying Methodology issued in 1999 formed the basis for country assessments up until late 2006. Starting October 2006 assessors are expected to follow the new (2006) BCPs and its accompanying methodology though the BCBS states that the 1997 framework has functioned well and has withstood the test of time. The intention of the 2006 update, therefore, was not to radically rewrite the BCPs but rather to focus on those areas where adjustments to the existing framework were required to ensure their continued relevance. Further, the 2006 BCPs and methodology, according to the BCBS, does not in any way call into question the validity of previous work already conducted, not least country assessments and reform agendas based on the 1997 framework. However, it is still too early to find many assessments made against the 2006 BCPs.

The Basel Committee as such, owing to lack of resources, does not make assessments per se; it does provide guidance in terms of advice and training to assessors. Each Principle consists of Essential and Additional Criteria which are described in the 1999 methodology. As the name suggests, essential criteria are those requirements that a country must meet in order for it to be considered compliant with a particular Principle. The additional criteria, on the other hand, are requirements that go above and beyond compliance. Depending on a country’s regulatory, institutional, or risk environment, there may be instances where all the essential criteria are not required to be met in order for a country to achieve compliance. Similarly, there other instances where a country is required to meet essential and some or all of the additional criteria in order for it to be considered as complying with the BCPs.

The IMF/World Bank Financial Sector Assessment Programs are the most common and comprehensive third-party assessments on countries’ compliance with the BCBs. It is worth noting that in 2007, the IMF released two country update reports based on the 2006 BCPs. Similarly, there are occasional self-assessments by national regulators that more or less follow the BCBS’ methodology and can be invariably used to assign compliance levels. Other international organizations, such as the European Central Bank, the International Institute of Bankers, also publish reports on countries’ banking supervision practices.