Regional Options for Financial Sector Supervision. in Forum Island Countries

Transcription

1 Regional Options for Financial Sector Supervision in Forum Island Countries Final Version dated March 2010 VINSTAR Limited 1 draft report dated September 2008 Andrew Milford 2 revised draft report dated February Vinstar Limited consultancy was lead by Dr Don Brash, former Governor of the Reserve Bank of New Zealand. 2 Andrew Milford is an ex-international Monetary Fund/ Pacific Financial Technical Assistance Centre Adviser on Financial Sector Supervision and currently undertakes consultancy work.

2 Contents Executive summary... 3 Section 1: Background... 5 Section 2: The Financial Sector in FICs... 7 Supervision in the region... 8 What are the gaps?... 9 Section 3: Why Supervise, and what is Involved? Section 4: International Requirements and FIC-Specific Needs A Role for Regional Approaches Section 5: Benefits and Costs of Possible Proposals (i) Memoranda of Understanding (MOUs) (ii) Sustainable Approaches to Technical Assistance, Regional Training Opportunities and Regional Attachments (iii) Outsourcing of Some Areas of Supervision (iv) Development of Shared Supervisory Services (v) Contracting of Supervisory Services (vi) A Further Option A Role for Auditors and Actuaries Section 6: Solutions to address the gaps (i) Establishing MOUs: (ii) Technical assistance: (iii) Contracting supervisory services Sub-groups of FICs, each with different needs Conclusion

3 Executive summary The 2006 Forum Economic Ministers Meeting (FEMM) Biennial Stocktake highlighted a number of areas where further action is required in financial sector reform by Forum Island Countries (FICs). In particular, FEMM recognised that prudential regulation and supervision of the financial sector, in its broadest sense, remains problematic in Small Island States (SIS) members and some consideration could be given to regional approaches. The FEMM in Palau in July 2007 proposed that consideration be given to improving the quality of supervision in the region by adopting greater regional or sub-regional forms of cooperation. 2. The scope and quality of financial sector supervision varies considerably among the 14 FICs, from the reasonably comprehensive supervision in those six countries which have their own central banks to the total absence of supervision in the four countries which have neither central banks nor any other form of supervisory agency. Across the region, a number of FICs have had experiences with problem financial institutions and in the extreme institutions have failed with consequences for stakeholders and the jurisdiction s economic development and well-being. 3. There appears to be very little enthusiasm for a regional or sub-regional approach to supervision among stakeholders. Opposition to a regional or sub-regional approach was weakest among the four countries which currently have no supervisory agency, namely Kiribati, Nauru, Niue, and Tuvalu. Supervision can continue as currently in the countries which have their own central banks, and probably must do in the three countries which have offshore financial centres to satisfy international concerns around money-laundering. 4. Despite the disparities between FICs and limited support for regional approaches, options exist for FICs which will enable them improve the quality of supervision. The appropriateness of each option to an individual country will vary according to its current approach to supervision and resources. For those FICs which are already undertaking supervision some of the options proposed offer avenues to further develop and strengthen capacity or better focus resources. For those FICs which do not undertake any form of supervision, the options should assist them to put in place measures that will go some way to ensuring that the stakeholders interests are protected. 5. Of the options previously canvassed at the 2007 FEMM, three are considered as achieving the balance between the cost of supervising financial institutions and the provision of financial services from sound financial institutions. These are: (i) FICs entering in Memorandum of Understanding (MOUs) with the home country supervisory agency of those foreign owned financial institutions operating within their jurisdiction. The MOU would provide for information sharing and could possibly include the sharing of supervisory resources. This option is applicable to FICs with supervisory capacity, with the possible benefit of better focussing efforts elsewhere, and those with little or no supervisory resources; - 3 -

4 (ii) Additional resources should be provided by donors and providers to bolster existing efforts to provide technical assistance. A stock-take, against international supervisory standards, of needs should be performed against the vulnerabilities of jurisdictions financial systems to loss either through fraudulent activities or mismanagement of financial institutions, such as pension funds. This option is applicable to FICs with supervisory capacity and those with little or no resources. Overtime and in response to changing donor priorities, FICs may be required to meet some of the costs associated with training and other initiatives to develop regional capacity; and (iii) For those FICs with limited or no supervisory resources, it is suggested that the Pacific Financial Technical Assistance Centre (PFTAC) in collaboration with PIFS and donors and providers of technical assistance establish a mechanism to provide for the contracting of consultants to conduct periodic reviews of financial institutions. 6. Each option requires jurisdictions, particularly those with no supervisory agency, to commit resources to ensure that they are in a position, given the importance of sound financial institutions to a jurisdiction s economic development, to monitor the activities of financial institutions. A first step for several FICs is the need to develop a legislative framework which provides for the supervision of financial institutions. 7. To supplement their efforts and to ensure that all participants in the financial system are subject to supervisory oversight, FIC jurisdictions should consider: Entering into a MOU with the home country supervisor covering foreign owned banks and insurers operating within their jurisdiction; and Seeking additional technical assistance to assist them identify areas and avenues to enable them to enhance their skills and capacity in relation to the supervision of other classes of financial institution (e.g. pension funds and other non-bank financial institutions)

5 Section 1: Background 8. At the 2001 Forum Economic Ministers Meeting (FEMM), Ministers adopted Principles for Financial Sector Reform which included, among other things, the development of strong independent supervisory agencies. 9. The FEMM 2006 Biennial Stocktake highlighted a number of areas where further action was required in financial sector reform by Forum Island Countries (FICs). In particular, FEMM recognised that prudential regulation and supervision remained problematic in Small Island State (SIS) members, and suggested that some consideration be given to a regional approach. This was seen as particularly important given the key constraint of lack of capacity (technical, human and financial) identified in the Stocktake. The Stocktake suggested that a regional approach, or even outsourcing of prudential regulation and supervision, could have considerable merit, especially for SISs: it could give efficiency gains to other (non-sis) FICs, and increase the likelihood of all FICs meeting international standards in this area. 10. At the July 2007 FEMM, Ministers reiterated that prudential regulation and supervision of the financial sector remained a challenge, particularly in SISs. The FEMM mandated a closer examination of the challenges and constraints in FIC supervisory frameworks, and an examination of potential solutions, including outsourcing, contracting, and development of shared supervisory services. The FEMM paper, Financial Sector Reform, Financial Sector Regulation and Supervision in Forum Island Countries, written by Mr Andrew Milford of the Pacific Financial Technical Assistance Centre (PFTAC), provides the relevant background information Following the presentation of this paper, the FEMM mandated that the Pacific Islands Forum Secretariat (PIFS), in collaboration with the PFTAC, do further work to strengthen financial sector supervision in FICs, and in particular in the SISs, by developing specific proposals for regional mechanisms to facilitate better regulation and supervision of the financial sector in FICs. 12. A contract to undertake this study was let to Vinstar Limited, an Auckland-based consultancy, and Vinstar Limited contracted Dr Don Brash to undertake the study on 22 July The study involved visiting nine specified FICs (Cook Islands, Fiji, Kiribati, the Marshall Islands, Nauru, Palau, Samoa, Tonga, and Vanuatu) and talking to those knowledgeable about financial sector regulation and supervision in the other five member countries (Federated States of Micronesia, Niue, Papua New Guinea, the Solomon Islands, and Tuvalu). In addition to speaking to those in all Pacific Islands Forum countries, the assignment involved talking also to a number of other people familiar with the issues facing the FICs, including the PIFS, PFTAC, APRA, the RBNZ and several people at the IMF and the Bank for International Settlements in Basel. A full list of those interviewed for the study is in Annex A. 3 Found at

6 13. The preliminary findings of the assignment were delivered by Dr Brash to FIC stakeholders (from all FIC members) at a Workshop hosted by the Pacific Islands Forum Secretariat on 29 August 2008, in Nadi. During the Workshop, key conclusions and recommendations resulting from the field visits and phone interviews were outlined to and discussed with attendees. There appeared to be a general acceptance by attendees of the appropriateness of the recommended approach to meeting the supervisory needs of the FICs At the 2008 FEMM, Ministers noted that the scope and quality of financial sector supervision varies considerably among Forum Island Countries, from supervision by central banks in six countries to the total absence of supervision in the four countries which have neither central banks nor any other form of supervisory agency. 15. Ministers, at the 2008 FEMM, also noted the preliminary conclusion of the draft study mandated by the 2007 FEMM, is that the sub-regional regulatory arrangements have the potential to mitigate the supervisory gaps in both the Freely Associated States and the group of countries currently without a supervisory agency, mainly the Small Island States. Australia offered to explore options to assist FICs with the supervision of their financial sectors including through relevant agencies such as the Australian Prudential Regulatory Authority. 16. At their 2008 meeting, Ministers also noted that the preliminary conclusion of the draft study is that those FICs with central banks have the potential, with appropriate support, to address the supervisory needs of their financial systems. Ministers encouraged ongoing capacity building and technical assistance support provided to FIC financial sector supervisory agencies by international and regional agencies, particularly Pacific Financial Technical Assistance Centre. 17. At the 2009 FEMM, Ministers noted that the recent global economic crisis has further highlighted the need for the financial sector to be appropriately regulated and supervised, including where appropriate prudentially regulated. Ministers noted the range of capacity building and technical assistance programs already underway across the region by development partners, including the Pacific Financial Technical Assistance Centre. They also noted the potential for greater private sector provision of capacity building and technical assistance in the financial services sector. 4 Those attending were not only officials from ministries in all FICs, but from PFTAC, and from the governments of Australia and New Zealand, as well. While it would be inappropriate to assume that all those present endorsed the conclusions of the study, there appeared to be a widespread acceptance that the recommendations arising from the study were broadly sensible. The most explicit concern noted was that the presentation was almost entirely silent on the supervision of pension funds, a deficiency which has been remedied in the final version of the report following further s and phone calls to most FICs

7 Section 2: The Financial Sector in FICs 18. In most FICs, the financial sector is dominated by the banking sector, and the banking sector is dominated in turn by foreign institutions operating either as subsidiaries of, or branches of, major institutions regulated and supervised outside the region. Thus, for example, the dominant banks in Palau are supervised by US authorities, and deposits with them are insured by the Federal Deposit Insurance Corporation up to the limit which applies to deposits in the US. In Kiribati, the only bank is 75% owned by the ANZ Bank in Australia, with the balance of the shares owned by the government. In Nauru, there is no bank operating (the government-owned Bank of Nauru having failed nearly a decade ago), but the government s intention is to encourage one of the large Australian banks to open a branch. 19. In Vanuatu, an estimated 85% of the banking market is in the hands of the ANZ and Westpac, with most of the balance held by a government-owned bank and a recently arrived subsidiary of a French bank. Three of the five banks operating in Fiji are owned by large Australian banks (two branches and one subsidiary), with the other two being branches of a large Indian bank and a bank incorporated in Papua New Guinea. In Tonga and the Cook Islands, some 85% of the banking industry is in the hands of the ANZ or Westpac, and those banks have only a slightly smaller share of the market in Samoa. In the Solomon Islands, all three banks operate as branches of foreign banks, and the only bank operating in Niue is incorporated in Papua New Guinea. Only in Papua New Guinea, the Federated States of Micronesia and the Marshall Islands is banking business divided roughly equally between a locally-owned bank and banks supervised by US or Australian authorities, while in Tuvalu there is no foreign bank operating. 20. There are, of course, development banks in several FICs, but these are not banks in the ordinary sense of the word. Most of them do not take deposits, and are best thought of as agencies of government established to make loans to favoured sectors (small businesses in most countries, but loans for housing dominate the balance sheet of development banks in Palau and the Marshall Islands). Some are subject to supervision by a central bank or other supervisory agency, while others are not. 21. The insurance sector is also dominated by foreign insurance companies, though in several countries insurance is sold through locally owned insurance agencies (with the underwriters offshore). In Fiji, for example, there are currently two life insurance companies - one a subsidiary of the Commonwealth Bank of Australia and the other a subsidiary of the Life Insurance Company of India. There are six fire and general insurance companies, one owned by a company in India and the other five owned by companies in Australia or New Zealand. In Vanuatu, the insurance industry is dominated by a subsidiary of QBE Insurance, a substantial Australian company, with the other two companies in the industry owned in Australia and Fiji respectively. In the Marshall Islands, there is no insurance company operating within the country, but several insurance agencies which write business for offshore underwriters. In Tonga, the insurance industry is dominated by a subsidiary of a New Zealand insurance company (though one in which the Samoan government has a minority stake), and the same company has a strong position in the Samoan insurance industry also

8 22. Only in the case of pension funds is local control dominant in those countries which have pension funds. For example, the Fiji Provident Fund is by far the largest of the pension funds in that country, with assets which are broadly the equivalent of the assets of the entire banking sector, and in the Cook Islands, Kiribati, Palau, Samoa, the Solomons, Tuvalu, and Vanuatu the only pension schemes operating are government-run schemes. Only in Fiji and Papua New Guinea are private pension schemes at all significant. A brief description of the financial sector in each FIC is contained in Annex B. Supervision in the region 23. As is widely recognised, financial sector supervision is highly variable throughout the region, but there are essentially three groups of countries: Countries with central banks Countries without central banks but with a supervisory agency Fiji Cook Islands* Kiribati Papua New Guinea Fed. States of Micronesia Nauru Samoa* Marshall Islands Niue Solomon Islands Palau Tuvalu Tonga Vanuatu* * Countries marked with an asterisk have offshore financial centres. Countries with no supervisory agency 24. The six countries which have their own central banks - Fiji, Papua New Guinea, Samoa, the Solomon Islands, Tonga and Vanuatu - are in general well ahead of the other countries in the region, no doubt because central banks tend to have more resources available to them to undertake supervision than most other government agencies. Vanuatu actually has the primary supervision function of banks and insurance companies in its central bank, while the Vanuatu Financial Services Commission supervises credit unions (although there is a proposal to move the supervision of and credit unions to the Reserve Bank of Vanuatu). 25. At the other extreme, some FICs have no supervisory agency at all. That is true, for example, of Nauru (which doesn t have any banks, insurance companies or pension funds), and of Kiribati (which has only a single, ANZ-controlled bank, a government development bank, a government Provident Fund, and a government Insurance Corporation). Neither Tuvalu nor Niue has any formal supervisory agency although Tuvalu is planning to introduce supervisory legislation. 26. Occupying an intermediate position are four countries without central banks but with some form of formal supervisory agency - the Cook Islands, and the three US dollarbased countries of the North Pacific (Federated States of Micronesia, Marshall Islands, and Palau). 27. During the field visits, meetings were typically held with the chief executive of the supervisory agency (the Governor or Deputy Governor where the supervisory agency was - 8 -

9 a central bank). These individuals were, by the nature of the case, usually confident that the quality of supervision which their institution was providing was of reasonable to good quality. Those interviewed in the banks and insurance companies which are subject to supervision were sometimes willing to express an opinion on the quality of that supervision, but those opinions were, again by the nature of the case, often less than fully objective. 28. In view of the timeframe of this assignment, and the consequentially small amount of field time which could be allocated to individual meetings, it is neither realistic nor appropriate to comment upon the quality of the work of each individual and/or agency. Rather, the situation, requirements and expectations of each individual and agency have been noted and taken fully into consideration when developing the conclusions and recommendations contained in this Report. What are the gaps? 29. PFTAC has advised the member countries of the Forum that in the area of bank, insurance and pension fund supervision, internationally accepted standards or principles have been developed. International bodies have developed frameworks that outline minimum standards for sound supervisory practices and are considered universally applicable regardless of the size and degree of sophistication of a country s financial system If that proposition is accepted at face value, it seems unlikely that any Forum Island Country meets all the standards mandated by the international community for the supervision of banks, insurance companies and pension funds, though the countries with central banks almost certainly come closest. 31. The 2007 FEMM paper identified gaps in supervisory systems which are summarized below: Legislative framework for supervision; Capacity in both onsite and offsite surveillance process; and Capacity in general supervisory arrangements. 32. These gaps would appear to remain largely unchanged across banking, insurance and pension fund supervision, although there are differences between supervisory standards applied to each class of financial institution within each of the FICs. 33. Annex C summarises key gaps or needs as identified in visits to FICs. The needs identified during visits do not measure the supervisory framework against international supervisory standards; a formal study is necessary to determine the nature and extent of any gaps and, undertaking such assessments was not possible given the timeframe for the project. However, reviews of responses reveal that some gaps, relating to legislative or capacity needs, may be emerging which give rise to the need for further development of supervisory resources: 5 Financial Sector Reform, Financial Sector Regulation and Supervision in Forum Island Countries, pp

10 Country Issue identified Potential gap Cook Islands Implementing Need for staff training in insurance, supervisory regime for development of reporting framework, insurers. development of on-site examination skills Federated States of Micronesia Legislation to provide for the supervision of insurers enacted. Fiji Extending the supervisory framework to private pension funds. Kiribati Marshall Islands Palau Tonga Need for legislation to provide for licensing of financial institutions (banks). Is there a need for insurance supervision? Increased focus on the supervision of locally owned banks. Insurance and pension fund sectors are not supervised. and process. Need for staff training in insurance, development of reporting framework, development of on-site examination skills and process. Development of legislation may be required. Additional trained staff resources may be required by the Reserve Bank to ensure the adequate supervision of private pension funds. Development of legislation which sets out licensing criteria and training/assistance for government officers in assessing applications. On-going assistance may be required if authorities assume any supervisory responsibilities. Undertake a risk assessment of the sector to determine the appropriateness of implementing a supervisory framework or leave existing arrangements in place. Assistance may be required to undertake this work and additional assistance will be required if authorities decide to implement a supervisory regime. Assistance may be required to further develop supervisory skills and with on-site examinations of institutions. Should authorities determine that these sectors are to be supervised, assistance may be required in a number of areas: drafting legislation; training staff; developing supervisory reports; and, developing guidelines and rules. 34. As most banks operating in the FICs are foreign owned and therefore subject to supervisory oversight by a home country regulator, supervisory oversight of foreign banks can be considered as reasonable as it is shared between the home country supervisor and the local supervisory agency (where one exists). Nevertheless, host country jurisdictions should be in a position to oversight and understand the activities of banks given their importance in the economy and for economic development. In addition, jurisdictions need to be able to supervise and monitor locally owned banks. While there may be fewer gaps in the area of bank supervision, there are significant gaps which need to be addressed in the areas of pension fund and insurance supervision

11 35. Of the 10 countries with pension funds, five (Fiji, PNG, Samoa, the Solomon Islands and Vanuatu) have those funds supervised, while five other (the Cook Islands, Kiribati, Palau, Tonga and Tuvalu) have no pension fund supervisor. Pension funds in the FICs are either accumulation funds i.e. members receive a payout based on the value of their accumulated contributions or defined benefit schemes which also pay members a pension. While a strong argument can be made that supervisory agencies do not need to supervise pension schemes in the conventional sense, i.e. consistent with the supervisory framework for banks, the history of pension funds in FICs and their growing importance suggest the need for the establishment of a supervisory regime. 36. As pension funds continue to grow they are looking for new avenues for investment and these can pose risks that may not be fully understood or appreciated by those charged with managing the funds. Pension funds are increasingly looking to invest in foreign markets (and in fact some already do) and this introduces a new range of risks (foreign currency risk, sovereignty risk, interest rate risk and counterparty risk). In the past, pension funds have experienced significant difficulties arising from poor investment decisions or governance problems (e.g. in the late 1990s, the Vanuatu National Provident Fund made a number of bad lending and investment decisions which resulted in the fund losing around Vt 2 billion and severely disrupting Vanuatu s economy and the Solomon Islands Provident Fund also experienced losses stemming from investment decisions). Problems in the PNG pension sector relating to fraud and poor governance have prompted Bank of Papua New Guinea, with APRA s assistance, to increase its supervision of PNG pension funds. 37. In short, pension funds represent an increasingly important sector of each FIC s financial system and these funds should be subject to a supervisory framework. There is a need for FICs to supervise and monitor the activities of these funds not only because of the size of the funds and their importance to the financial system as an important source of liquidity but also their potential to disrupt the economy should they fail. 38. The degree of insurance supervision across the FICs is mixed reflecting several factors: market size and development; and, the capacity of supervisory agencies to supervise insurers. In a number of the smaller FICs (Palau, Micronesia, Marshall Islands, Tonga and the Cook Islands) insurance is typically sold through subsidiaries of foreign owned insurers (Cook Islands and Tonga it should be noted that the parent companies, which are based in NZ, are not subject to supervision in its home market) or through agents representing foreign insurers. In other jurisdictions (Fiji, PNG, Solomon Islands, Samoa and Vanuatu) insurers are subject to supervisory oversight. 39. In some jurisdictions where there is no effective supervision of insurers or those selling insurance products there have been mixed experiences with agents on occasion collecting premiums and then absconding with the premiums, leaving policy holders with no coverage. The relative importance of insurance in that it provides: the population with the opportunity to insure against the impact of natural disasters; life insurance products; or the opportunity to invest in wealth management products which may not be offered by other providers of financial services

12 There is a strong case to ensure that there are those offering insurance products are subject to some form of supervision or oversight. 40. While reliance can be placed on the home country supervisor to safeguard the safety of the insurance group and to share information with FICs through a MOU, the needs of smaller jurisdictions where foreign insurers are represented through agents or locally established branches or subsidiaries need to be considered by establishing an appropriate supervisory regime which encourages market participants to offer insurance while at the same time extending greater protection to policyholders. 41. All the FICs have limited resources to devote to regulation and supervision function - limited financial resources and, equally important, limited human resources with sufficient knowledge and experience to undertake financial sector supervision in a competent fashion. The reality is that banking and insurance increasingly involve highly specialized skills, and the likelihood of public servants in developing countries being able to discern any but the most serious problems is not high. Indeed, even in highly developed countries the ability of bank supervisors to stay on top of many of the more complex financial instruments is doubtful. 42. There is no doubt that PFTAC and other agencies, including in particular APRA, have been very helpful in providing training programmes, and several supervisory agencies spoke warmly about the help they have obtained from those agencies in recent years. But such training programmes may not be a sustainable solution in the long term: it is clear that, after supervisors from FICs receive training, they are more marketable in high income countries such as Australia, New Zealand and the US, and often leave FICs permanently. In one of the countries of the North Pacific, the head of the supervisory agency receives a salary equal to some 20% of what he might receive in the US, creating an ongoing risk that he may leave. 43. Not surprisingly, attention has turned to the feasibility of a regional, or subregional, approach to financial sector supervision. Already the countries of the region have established the Association of Financial Supervisors of Pacific Countries (AFSPC) to which most FICs belong. PFTAC acts as the Secretariat for AFSPC, with administrative support from the Reserve Bank of Fiji. The purpose of the organisation is to facilitate the sharing and coordination of matters relating to supervision and regulation of financial institutions within the region, to strengthen regional cooperation in the area of financial regulation and supervision and to facilitate the development of a common set of prudential indicators for each of its members. To date the AFSPC has not assumed responsibility for actually undertaking regulation or supervision in any of the FICs and nor is it in a position to do so

13 Section 3: Why Supervise, and what is Involved? 44. A primary motivation for financial sector supervision is to protect the interests of depositors, policy holders in the case of insurance companies and beneficiaries in the case of pension funds. 45. Within the FICs, the financial assets of the population can be summarised in broad terms as: deposits with banks; real assets (such as houses, cars etc., which may or may not be insured); and balances with pension funds. Increasingly, pension funds are becoming more dominant and an important source of liquidity in financial systems within FICs. Therefore it is desirable from a policy perspective for there to be supervisory framework which seeks to balance an appropriate level of stakeholder holder protection against any adverse impact on financial institutions. Against this background, FICs should endeavour to establish a supervisory framework which balances scarce resources and the need to ensure the availability of financial services to the population from safe and well managed financial institutions. 46. In the area of bank, insurance and pension fund supervision, internationally accepted standards or principles have been developed. International bodies have developed frameworks that outline minimum standards for sound supervisory practices and are considered universally applicable regardless of the size and degree of sophistication of a country s financial system. 47. The application of these principles requires a sound legislative framework which enables supervisory agencies to collect a range of data on the performance of supervised entities, the ability to meet with the board and management on a regular basis and the power to conduct on-site inspections. The legislation also needs to give supervisors power to act against entities and this includes the ability to issue directives and regulations, the power to take control of an entity experiencing difficulties and, in the extreme, to close and wind-up an entity which is insolvent or conducting its operations in a manner detrimental to the interests of stakeholders. In addition to the legislative element other aspects of the supervisory function are: Collection and analysis of key data such as capital adequacy, levels of asset concentration, the composition of assets and liabilities, asset quality and levels of bad debts, information on premium income, claims experience and the creditworthiness of reinsurers. Understanding the institution s risk appetite and governance framework through a review of risk management policies, meetings with senior management and conducting on-site examinations of institutions to ensure that the supervised entities have prudent risk management policies in place (e.g., in the areas of credit and operational risk and investment and anti-money laundering and terrorist financing). Develop guidelines and rules to assist in the establishment of sound risk management practices and prudentially operated financial institutions

14 48. Across the FICs, those jurisdictions with central banks with a supervisory responsibility or other type of supervisory agencies undertake the usual range of supervisory functions. Data is collected and analysed, usually on a quarterly basis, and on-site examinations are undertaken based on a combination of risk assessment or a supervisory work-plan. The frequency of on-site examinations differs across jurisdictions reflecting issues such as resourcing and the work-plan. All supervisors have issued a number of guidelines to financial institutions (primarily related to banks) covering issues such as risk management, capital adequacy and concentration/exposure limits. To continue to strengthen supervisory capacity within the region, on-going technical assistance is needed by all FICs and jurisdictional needs will vary reflecting the state of development. For some agencies, technical assistance may focus on further developing and refining existing skills while in other cases more intensive assistance may be required. 49. As increased demands are placed on supervisors to extend the supervisory umbrella to all class of financial institution, technical assistance needs will change and providers of technical assistance will need to ensure that they have the resources in place to cover these potentially increasing demands. For example, Annex C reports that the Cook Islands and Federated States of Micronesia are in the process of implementing a supervisory regime for insurers and technical assistance may be required to assist in the successful implementation of the framework. Additionally, the supervisory burden is expanding with supervisors in a number of FICs undertaking additional work relating to Anti Money Laundering and Combating the Financing of Terrorism (AML/CFT) as part of initiatives implemented by their jurisdiction in response to global AML/CFT measures. These additional duties can impact work-plans and require more resources and/or training and place further demands on technical assistance

15 Section 4: International Requirements and FIC-Specific Needs 50. At the moment, much of the focus of the discussion on financial sector supervision is on answering the question: How do the FICs comply with the standards of financial sector supervision mandated by the IMF, G-10 bank supervisors, and others? In other words, how do the FICs comply with the Core Principles for banking supervision adopted by the Basel Committee on Banking Supervision, the Insurance Core Principles adopted by the International Association of Insurance Supervisors, and the Principles of Private Pension Fund Supervision adopted by the International Organisation of Pension Supervisors? Most FICs are a very long way from successfully implementing those various Principles, and some, especially in the SISs, have not even begun the long journey to those goals. (Annex B attempts a summary description of the extent of supervision in each FIC, while Annex B highlights the most significant gaps.) 51. But there are a number of experts who are increasingly questioning whether those Principles are appropriate even for highly developed countries, with sophisticated financial systems. Academic research by James Barth, Gerard Caprio Jr., and Ross Levine found as long ago as 2004 that financial development is (1) positively associated with supervisory approaches that force information disclosure and (2) negatively associated with powerful supervisors that directly monitor and discipline banks. 6 On the basis of his own empirical work, Ross Levine concludes The microeconomic evidence is generally inconsistent with the official supervisory approach to bank supervision and regulation and broadly consistent with the private monitoring view. In particular, the data indicate that empowering official supervisors tends to increase the degree to which corruption of bank officials hinders firm performance.the firm-level evidence indicates that official supervisory power exerts a negative influence on the functioning of banks and the bank-level results (do) not provide any compensating evidence to support the official supervision view And of course, over the last two years the world financial system has been severely shaken not by the failure of unsupervised institutions but by the failure or nearfailure of institutions which are subject to exactly the kind of supervision mandated in the Core Principles. The most extraordinary examples are Freddie Mac and Fannie Mae - two institutions which would have failed were it not for the massive support of the US government and central bank, despite having a supervisory agency devoted almost exclusively to their supervision. As Alan Greenspan observed in a recent article in the Financial Times, when the current crisis emerged, it was assumed that the weak links would be unregulated hedge and private funds. The losses, however, have been predominately in the most heavily regulated institutions - banks It was always unrealistic to assume that Niue - or Palau, Nauru, Kiribati, Tuvalu and other very small countries - could put in place a fully Basel-compliant supervisory regime. Standard setters acknowledge that not all jurisdictions have the resources to 6 Quoted in The Microeconomic Effects of Different Approaches to Bank Supervision, by Ross Levine, 6 February 2004, p Ibid., p Financial Times, 4 August

16 implement fully compliant regimes. FICs should and are encouraged to implement international supervisory standards for those financial institutions/risks which are present in their market. A number of smaller FICs have made significant progress toward implementing international supervisory standards for banks and insurance companies. 54. The key question to be addressed, therefore, may be How does each FIC create a supervisory framework which meets international standards for the supervision of banks, insurance companies and pension funds? but rather How does each FIC ensure that their financial system best serves the needs of their people? The two questions may have identical answers in large and sophisticated countries, but are likely to have quite different answers in very small countries with minimal financial institutions. 55. What each country needs is a financial system characterised by prudentially sound institutions, ideally operating in a competitive environment. And in the smaller countries that will best be achieved by allowing well established foreign banks and insurance companies to operate, while allowing home country supervisors to look after supervision. The reality is that the Bank of Hawaii in Palau, or the ANZ Bank-controlled Bank of Kiribati in Kiribati, will not collapse because of anything that happens in Palau or Kiribati - and therefore nothing that the local supervisor in Palau or Kiribati can do will make the slightest difference to the survival of those banks. 56. But what about the banks which are locally owned? Aren t there already small local banks operating in some FICs? Indeed, there are - seven banks in total, for example, in Palau, four of them branches of banks incorporated outside Palau and three very small locally owned banks (all of them so small that they would certainly not qualify as banks in most countries). But it is entirely unclear why the very limited human resources of the Palau government should be diverted to trying to supervise all of those seven banks. Instead, it should look to establish MOUs with foreign supervisory agencies and focusing resources on the locally owned banks given the failure of one bank in Several countries in the region have development banks, designed to encourage the development of the small business sector and, in some cases the housing market. As already noted, in some cases these are supervised and in some cases they are not, but since few of them are funded by deposits from the public the need to have them supervised in the conventional way is not obvious. However such agencies still require some oversight to ensure that public funds are not being misused by bank officials or that poor quality loans are being written. A Role for Regional Approaches 58. The field visit meetings and phone interviews undertaken for this assignment were predominantly with Ministers, Governors and Deputy Governors of central banks, the heads of supervisory agencies and the chief executives of banks and insurance companies. Given the level of seniority of those talked to, it is clear that their views represent the clear will of the country and their respective financial sectors. A sampling of those views is included in Annex D. 59. All in all, there is considerable reluctance in most countries to contemplate any form of regional or sub-regional supervisory agency, and even a reluctance to consider the idea of sub

17 contracting some aspects of supervision to other FICs. There is, however, a somewhat greater willingness to consider the exchange of staff, and more training sessions to share experience and knowledge. 60. To anticipate somewhat, a sub-regional approach - perhaps linking the three countries of the North Pacific in one group, and Vanuatu, Kiribati, Nauru and Tuvalu in another - might work. 61. But understandable national differences, compounded by the enormous distances between most of the countries of the region, would make any kind of close regional or subregional approach to supervision difficult - and of course, unless a regional approach made employment in a supervisory agency much more attractive than currently, establishing a regional or sub-regional agency would do nothing to deal with the real problem, which is the lack of suitably experienced supervisory staff. 62. In assessing the feasibility of a regional approach to financial sector supervision, it is worth assessing whether successful models of regional supervision exist anywhere else in the world. Supervision is conducted on a regional basis across eight of the small island economies in the Caribbean 9, but that is conducted under the aegis of the Eastern Caribbean Central Bank and does not extend beyond the ambit of that central bank. Within the countries of the European Monetary Union, there is increasingly close liaison between the separate national supervisory agencies and some people are contemplating a move to a single regulator in due course. But even among those countries, with a common central bank and close geographical proximity, a single regulator covering the whole region seems some distance away. 63. An alternative regime, demanding less in the way of skilled supervision capacity within the FICs, could be given thought. This issue was not explicitly requested in the report based on the ToR, and therefore some brief discussion is contained in Annex E. The alternative regime requires a minimum investment in financial sector supervision by FICs. The alternative regime is not without issues which would need to be considered by individual FICs. Jurisdiction specific studies would need to be undertaken if some FICs consider the alternative regime may be more appropriate to its needs. 9 Anguilla, Antiqua and Barbuda, Commonwealth of Dominica, Grenada, Montserrat, St Kitts and Nevis, Saint Lucia, St Vincent and the Grenadines

18 Section 5: Benefits and Costs of Possible Proposals 64. The paper prepared by PFTAC for 2007 FEMM consideration, took into account these broader issues and listed five possible measures which might assist the current situation, and a prime purpose of the present paper was to assess these measures and the predicted benefits of each one, looking at both sectoral benefits and benefits for the wider economy of FICs. These options were: Memoranda of Understanding which allow for sharing of supervisory practices/processes and information on the condition of a bank and sharing of prudential indicators; Sustainable approaches to technical assistance needs; Outsourcing of some areas of supervision to other, typically larger, member countries, while leaving local supervisors with responsibility for some aspects of the supervisory framework such as licensing and ownership of institutions which operate in their jurisdiction; Development of shared supervisory services, for example, an FIC might call upon a shared regional supervisory agency located in, say, the Cook Islands, or they might call upon a small unit in another organisation in the region. Again, an issue requiring careful consideration is that of confidentiality of data and addressing issues that may arise should a supervised institution fail (for example, accountability, possible litigation against the provider of supervisory services and, costs associated with any bail-outs); and Contracting of supervisory services, for example, a periodic contract through a regional organisation/agency for supervisory services to the FICs. 65. The costs and benefits of each proposal suggested in the 2007 FEMM paper by PFTAC, in broadest terms, are considered below. (i) Memoranda of Understanding (MOUs) 66. There is merit for the FICs, and in particular the Small Island States (SIS), signing MOUs with home country supervisors of those foreign financial institutions (banks and insurers) operating within their jurisdictions. The MOU could allow for: Sharing of supervisory practices/processes and information on the condition of a bank or insurer and sharing of prudential indicators. This would extend to providing for the home country supervisor conducting (or participating in) on-site examinations of foreign owned institutions when requested by the host country supervisor; Allow regional attachments for FIC supervisors to the supervisory authority in larger Forum countries (e.g. attachments to the Bank of Papua New Guinea in relation to PNG based financial institutions which are extending the scope of their operations in the region); Requiring greater information sharing between the home and host supervisors and co-operation in the supervision of local entities; and

19 Provide for greater opportunities for FIC supervisors to be attached to large supervisory agencies such as the FDIC and APRA as appropriate. Benefits Would enable the FIC to focus limited supervisory resources on locally owned institutions. Would give the FIC an avenue to raise concerns about the operations of a foreign owned institution. Would ensure that the home country supervisor is able to assist the FIC develop supervisory skills through sharing of supervisory methods (e.g. how to conduct on-site examinations). Would ensure that FICs are alerted to problems within the parent institution which may impact on local operations (e.g. weaknesses in governance or risk management controls and procedures). Would result in development of capacity in FIC supervisory institutions (where these exist). Where no supervisory resources exist, would allow FIC to take comfort that local operations (and the soundness of the institution) are being monitored and any concerns are communicated to the FIC government. Cost/Potential problems The willingness of larger supervisory agencies to enter into MOUs with FICs which provide for the use of their supervisory resources which do not correspond to the relative risk posed by the institution s operations relative to the entire financial entity, i.e. there are materiality issues. The home country supervisor may not be willing to enter into MOUs that provide for staff sharing, i.e. information sharing MOUs vs cooperation MOUs. MOUs would need to address issues of data confidentiality (and provide appropriate protections if staff sharing occurs). Costs related to attachments (from the FIC to supervisory agency) and on-site examinations performed by the home country supervisor would need to be addressed. It is likely that costs to FICs would need to be covered by donors if the FIC supervisory agency does not have sufficient financial resources. Assistance may be required from PIFS to assist FICs develop a MOU which could be standardized for use across all FICs. In the absence of legislative/statutory power, the FIC government/supervisory agency may not be able to require a financial institution to address problems in the local operation. The FIC would need to rely on the home country supervisor ensuring that local management implemented remedial actions