Reports on Observance of Standards and
Codes
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Banking Supervision1 1. This report provides an assessment of Canada's observance of and consistency with relevant international standards and core principles in the financial sector, as part of a broader assessment of the stability of the financial system. This assessment work by the IMF was undertaken under the auspices of the IMF-World Bank Financial Sector Assessment Program (FSAP) based on information up to October 1999. This has helped to place the standards assessments in a broader institutional and macroprudential context, and identify the extent to which the supervisory and regulatory framework has been adequate to address the potential risks in the financial system. The assessment has also provided a source of good practices in financial regulation and supervision in various areas. | |||||||||||||||||||
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2. The assessment covered (i) the Basel Core Principles for Effective Banking Supervision; (ii) the International Organization of Securities Commissions' (IOSCO) Objectives and Principles of Securities Regulation; (iii) the International Association of Insurance Supervisors' (IAIS) Supervisory Principles; (iv) the Committee on Payment and Settlement Systems' (CPSS) Core Principles for Systemically Important Payment Systems; and (v) the IMF's Code of Good Practices on Transparency in Monetary and Financial Policies. Such a comprehensive coverage of standards was needed as part of the financial system stability assessment for Canada in view of the increasing convergence in the activities of banking, insurance, and securities firms, and the integrated nature of the markets in which they operate. It should be noted that some of the standards are still in draft form, and some do not yet have a complete methodology to systematically assess compliance or consistency.2 This module was prepared in consultation with the Canadian authorities in the context of the IMF FSAP mission that visited Canada in October 1999, and constitutes a summary of the detailed assessments prepared by the mission. The summary was part of the Financial System Stability Assessment (FSSA) report that was considered by the IMF Executive Board on February 2, 2000, in the context of the IMF's Article IV consultation discussions with Canada. 3. The assessment of standards and codes draws on the self-assessments of the Canadian authorities, and on the field work undertaken October 11-22, 1999, based on a peer review process by Kai Barvll (Payment Systems, Sveriges Riksbank), Karl Driessen and Charles Siegman (Transparency Code, IMF), Alvir Hoffmann (Banking Supervision, Banco Central do Brasil), Rodney Lester (Insurance, World Bank), Michael Martinson (Banking Supervision, Board of Governors of the Federal Reserve System), Stefan Spamer (Banking Supervision, Deutsche Bundesbank), and Shane Tregillis (Securities, Australian Securities and Investments Commission). The expert team was coordinated by the IMF FSAP mission, led by V. Sundararajan, and comprised R. Barry Johnston, Karl Driessen, Haizhou Huang and Martin Cerisola. The assessment has been communicated to the authorities. 4. Overall, the assessment found a high degree of compliance that had contributed to a stable financial system. Minor deviations from Basel Core Principles of Effective Supervision were detected, which are addressed by proposals contained in the Policy paper.3 Full compliance with the Core Principles for Systemically Important Payment Systems was noted for the Large Value Transfer System. Canada is broadly compliant with all principles of insurance regulation, and is broadly consistent with IOSCO Objectives and Principles of Securities Regulation. The complexity of federal/provincial regulatory arrangements, oversight of mutual funds, and resource limitations on the enforcement capacity of some securities commissions are areas of concern that are being addressed. There is a high degree of consistency with the Code of Good Practices on Transparency in Monetary and Financial Policies. The more specific findings in the area of banking supervision are discussed below. A. Background and Overview5. Canada has a highly developed, well diversified, and sound financial system which plays an important role in the economy. Assets held by the Canadian financial sector represented the equivalent of about 250 percent of GDP in 1997, with chartered banks accounting for roughly 60 percent of total assets. The banking sector has been largely dominated by six widely held domestic banks, with closely held foreign banks playing a relatively minor role; the "Big Six" chartered banks represent about 90 percent of banks' assets and deposits. The responsibility of the federal government in banking is explicitly set out in the constitution. Thus, all banks and federally chartered trust and loan companies fall under the jurisdiction of the Office of the Superintendent of Financial Institutions (OSFI). 6. The banking system has a strong capital position, with capital adequacy ratios above Basel minimums, and is adequately provisioned against impaired loans. Profitability of the domestic banks is good, with a return on equity of around 15 percent for the six large banks, although profitability of foreign banks has been weak. The large domestic banks have increasingly absorbed other financial institutions-the trust companies and securities dealers. Banks' off balance sheet and derivative transactions have grown rapidly and banks have become much more reliant for their income on capital market activities. Banks' overseas exposures have also grown rapidly and they have strategically refocused on the U.S. market thus making them more dependent on the outlook for the U.S. economy. The major banks that are most active in off balance sheet and derivative transactions have upgraded their risk-management systems. 7. In the banking sector, there is virtual full compliance with the Basel Core Principles of Effective Banking Supervision. The overall assessment is that there is full compliance with 23 core principles and partial compliance with 2 core principles (see Table 1 for a tabular summary). Some minor shortcomings were noted with regard to the following principles:
8. Full compliance for Core Principle 14 and 22 will be achieved after the implementation of the proposals contained in the Policy paper. According to those proposals, the Superintendent of Financial Institutions will have additional supervisory powers to deal with the potential for increased risk in the system, including granting the Superintendent the power to remove directors and senior officers from office in certain circumstances, such as in instances of misconduct, and additional powers to deal with related party transactions of financial institutions. 9. To the extent that nonbank deposit-taking institutions are supervised by OSFI, the same evaluation of the Core Principles of Effective Banking Supervision as provided above applies. However, no systematic assessment of compliance with these principles of provincial regulators-who oversee deposit-taking institutions with a combined market share of about 10 percent-exists, and information and resources were not available to perform such an assessment. However, limits on lending concentration and lending to related parties seem to be observed. Table 1. Canada: Compliance with the Basel Core Principles
2/ BC: Broadly compliant 3/ NC: Non-compliant 4/ Mat. NC: Materially non-compliant B. Assessment of Core PrinciplesCore Principle 1Responsibilities, objectives, operational independence, resources, legal framework for powers, protection for supervisors, information sharing 10. The banking system is regulated by a tripartite structure, the Office of the Superintendent of Financial Institutions (OSFI), which is the only agency responsible for supervising banks in Canada, the Canada Deposit Insurance Corporation (CDIC), and the Department of Finance-in charge of developing the policy and legislative framework for the financial sector. The Bank Act provides a comprehensive legislative framework for banking and requires a review of the act every five years. The OSFI Act mandates the responsibilities and objectives of OSFI. The CDIC Act sets forth the responsibilities and objectives of CDIC. 11. The Bank Act requires banks to provide the Superintendent with such information, at such times and in such form as the Superintendent may require. The Bank Act provides legislated authority for OSFI to address compliance with laws and with safety and soundness of banks. OSFI has a number of means at its disposal to intervene, if needed, in the activities of a financial institution. The Bank Act provides specific criminal sanctions for non-compliance with the legislation. As part of an upcoming legislative package, OSFI is seeking authority to levy civil monetary penalties for breeches of legislation and supervisory agreements. The legislation gives each agency operational independence (the superintendent is appointed for seven years and OSFI is primarily financed by the industry it regulates). However, the Minister of Finance has some formal powers to overrule OSFI on chartering and some banking policy issues. 12. Assessment: There is compliance with Core Principle 1. However, there is some uncertainty about the involvement of the Department of Finance in licensing (see CP 3), and the effectiveness of the ongoing exchange of information, coordination and responsibilities between OSFI, CDIC and the provincial securities supervision authorities. Core Principles 2-5Licensing, Ownership 13. An effective supervisory framework exists governing the use of the term "bank", the licensing process, ownership control and acquisitions and investments. The use of the term bank is restricted and the permissible activities of banks and the permissible investment powers are clearly defined by the Bank Act. Only licensed and supervised institutions are permitted to take "proper bank deposits" from the public. The licensing authority is the Minister of Finance, not the Superintendent. The Bank Act authorizes the Minister of Finance to issue letters patent incorporating a bank. OSFI is the sole authority responsible for recommending the issuance of letters patent. In the case of foreign banks, OSFI requires consent from the home country supervisor. In Canada "significant" ownership is clearly defined in Schedule I bank ownership rules. Any change in the ownership/control of Schedule II banks requires the Minister's approval. Canadian supervision authorities have the authority to establish criteria for reviewing major acquisitions or investments by a bank and for ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision. 14. Assessment: The Canadian authorities comply with these principles. The Minister of Finance's involvement makes the licensing process more complicated. However, in practice the Minister of Finance apparently does not override OSFI recommendations based on safety and soundness grounds. Core Principles 6-15Prudential regulations and requirements 15. Canadian banks are required to comply with the capital adequacy requirements established in the Basel Accord. In a letter dated January 28, 1999, the Superintendent set minimum target for risk-based capital ratios of 7 percent for Tier 1 capital and 10 percent for total capital. All banks complied at the end of June 1999. 16. OSFI employs a risk-based methodology to evaluate an institution's risk profile, financial condition, risk management processes and compliance with applicable laws and regulations. In addition, institutions are required to perform annually a self-assessment of their adherence to the CDIC Standards of Sound Business and Financial Practices. 17. With respect to concentrations in the portfolio and limits to restrict bank exposures to single borrowers or groups, OSFI requires credit limits to single or connected borrowers of 25 percent of regulatory capital. There are also requirements for information systems in place to identify the concentrations. An institution's practices with respect to large loan exposures would be reviewed in the context of the institution's risk profile. OSFI's Prudent Person Approach requires institutions to manage concentration of risks in investment and loan portfolios. CDIC's Standard of Sound Business and Financial Practices on Credit Risk Management provides additional guidance to institutions on best practices associated with the management of credit risk. 18. OSFI requires that for the validation of banks' Value-at-Risk (VAR) models for reporting market risk capital, such models accurately measure, monitor and adequately control market risks (see above). OSFI requires that banks have comprehensive and robust scenario and stress testing programs and contingency plans, and that they perform such tests at least once a month (most Canadian banks do this weekly, while some banks do them even daily). 19. OSFI requires that banks have internal controls in place that are adequate for the nature and scale of their business. Sound internal control practices are also addressed in CDIC's Standards which require risk identification, evaluation and management systems to assist in prudential management of a bank's operations. Internal control policies and procedures need to be approved by the Board of Directors, and their effectiveness assessed by an independent internal audit/inspection function, on an annual basis. 20. OSFI's Supervisory Framework requires that the quality of risk management be evaluated for each significant activity in which the bank is engaged. Board oversight and senior management are identified as two critical management control functions and are assessed in order to arrive at an overall evaluation of the quality of risk management. Liquidity risk, interest risk and operational risk are specifically identified as risk categories in OSFI's Supervisory Framework. The Framework requires a dynamic risk assessment process to assess inherent risk. This is based on a thorough understanding of the environment in which the institution operates and its various business activities. In addition, banks in general have liquidity contingency plans in place. 21. OSFI expects banks to have codes of conduct that, among other matters, deal with ethical behavior towards customers. The CDIC Standards Assessment and Reporting Program (SARP) also includes an Internal Control Standard that, among other requirements, requires a bank to have a comprehensive code of conduct. Since January 1, 1990, OSFI has included an examination of money laundering detection procedures residing in institutions as part of its examination of deposit-taking institutions. 22. Assessment: Partial compliance. Regarding Core Principle 14, the supervisor does not have the legal authority to require changes in the composition of the Board and management. Nor does the Superintendent have the explicit legal authority to remove board members. Full compliance with Core Principle 14 will be achieved after the enactment of the Policy paper proposals. Regarding Core Principle 9 additional criterion 1, there is no requirement to identify exposures of 10 percent or more of bank's capital as a large exposure. Regarding Core Principle 10, while most related party transactions are not subject to approval by the bank's board, the Conduct Review Committee of the board is required to review the bank's practices and procedures, to ensure that such transactions are proper individually and in the aggregate. Core Principles 16-20Supervision approach, ongoing supervision 23. Consolidated supervision is an essential element of banking supervision in Canada. OSFI reviews the organizational structure as a part of the planning phase of its supervisory activities and in the development of the risk profile of the bank. Where the bank has corporate bodies responsible for activities that are deemed to be of significance in relation to the risk profile of the consolidated group, OSFI will extend its supervisory processes to that corporate body. OSFI's risk-based approach to supervisory activities includes the evaluation of all significant activities of the bank, whether banking-related or non-banking related. This includes domestic and foreign operations, and activities of subsidiaries and affiliated companies of the bank. This also implies that all regulatory filings are to be prepared on a consolidated basis. 24. Consolidated supervision is carried out through a combination of on- and off-site supervision. In the context of off-site supervision, an essential element is that OSFI meets with key officers and management of a bank on a regular basis. A key principle of the supervisory framework is the process of reliance on external auditors, which includes enabling OSFI to review the working papers of external auditors in support of the annual audit of banks' financial statements. 25. Assessment: Full compliance. Regarding Core Principle 17, although there exists no legal requirement to notify the supervisor of any substantive changes in activities or any adverse developments, this is done in practice through on-going monitoring and on-site supervision. Regarding Core Principle 19, there does not exist a guideline for the quality of work done by external auditors for supervisory purposes. Core Principle 21Information requirements 26. The Bank Act requires banks to prepare their annual statements in accordance with Canadian Generally Accepted Accounting Principles. Supervisory reports are prepared on a basis consistent with that used for public reporting. Reporting frequency depends on the nature and purpose of the report and will be either monthly or quarterly. The Bank Act further requires banks to be audited in accordance with generally accepted auditing standards. Although the Bank Act does not require Canadian banks to apply international accounting and auditing standards, this objective is being achieved indirectly through CICA's efforts to harmonize accounting standards. 27. Assessment: OSFI fully complies with the spirit of Core Principle 21. Improvement in this area could be reached if Canadian banks apply international accounting standards directly. Core Principle 22Corrective actions 28. OSFI has extensive powers to safeguard the soundness of the banking system. It clearly participates in deciding when and how to effect the orderly resolution of a problem bank situation. OSFI's mandate and related supervisory powers are focused on early intervention. OSFI has the authority to directly take control of an institution and initiate legislative procedures, but the Minister of Finance has a veto on public interest grounds. Also, the government has documented and publicly disclosed a guide to intervention for federal financial institutions, which provides an outline of the coordinated intervention processes applied by OSFI and CDIC. As part of the Policy paper, it is proposed that OSFI have the authority to also impose civil monetary penalties for violations of legislation or written agreements with banks and other federal financial institutions. 29. Assessment: Partial compliance. Legislation does not currently provide authority to bar the appointment of an individual from banking once the person has been hired. Full compliance will be reached after the implementation of the Policy paper proposals. Core Principles 23-25Cross border supervision 30. The Bank Act requires a bank to provide access to records of controlled domestic and foreign subsidiaries and authorizes the Superintendent to enter into agreements with foreign regulators in that regard. The Superintendent may also direct any affiliate of the bank to provide information. The Supervisory Framework applies equally to all significant activities of the bank regardless of whether that activity takes place in a foreign branch, joint venture or subsidiary. 31. A key component of consolidated supervision is establishing contact and information exchange with other and foreign supervisors. OSFI has formal agreements (MoUs) with banking supervisors in the US and UK (representing 65-70% of domestic banks' international exposures) as well as Hong Kong, covering information exchange and promoting regular contacts. These MoUs cover the above noted matters. 32. OSFI's supervisory framework applies to all federally regulated institutions, including subsidiaries of foreign banks. There are currently no foreign bank branches in Canada, although the legislation has recently been amended to permit foreign bank branching. Foreign bank subsidiaries, like domestic banks, are subject to an annual examination. As part of the licensing of a foreign bank subsidiary, the Superintendent will consider the nature and degree of supervision of the foreign bank in its home jurisdiction, especially with respect the home supervisor's practices of consolidated supervision. 33. Assessment: Full compliance 1 The work of the mission was coordinated by an FSAP team led by Mr. V. Sundararajan (IMF). Messrs. Alvir Hoffmann (Central Bank of Brazil), Michael Martinson (Board of Governors of the Federal Reserve System), and Stefan Spamer (Deutsche Bundesbank) were the principal contributors to this module. 2 The Basel Core Principles were issued in September 1997; a Core Principles Methodology was released in October 1999 by the Basel Committee on Banking Supervision. The Code of Good Practices on Transparency was adopted by the Interim Committee in September 1999; work on a supporting document is in progress. The IOSCO Objectives and Principles were issued in September 1998, and a detailed self-assessment methodology is being developed. A draft of the Core Principles for Systemically Important Payment Systems was issued for public comment in December 1999. The IAIS Insurance Supervisory Principles were issued in September 1997; a self-assessment program has been developed to assist member countries in evaluating compliance. 3 Department of Finance, Canada (1999), "Reforming Canada's Financial Services Sector: A Framework for the Future," June 25. |