Special Report 34 - Central Bank Financial Regulation
Published on 30 December 1999
The importance of the financial services sector to the Irish economy has increased significantly in the past 15 years. As a result, the financial regulation of the sector by the Central Bank (the Bank) is receiving more attention.
Financial regulation can be divided into three types of supervision
- Prudential supervision aims to establish that financial institutions comply with a set of rules designed to ensure their continuing solvency and liquidity. The rules cover prudential and financial stability, internal control arrangements and corporate governance.
- Systemic supervision aims to establish that risks to the financial system as a whole are minimised.
- Conduct of business supervision aims to establish that there is a degree of protection for depositors with credit institutions and clients of investment firms. Aspects of conduct of business supervision dealing with consumers of financial services are not within the statutory mandate of the Bank.
The enactment in 1995 of legislation to counter money laundering has increased the scope of regulation.
This report is concerned with the approach adopted by the Bank in the regulation of credit institutions and investment institutions in Ireland. The examination sought to establish how the Central Bank discharges its role to regulate and what practices are followed to determine the effectiveness of its regulation activities. The response of the Bank to the requirements to counter money laundering was also considered.
Prudential Regulation of Credit and Investment Institutions
The Bank's approach to the prudential regulation of credit and investment institutions is derived from legislation. This empowers the Bank to establish minimum standards for the regulated institutions which, if complied with, would achieve the objectives of regulation. These rules are published in various documents including licensing requirements, banking directives and codes of conduct. In establishing and maintaining the rules, the international norms which are codified in core principles for effective banking supervision (the Basle principles) and in EU directives are applied.
The prudential regulation of credit institutions provides some consumer protection reassurance to depositors from the point of view of monitoring the stability and financial strength of the institutions. The regulation of investment institutions is of more recent origin and the nature of business of these institutions requires closer supervision of the interaction between them and their investor clients. Much attention on the regulation of investment institutions has been devoted to the establishment of licensing requirements and codes of conduct.
The actual regulation activities performed by the Bank cover the licensing of institutions, the analysis of prudential data which is submitted by the institutions to the bank on a regular basis, review of audit reports and a continuous programme of formal inspections and review meetings with the institutions. The Bank does not undertake a detailed review of transactions in the institutions or of the implementation of control procedures at branch level as it considers this to be inefficient in discharging its role. Instead, it aims to apply a more balanced approach between reliance on on-site inspection activities, meetings and the remote monitoring of the performance of institutions.
The examination noted some potential areas for improvement.
- The effectiveness of regulation is ultimately reflected in the relative stability of individual institutions. An assessment of the prudential risk profile of institutions is a good indicator of relative stability. The documentation of the risk profile of credit institutions could be improved as an aid to determining the effectiveness of regulation. So far, the Bank has found this unnecessary clue to the small number of institutions involved.
- Since 1989, external auditors are required to report to the Bank any material defects in internal control or suspicions of impropriety which they uncover in the course of their audit work. In practice, no such reports have been received by the Bank. Also, management letters raising specific internal control issues are not routinely issued by the external auditors. There is scope for requiring external auditors to specifically report to the Bank that no matters of potential concern have come to their attention in the course of their audit of the financial statements of institutions. Additional assurance on the implementation of an adequate internal control structure could also be sought from external auditors.
- In addition to an annual planning process which is risk based, the Bank uses a benchmark for the frequency of inspections and review meetings with individual institutions which does not take account of risk assessment or of evidence available from other regulatory activities. The actual number of inspections has fallen short of the benchmark in recent years. An alternative set of measures and criteria more directly related to an assessment of the required minimum set of tasks to ensure effectiveness should he developed.
Procedures to Counter Money Laundering
The enactment of anti-money laundering regulations in 1995 represented a significant expansion in the scope of regulation of financial institutions. The Bank has responded well to the new requirements. In conjunction with the Money Laundering Steering Group, a set of regulations has been developed and enforced. The Bank's inspection procedures manual was expanded to cover review of compliance with the anti-money laundering requirements. An independent external review in 1998 found that the actions taken by the Bank were satisfactory.
The development of techniques specifically designed to assess the effectiveness of the regulatory activities covering procedures to counter money laundering is on-going. These procedures should ultimately relate the level of money laundering detected with some estimate of the extent of money laundering in the economy.
One of the overall objectives of the Bank is to contribute to the stability of the financial system. From a domestic point of view, the Bank considers that if the prudential health of each individual credit institution is established, then there are no grounds for the overall system to fail. The susceptibility of the financial sector to international risks is monitored by various departments in the Bank. Other activities relevant to systemic regulation, such as monetary policy implementation and the overseeing of payment and settlement systems take place outside the Supervision Division. The documentation of the contribution of these activities to systemic regulation should be consolidated.
The primary measure of systemic stability, established internationally, is the incidence of institutional failure. A more comprehensive set of measures based on the criteria which identify the level of systemic risk would facilitate effectiveness evaluation. Greater use of benchmarking and comparative analysis should be made.