Assessing Regulatory Practice and Effectiveness
The regulatory regime for OFIs should help meet regulatory objectives—effective competition, good conduct of business and financial integrity, and prudent operations—while ensuring that regulations reflect the specific operational characteristics of the OFIs and promote their development. From this perspective, many core principles of effective bank supervision and regulation also apply to OFIs. The general rule is that financial institutions that do not have deposit-like liabilities to the general public do not need to be regulated and supervised as closely as those that do. The tools and techniques for deposittaking OFIs would follow the standards contained in the BCPs. Financial institutions that are banklike in all but name should also be just as closely regulated and supervised. In several countries, OFIs that were (formally or informally) taking deposits from the general public and were either not required to conform to banking regulations or did not come under the supervision of the main supervisory authority have faced difficulties that necessitated the intervention of the government (World Bank 1999).
Given the diversity of institutions that make up the group of OFIs, certain additional principles and considerations can complement the BCPs and help adapt them to the supervision of OFIs. Such principles and considerations, regardless of the institutional structure (unified or segmented), include modifying prudential rules to accommodate the operational characteristics of OFIs; ensuring consistency in decision making; recognizing the unique risks of OFI; ensuring that supervision is proportionate and consistent with costs and benefits; and maintaining resources and skills sufficient and adequate to face the growth of the OFIs sector. Those principles are similar to those applying to banks, and are further explained in Annex 6.A. Their implementation can be a challenge. For example, housing finance institutions, including building societies, often offer deposit services (not necessarily checking accounts) and may need to be regulated as banking institutions (see box 6.1). In many cases, tailoring regulations to the specific operational characteristics of the OFIs and avoiding overregulation is important for the development of the sector.
For the majority of OFIs where retail deposits and systemic issues are not involved, competition and market conduct regulations—such as entry and disclosure requirements and monitoring association with other institutions—should be sufficient. With regard to entry requirements, the regulator would encourage low barriers to entry into these sectors by ensuring that there are minimal restrictions on the corporate form and ownership structure of OFIs, freedom of entry for foreign firms, and strong antitrust conditions to prevent excessive concentration in the industry. Disclosure of correct and timely information to market participants complements supervision.3 Regarding the association of OFIs with other institutions, particular attention should be given to OFIs established as subsidiaries of regulated institutions as a means of circumventing the regulation. The dangers of excessive growth in unregulated subsidiaries were highlighted in a number of crises (see World Bank 2001).
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When corporate laws are still evolving, however, additional conditions in financial regulation can support the good market conduct and prudent operation of OFIs. Those additional conditions could cover the following:
• Licensing requirements. As with any financial institution, the purpose of licensing OFIs should be to ensure adequate capitalization and sound management, not to limit entry or restrict competition. Regulators should have the authority to screen potential owners and managers to prevent those lacking professional qualifications, financial backing, or moral standing from obtaining a license. An OFI license should not become a simple alternative for applicants who could not meet the requirements to be granted a commercial bank license. Liberal entry into the financial system should not mean unqualified entry. Countries with easy entry have often experienced problems with insufficiently regulated, undercapitalized, and poorly managed institutions.
In some countries, once an OFI has been licensed, it conducts activities that are normally not permissible under the range of activities specified in its license. The balance sheet restrictions for each group of financial institution should, therefore, be closely monitored (e. g., limits on assets and liabilities, prohibition on particular classes of assets or liabilities, restrictions on the types of assets held, and mandated maximum or minimum holdings of particular assets).
• Minimum capital requirements. With regard to minimum capital requirements (and all the main rules for the conduct of the institution), the requirements for banks
should not be applied to OFIs when not adequately justified. The minimum capital requirement is usually part of the financial institution’s licensing requirements, but should not inhibit the start-up of new institutions or act as barrier to competition. The amount of capital appropriate for a group of OFIs or an individual institution is a function of the institution’s potential to incur unexpected losses. A higher than necessary limit could restrict the industry’s growth.
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Accountability requirements. In many countries, accountability requirements, including accounting and auditing practices by OFIs, are inadequate.4 This deficiency increases the chance that misleading information could cause market instability. Facilitating market discipline and sound practices for accounting and auditing helps reinforce supervisory efforts to encourage OFIs to maintain sound risk management practices and internal controls. As with any financial institution, OFIs need sound accounting standards to achieve satisfactory transparency—public disclosure of reliable information that enables market participants and other users of that information to make an accurate assessment of the institution’s financial condition and performance, its business activities, and the risks related to those activities.
• Risk management practices commensurate with the risk profile in the industry. Measuring, monitoring, and controlling risks are often issues of concern with OFIs, especially in countries where licenses were granted too liberally. It is important that the OFI put in place a risk management process adequate for the size and the nature of its activities. Regulators should ensure that such a risk management system is not static, but rather adjusted to the OFI’s risk profile (concentration, credit, currency, or tax-related risks). This process is not only helpful in identifying potential systemically important OFIs, but also in setting priorities for allocation of limited supervisory capacity, for instance, to determine the frequency of reporting and the depth and focus of onsite supervision.
Building supervisory capacity does not mean that all OFIs need to be supervised, and when they do, they usually do not require the same level of supervision and resources as banks. The supervisory authority must establish priorities for the allocation of regulators’ supervisory capacity. There is sometimes little benefit in trying to regularly visit small, dispersed OFIs that, with modest change in regulation (e. g., licensing, minimum capital, accounting, auditing, and disclosure requirements), could present negligible risk.
After establishing supervisory priorities, regulators should also ensure that OFIs (particularly small non-deposit-taking institutions) are not overwhelmed by excessive reporting requirements when they do not present major variations in their portfolios from one period to the other. In most cases, quarterly or even semiannual returns (instead of monthly returns) would be appropriate. For those institutions accuracy and completeness are far more important than frequency. At the same time, more attention should be given to OFIs with substantial assets whose reporting should be more frequent. Other recurrent issues relate to the following:
• Deficiencies with offsite supervision, which weaken early warning systems to identify weak OFIs
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Unreliable and rudimentary working methods, which prevent regulators from efficiently and accurately assessing the OFI’s exposure to various risks and, for the most part, its soundness and financial performance
• The lack of internal guidelines or manual for onsite and offsite supervision, which are important to determine the examination procedures and policies for OFIs
An adequate information system and a guideline or manual are useful tools to help address the specific risks inherent to OFIs.
