III. Role of Supervisors and External auditors in
identifying problem loans
In summer 1993, Banco Español de Crédito (Banesto),
the Spain fourth-largest bank in terms
of deposits issued stocks for the global amount of 93 billion
peseta ($645.3 million). These stocks were worth almost nothing six months
later. In December, the Bank of Spain seized control of Banesto and fired its
management, trying to head off the run on deposits.
Two thrift institutions were charged by analysts for
having misled the investors of those stocks:
· Spain's central bank approved the rights issue
without a thorough inspection of the bank's accounts. Bank of Spain also did
not disclosed that Banesto had purchased 30 percent of
its own stocks despite the bank regulation that forbids banks to
own more than 5 percent
of their own shares.
· Price Waterhouse, the bank's external
auditor, only looked at the large loans without doing even a sampling of
the smaller loans and disregarding that different types of loans have different
rates of non-performance. The positive results of that audit were often
cited
by Banesto in presentations it made before the rights issue.
This example, among others, shows how important can be the role
of supervisors and external auditors in the stability of banking and financial
system.
This section is divided into two parts:
The first one demonstrates that, if well applied, any banking
supervision embodies the key elements to prevent from and identify problem
loans.
The Bank for International Settlements (BIS) through
the Basel Committee on Banking Supervision (BCBS) has performed 25
«core principles»10 that should be the bases of
an effective banking supervision. Bank regulations vary from one country to
another as do the
domestic circumstances. The core principles are seen to
be the minimum standards any
10 The exhaustive list of the 25 core principles is
available in appendix 2.
19 MBA in Banking and Finance
supervisory authority should comply with. For that reason
focus will be put on the core principles to show the contribution of
supervisors in identifying problem loans.
The second part of this section shows the capability
of a well conducted external audit mission to identify problem loans. In
the core principles, reference is also made to external auditors as key role
players in the financial stability of the banking system and the problem loans
issue.
1. The role of banking supervision
Twelve (12) core principles11 make reference to
problem loans issue generally. They can be
gathered in three groups dealing with the three following
items:
¾ general advices to prevent the bank from problem loans
(CP11 to 15)
¾ checkpoints, criteria, ratios to respect (CP7 to 10)
¾ controls and coercion measures (CP16, 19 & 22)
a. General advices
From core principle 11 to 15, the following functions of
the banking supervision are highlighted:
- Control over banks organisation to ensure they have
effective information systems and risk management processes to monitor all
kinds of risk (country, transfer, market risks)
- supervisory authority must be sure appropriate reserves
and provisions are held against such risks where they may occur
- supervisors must ensure banks have strict
«know-your-customer» rules to avoid criminal activities (i.e.
money laundering)
- banks audit function is assessed to make certain the
internal control is sound and periodically reviewed to meet the changing in
the bank's activities
b. Checkpoints, criteria, ratios
Areas of interest of the supervisor in connection with problem
loans specifically are dealt with
in 4 core principles (CP7 to 10) and can be summarized as
follows:
- Evaluation and periodical review of policies, practices
and procedures of loans granting and their ongoing management
11 The 12 core principles are CP 7 to 16, 19 &
22.
20 MBA in Banking and Finance
- evaluation of policies and procedures of assessment of the
quality of assets and loans loss provisioning and reserves including asset
grading and classification
- limits are set by supervisor to avoid credit concentration
(i.e. large credits granted to single or related borrowers) and prevent banks
from great exposures
The items listed above are guidelines. Supervisors have the
responsibility to set quantifiable ratios and criteria to be followed by
banks.
c. Controls and coercion measures
In order to enforce its recommendations, supervisor has the right
to:
- Control banks both on-site and off-site to verify
the reliability of the information provided. This supervision can be
conducted either by supervisor's staff or by external auditors and also aims to
provide any additional information needed to better assess banks
- take remedial actions to address problems that occur
when banks fail to meet requirements
- revoke the banking license in case of extreme violation of
regulations
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