Banking Supervision
Supervisors
Supervision Principles
Preconditions for Effective Banking Supervision
Licensing Process and Structure
- Permissible Activities
- Scope of Licensing
Prudential Regulations and Requirements
- Capital Adequacy
- Lending and Investment Policies
- Asset Quality
- Management Information Systems and Prudential Limits
- Connected Lending
- Country and Transfer Risk
- Market Risk Management
- Risk Management
- Internal Controls
- Know Your Customer
Methods of Ongoing Banking Supervision
- On-site and Off-site Supervision
- Supervisory Contact
- Reports and Returns
- On-site Examinations and External Audit
- Consolidated SupervisionSupervisors
Starting from July 1, 2001 the Latvian Banking system is supervised by the Financial and Capital Market Commission that incorporated the supervision department of the Bank of Latvia. Commissions main task is to protect the interests of investors, depositors and the insured, and to promote the development and stability of the financial and capital market. Previously, supervision function was performed by the Bank of Latvia. This change mainly was structural because now supervision of all the financial and capital market participants (issuers, investors, credit institutions, insurers, private pension funds, insurance brokers, stock exchanges, depositories, broker companies, brokers, investment companies and investment consultants) is centralized under the newly established Financial and Capital Market Commission. Banking supervision principles, laws and regulations was transferred the same, developed when the Bank of Latvia supervised banking sector in Latvia.
Supervision Principles
The Core Principles for Effective Banking Supervision, developed by the Basle Committee on Banking Supervision and published in September 1997, are an important and comprehensive international standard for effective banking supervision in Latvia. The principles have been designed in collaboration with a number of supervisory authorities throughout the world and comprise the expertise acquired in this field. The 25 principles form the basis for any effective supervisory system, and cover preconditions for effective banking supervision, licensing, prudential regulations and requirements, methods of ongoing banking supervision, information requirements, formal powers of supervisors and cross-boarder banking.
In July 2000, Latvia was graded as "compliant" with 17 of the 25 principles and "largely compliant" with eight principles.
Full coverage of compliance with these principles you can find in Credit Institutions Supervision Department Annual Report 2000. Here you can get acquainted with brief
Preconditions for Effective Banking Supervision
Principle 1: An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banking organisations ...
In Latvia, credit institutions are supervised by the Financial and Capital Market Commission, whose responsibilities, tasks and rights are set out in the Laws "On the Financial and Capital Market Commission" and "On Credit Institutions". Pursuant to the Law "On Credit Institutions", the Financial and Capital Market Commission issues and revokes credit institution operating licenses (permits), and conducts the supervision of credit institutions in accordance with Republic of Latvia laws and Financial and Capital Market Commission regulations. Banking laws and regulations are revised and amended on a regular basis, to follow tendencies in the development of the banking sector, supervisory practices and, in view of Latvia's preparation for accession to the EU, to incorporate EU requirements in Latvian banking laws and regulations.
Principle 1: ... Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place.
At the end of 1998, the Bank of Latvia concluded agreements on cooperation with the Securities Market Commission and the Insurance Supervision Inspectorate. These agreements envisage information exchange on the organization of financial market participants, their management, strategy, shareholders and owners, investments, and other information needed for the purposes of supervision. The Law "On Credit Institutions" stipulates that the Financial and Capital Market Commission, upon mutual agreement and on terms of confidentiality, is entitled to disclose confidential information to foreign supervisory institutions for the purposes of supervision, provided legislation in their home country envisage liability for disclosing confidential information. The Financial and Capital Market Commission discloses information on a credit institution's activity only in due course of law to the court and the prosecutor's office, the State Police, the State Revenue Service and the Disclosures Office. The Law "On Credit Institutions" prescribes liability for an unauthorised disclosure of information.
Licensing Process and Structure
Permissible Activities
Principle 2: The permissible activities of institutions that are licensed and subject to supervision as banks must be clearly defined, and the use of the word "bank" in names should be controlled as far as possible.
The Law "On Credit Institutions" lists permissible activities of credit institutions. Pursuant to the above Law, only those credit institutions that have a credit institution operating license issued by the Financial and Capital Market Commission may use the wording "credit institution", "bank", "credit union" and any combination of these either in their name or for marketing purposes. Only credit institutions are allowed to advertise the acceptance of deposits and other repayable funds and to receive them. A credit institution may accept deposits from natural persons, provided it has been licensed to render this type of financial services.
Scope of Licensing
Principle 3: The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation's ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organisation is a foreign bank, the prior consent of its home country supervisor should be obtained.
Pursuant to the Law "On Credit Institutions", credit institutions, their branches and representative offices may start their activity in Latvia only after they have received a license (permit) issued by the Financial and Capital Market Commission. The "Regulation for Granting Credit Institution Operating Licenses and Permits" specifies the procedure for granting licenses (permits) to credit institutions. The minimum founding share capital of a bank is the lats equivalent of five million euros. The Financial and Capital Market Commission establishes criteria for principal shareholders, follows that the structure of a credit institution's owners is transparent, checks the availability and amount of free capital, and ensures an adequate internal control system. When reviewing a new credit institution's application for a licence, the Financial and Capital Market Commission evaluates the credit institution's strategies described in its business plan, financial projections for the first two years of operation, marketing plan and organisational structure, which explicitly reveals the responsibilities and rights of the members of its board and executive board, defines the tasks of its organisational units and managers' responsibilities. Where a foreign bank wishes to open a branch in Latvia, it has to submit to the Financial and Capital Market Commission a permit issued by the supervisory authority of its home country. The Financial and Capital Market Commission has the right to refuse a licence to a new credit institution, if during the founding of the credit institution Republic of Latvia laws and Financial and Capital Market Commission regulations have been violated and the intended activity of the credit institution does not correspond to the interests of the Latvian State.
Prudential Regulations and Requirements
Capital Adequacy
Principle 6: Banking supervisors must set prudent and appropriate minimum capital adequacy requirements for all banks. Such requirements should reflect the risks that the banks undertake, and must define the components of capital, bearing in mind their ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the Basle Capital Accord and its amendments.
The Law "On Credit Institutions" states that the ratio of own funds to total risk-weighted assets and off-balance-sheet items (capital adequacy) must not fall below 10 per cent. The definition of a credit institution's own funds and methods for calculating the capital adequacy ratio are set out in supervising organization's regulations, which follow the Basle Capital Accord and are even stricter in some cases. When calculating capital adequacy, the risk-weighted value of assets and off-balance-sheet items is determined on the basis of credit and foreign exchange risks inherent in the particular item. As of January 1, 2001, the capital adequacy calculation has been expanded to include requirements to a credit institution's trading book with regard to other market risks, where the trading book exceeds the established limits. This ensures full compliance with the above principle. Own funds are divided in Tier I and Tier II capital elements. Tier II capital elements in total must not exceed Tier I capital elements. This division is based on the sources of capital. Upon the Bank of Latvia's permission, it is possible to use Tier III capital to partly meet capital requirements for market risks (up to 66.7 per cent). Pursuant to the Law "On Credit Institutions", credit institutions that are subject to consolidated supervision calculate capital adequacy based on consolidated financial statements. The capital adequacy calculation has to be submitted on a monthly basis. If the capital adequacy ratio of a credit institution falls below 10 per cent, the Financial and Capital Market Commission, pursuant to the Law "On Credit Institutions", may apply intensified supervision, within its framework warning the credit institution, fully or partially restricting its activities and appointing a proxy. This has been applied on several occasions.
Lending and Investment Policies
Principle 7: An essential part of any supervisory system is the evaluation of a bank's policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios.
Pursuant to the Law "On Credit Institutions", a credit institution must grant loans in accordance with its lending policy, which specifies lending and repayment procedures, principles for monitoring loans outstanding and criteria for assessing the quality of the loan portfolio. The Financial and Capital Market Commission's "Guidelines for Establishing an Internal Control System in Credit Institutions" require credit institutions to develop and implement policies and procedures for managing major risks. Where a credit institution makes investments and their value is considerable, the supervising organization requires the credit institution to work out the investment policy. Policies have to be approved by the credit institution's board, revised at least once a year and known to all employees involved in the relevant process. During on-site examinations, the Financial and Capital Market Commission's supervisors check whether lending policies and, where appropriate, investment policies and procedures are observed and whether they are revised and updated on a regular basis.
Asset Quality
Principle 8: Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss reserves.
Pursuant to the Bank of Latvia's "Regulation for Evaluating Assets and Off-Balance-Sheet Liabilities", credit institutions must evaluate assets and off-balance sheet liabilities at least once a quarter and make adequate provisions. Likewise, credit institutions have an obligation to develop the policies and procedures for evaluating the quality of assets and the adequacy of provisions, observing the consistency and prudence principles. During on-site examinations, the Bank of Latvia's supervisors assess the loan portfolio and other risk assets and off-balance-sheet liabilities, and evaluate the timeliness and adequacy of provisions against losses. Particular attention is paid to the efficiency of the relevant policies and procedures. If necessary, a credit institution may be asked to revise and update the relevant policies and procedures.
Management Information Systems and Prudential Limits
Principle 9: Banking supervisors must be satisfied that banks have management information systems that enable management to identify concentrations within the portfolio and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers.
The Law "On Credit Institutions" prescribes that exposure to a single customer or a group of connected customers must not exceed 25 per cent of a credit institution's own funds, and the total of large exposures (those exceeding 10 per cent of a credit institution's own funds) must not exceed a credit institution's own funds more than eightfold. Credit institutions have to work out policies and procedures with regard to exposures. All credit institutions must have management information systems that cover all material risks. On a monthly basis, banks report on large exposures and compliance with restrictions on exposures. Likewise, credit institutions regularly submit to the Bank of Latvia information on loans to residents, types of loans and the sectoral breakdown of loans, and information on claims on non-residents in breakdown by country. Credit institutions that are subject to consolidated supervision submit consolidated reports on large exposures on a quarterly basis. During examinations, supervisors assess whether credit institutions comply with the above requirements and whether reports on exposures are correct and true.
Connected Lending
Principle 10: In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm's length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks.
The Law "On Credit Institutions" stipulates that total exposure to persons related to a credit institution must not exceed 15 per cent of the credit institution's own funds. Loans that exceed the amount of 1 000 lats may be granted to a person related to a credit institution only upon a unanimous decision by the executive board of the credit institution. Once a month credit institutions submit a report on transactions with related parties, disclosing the amount and type of exposures as well as the identity of related parties. The supervising organization verifies whether these reports are true and comply with the regulatory requirements.
Country and Transfer Risk
Principle 11: Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriate reserves against such risks.
Credit institutions have to develop a policy for managing country risk and related procedures, stating restrictions on exposures to country risk and procedures for setting, observing and controlling such restrictions. A report on country risk, which includes information on exposures to individual countries and transfer of country risk, has to be submitted on a monthly basis. There are imposed restrictions on exposures to Zone B countries (non-OECD countries): a credit institution's exposure to residents of a single Zone B country may not exceed 25 per cent of the credit institution's own funds (50 per cent of the credit institution's own funds, where exposure is to residents of Estonia and Lithuania), while its total exposure to residents of all Zone B countries may not exceed own funds more than twofold. Pursuant to the "Regulation for Assessing Assets and Off-Balance-Sheet Liabilities", country risk is one of the criteria for assessing a borrower's creditworthiness and establishing the amount of provisions; and therefore, when evaluating loans, banks must take into account country risk. During on-site examinations, management information systems, policies for managing country risk and compliance with related procedures, and the efficiency of internal controls are evaluated.
Market Risk Management
Principle 12: Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor and adequately control market risks; supervisors should have powers to impose specific limits and/or a specific capital charge on market risk exposures, if warranted.
The Law "On Credit Institutions" establishes limits on the net open foreign exchange position in a single currency (10 per cent of own funds) and the total net foreign exchange position (20 per cent of own funds). Likewise, the "Regulation for Calculating Capital Adequacy" lays down requirements to the total net foreign exchange position. As of January 1, 2001, when capital requirements with regard to other market risks (position, commodities, settlement and counterparty risks) are in force, full compliance with this principle has been achieved. Credit institutions must develop a policy with regard to the trading book, setting limits for various market risks, e.g., limits for dealers, transactions, financial instruments and counterparties. During on-site examinations at credit institutions, supervisors assess compliance with the relevant policies and procedures, including procedures for setting and observing limits and the efficiency of the internal control system.
Risk Management
Principle 13: Banking supervisors must be satisfied that banks have in place a comprehensive risk management process (including appropriate board and senior management oversight) to identify, measure, monitor and control all other material risks and, where appropriate, to hold capital against these risks.
The "Guidelines for Establishing Internal Control System in Credit Institutions" stipulate that credit institutions must develop and implement the required policies and control procedures for managing all material quantitative risks, as well as apply appropriate procedures to reduce risks that cannot be quantified (e.g., operational risk, fraud, embezzlement, repute risk, legal risk). Pursuant to the Financial and Capital Market Commission's "Regulation for Compliance with Liquidity Requirements", each credit institution must maintain liquid assets in the amount adequate to meet the legally valid claims of its creditors at any time, and such assets must not fall below 30 per cent of current liabilities. To ensure the security of IT systems, banks have to comply with the "Regulation for the Security of Bank Information Technologies", which lays down procedures for protecting their information and technical resources. The supervising organization has a group of IT experts for auditing banks' information systems. To achieve full compliance with this principle, guidelines for managing interest rate risks have to be worked out.
Internal Controls
Principle 14: Banking supervisors must determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and appropriate independent internal or external audit and compliance functions to test adherence to these controls as well as applicable laws and regulations.
Pursuant to the Law "On Credit Institutions", a credit institution must have an effective internal control system and is responsible for ensuring its functioning to achieve the identification, analysis and management of all material operational risks. Likewise, a credit institution must safeguard its assets, ensure that its information to the management is true and timely, and comply with Republic of Latvia laws and Financial and Capital Market Commission regulations, its own policies and procedures. Pursuant to the supervising organization's "Guidelines for Establishing an Internal Control System in Credit Institutions", an internal control system includes activity planning, the organizational structure of a credit institution, risk management, appropriate accounting and a management information system. When setting up an internal control system, a credit institution must take into account the adopted strategies, the scope of operation, opportunities for identifying material risks, the adequacy of the accounting system, the security of assets and information systems, as well as possibilities for reviewing and updating the system, where necessary. A credit institution must segregate duties and functions, such as execution of transactions, cross-checking and making book entries. A credit institution must establish internal audit function to ensure an independent supervision of the internal control system. Pursuant to the Law "On Credit Institutions", annual financial statements are audited by external auditors, which are approved by the Financial and Capital Market Commission.
Know Your Customer
Principle 15: Banking supervisors must determine that banks have adequate policies, practices and procedures in place, including strict "know-your-customer" rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements.
Pursuant to the Law "On the Prevention of Laundering of Proceeds Derived from Criminal Activity", credit institutions report about unusual financial transactions that have at least one of the features specified in the list of indicators of unusual transactions, which is approved by the Cabinet of Ministers, and other transactions that cause suspicion that legalization of illegal proceeds, or attempt thereof is taking place. Likewise, credit institutions must develop internal control procedures to comply with the requirements of the above law. To assist credit institutions in identifying suspicious transactions and to prevent such transactions, the Financial and Capital Market Commission has developed "Guidelines for Developing Procedures for Identifying Suspicious Financial Transactions", which require credit institutions, where they suspect that a customer acts on behalf of a third party, to take measures to identify the true beneficiary. Likewise, employees of credit institutions must know the business activities of a customer and the related cash flows. During on-site examinations, the Financial and Capital Market Commission verifies the relevant control procedures. The Financial and Capital Market Commission has an obligation to report to the Disclosures Office about financial transactions that have features specified in the list of indicators of unusual transactions, where a credit institution has not done so.
Methods of Ongoing Banking Supervision
On-site and Off-site Supervision
Principle 16: An effective banking supervisory system should consist of some form of both on-site and off-site supervision.
To ensure ongoing banking supervision, the staff of the Supervision Division of the Credit Institutions Supervision Department conducts both on-site and off-site supervision. Off-site supervision relies on regular statistical reports and reports on compliance with regulatory requirements. Pursuant to the Law "On Credit Institutions", the Financial and Capital Market Commission inspects activities of credit institutions at least once a year. During on-site examinations, supervisors examine source documents to check whether a credit institution's activities comply with Republic of Latvia laws, Financial and Capital Market Commission regulations and requirements, as well as relevant policies and procedures. Employees of the Credit Institutions Supervision Department perform their duties pursuant the core principles for on-site examinations and analysis of credit institutions' assets and risks as defined in the Off-site Supervision Procedures and Supervisors' Manual.
Supervisory Contact
Principle 17: Banking supervisors must have regular contact with bank management and a thorough understanding of the institution's operations.
On-site and off-site supervisors of the Credit Institutions Supervision Department maintain regular contacts with credit institutions' management to analyse and assess the soundness and stability of individual institutions. Likewise, they meet with the senior management to discuss development strategies and trends, the efficiency of organisational units of a credit institution, risk management and other significant issues. Pursuant to the Law "On Credit Institutions", a credit institution must inform the Financial and Capital Market Commission on all the circumstances that could substantially influence its future activity.
Reports and Returns
Principle 18: Banking supervisors must have a means of collecting, reviewing and analysing prudential reports and statistical returns from banks on a solo and consolidated basis.
Pursuant to the Law "On Credit Institutions", a credit institution must submit to the Financial and Capital Market Commission and the Bank of Latvia all information that the Commission requires for supervisory purposes, and observe the deadlines set by the Bank of Latvia. Credit institutions regularly submit reports on both a solo and consolidated basis, and all reports are checked using mathematical and logical methods and thereafter analysed. Reports on the balance sheet and condensed balance sheet, the profit and loss statement, compliance with regulatory requirements and other issues are used for the day-to-day supervision purposes to analyse trends in the banking sector. Where a credit institution fails to submit information required by the deadline, a fine may be imposed on such credit institution. Two supervising organization's databases, which hold information from credit institutions' reports, allow supervisors to view time series and obtain information on shareholders, management, foundation, organisation of credit institutions and other issues.
On-site Examinations and External Audit
Principle 19: Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors.
Reports submitted to the Financial and Capital Market Commission are audited at least once a year during on-site examinations. For the purposes of planning, conducting and reporting on examinations, on-site supervisors use the Supervisors' Manual, which contains detailed descriptions of each activity to be examined, objectives of and procedures for examination. Occasionally, the Bank of Latvia also asks internationally recognised auditing companies to conduct the audit of semi-annual financial statements or examinations with a focus on individual areas of activity and their internal control. Supervisors verify whether their reports have been true by analysing audited annual financial statements of credit institutions. As required by the Law "On Credit Institutions", the Financial and Capital Market Commission approves a list of auditors that are entitled to audit annual financial statements of credit institutions in accordance with International Standards on Auditing.
Consolidated Supervision
Principle 20: An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis.
A credit institution that is either the parent undertaking of other credit or financial institutions, or a direct or an indirect owner of 20 or more per cent of share capital or voting shares in other credit or financial institutions, or whose parent undertaking is registered in Latvia as a financial holding company must comply with the requirements governing the activity of credit institutions on the consolidated basis. The Financial and Capital Market Commission is entitled to conduct on-site examinations in undertakings whose financial statements are consolidated, in order to verify whether the received information is true. To ensure full compliance with this principle, amendments to the Law "On Credit Institutions" have been drafted. The draft amendments establish the supervising organization's right to request any credit institution to terminate close relations with third parties (including associates), or prohibit it from transacting with such parties, where such relations can endanger the credit institution's stability or hinder the supervising organization in discharging its supervisory function. Prior to establishing close links, a credit institution must seek the supervising organization's consent.
Source: Bank of Latvia
Related links: Financial and Capital Market Commissions
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