Moving Towards Risk-based Supervision in Developing Economies

This paper addresses the following three questions:

• Are government regulatory institutions, especially those in developing countries, keeping up with the pace of change?
• Where does microfinance, fit into the regulatory scheme?
• Can current regulatory techniques detect less-obvious risks such as the foreign exchange risks that precipitated the recent crisis in Asia that have become part of the new financial world?

The purpose of this paper is to help familiarize government officials and professional staff of donor organizations as to what risk based supervision is and how it can improve supervision in two cases:

• When risks are hidden, as in the implicit foreign exchange risk in dollar loans to the non-tradable goods sector that played a major role in the Asian crisis;
• When lending may be unnecessarily limited, such as to micro-entrepreneurs who lack traditional collateral or written records.

Among the important attributes and potential benefits of risk-based supervision discussed in this paper are that it:

• Provides a framework that offers two distinct advantages;
• Establishes common terminology and approaches to evaluate risk and risk management in financial institutions;
• Is flexible enough to be applicable to all financial products and services and to all types of financial institutions from large banks to small credit unions;
• Unlike traditional supervision, which focuses on the internal operations of a single institution, risk-based supervision considers external factors affecting not only individual banks but also the banking system as a whole;
• Provides a regulatory environment in which banks are not just pushed to avoid risks but can also mitigate and offset risks as acceptable risk-management practices.

The paper concludes that:

• The timeliness and potential importance of risk-based supervision and its accompanying analytical tools are clear from the emphasis currently being given by such donors as USAID and the World Bank, for whom initiatives to resolve systemic problems in banks and other financial institutions in developing and transitional economies have become a high priority;
• Risk-based supervision is not designed to solve the problems of failing banks;
• Traditional, transactions-oriented approaches to banking supervision are more appropriate because they are designed to quantify as precisely as possible the extent of losses that will need to be covered in either rehabilitation or liquidation;
• The special usefulness of risk-based supervision is to identify ahead of time risks that may cause serious problems in the future and to assess the ability of bank management to deal with the risks identified.

 It is hoped that donor officials and government policymakers will hopefully have gained enough detailed information to understand how far the many countries that assert that they are already implementing risk-based supervision still have to go