Basel II's supervisory review process guidelines and its potential impact on Austria's financial market supervision

Illustrated through the BAWAG case

Diploma Thesis, 2007
148 Pages, Grade: 1

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Table of content

1. Introduction
1.1. Motivation for choosing this topic
1.2. Background information
1.2.1. Basel II history & implementation
1.2.2. The BAWAG bank – most important facts & dates
1.3. Problem statement
1.4. Goals of the thesis
1.4.1. Main goal
1.4.2. Sub-goals
1.5. Research questions & hypothesis
1.6. Methodology
1.6.1. Methods/approaches applied
1.6.2. Structure of the paper & sources

2. Review of Literature
2.1. Supervision & Auditing
2.1.1. Supervision – a short introduction Key competences & authorities in supervision Integrated versus sectored supervision The role of central banks in supervision
2.1.2. Trends & issues in supervision Home-host supervisor cooperation The trend towards financial conglomerates The usage of market information for supervisory purposes
2.1.3. Auditing Tasks & responsibilities of internal auditors Tasks & responsibilities of external auditors Cooperation between the banking supervisors, internal & external auditors
2.2. The Basel II Accord
2.2.1. General information The legal basis The scope of application The application dates
2.2.2. A short summary of pillar one – Minimum Capital Requirements The Basel I Accord & its modified version within Basel II The calculation & implication of credit, operational & market risk
2.2.3. A short summary of pillar three – Market Discipline
2.2.4. Pillar two – The Supervisory Review Process The aim & focus of pillar two The main tasks & responsibilities of supervisory authorities The four key principles of supervisory review Other key areas of pillar two
2.2.5. Supporting guidelines & principles The BCP The Core Principles Methodology (CPM) Compliance & the compliance function The CEBS guidelines on supervisory disclosure
2.2.6. The Basel II implementation The potential impact of Basel II General implementation issues The scope of application The determination of appropriate approaches
2.2.7. The strengths and weaknesses of the Basel II Accord The strengths The weaknesses
2.3. The current supervisory situation in Austria
2.3.1. The governing law for the Austrian Banking Sector The Austrian Banking Act Additional regulations A comparison of the Austrian Banking Act and the Basel II framework
2.3.2. The supervisory authorities in Austria The FMA The Austrian National Bank (OeNB) Cooperation between the FMA & OeNB
2.4. The BAWAG affair
2.4.1. The most important events related to the BAWAG scandal
2.4.2. The most important characters & institutions involved
2.4.3. Reasons for the delayed discovery of the BAWAG affair

3. Results & Discussion

4. Executive summary & final thoughts

5. List of abbreviations

6. List of graphs and illustrations

7. Bibliography

8. Appendix

1. Introduction

The following sub-chapters will supply the necessary background information, as well as the problem statement, goals, research questions and the hypothesis for this thesis.

1.1. Motivation for choosing this topic

In the fifth semester of my current studies, I had the valuable opportunity to fulfill a six months internship in an insurance company in Bratislava, Slovakia. During this period I was enabled to work in several different departments including the investment, re-insurance and internal audit department which provided me with the unique possibility of gaining practical experience in these fields.

Especially the duties of the internal audit department triggered my personal interest in the topics of auditing and supervision in the financial market, since I believe that both can contribute substantially to the benefits of the financial institution and the society. Strong and independent auditors do not only perform internal controls but also provide advice regarding areas of concern. Supervisors, on the other hand, can not focus on detailed supervision of individual institutions since they are in charge of the whole financial system.

This fact reinforces the importance of effective communication and cooperation between auditors and the supervising authorities. The BAWAG case clearly demonstrates that there is still much room for improvement for the Austrian authorities in this area. The adoption of the Basel II accord seems to be an important step in this direction since this framework does not solely aim at strengthening the financial stability of the banking system, but also at the enhancement of international cooperation between supervisors and auditors.

1.2. Background information

The upcoming paragraphs will entail some basic information about the topics discussed in the literature review section.

1.2.1. Basel II history & implementation

The origin of this framework can be traced back to the year 1988, when the Basel Committee on Banking Supervision (BCBS)[1] issued the Basel Capital Accord which is also known as the Basel I Accord. The main objective of this agreement was to enhance the financial stability of the banking sector by setting minimum capital requirements.

Since 1988, this standard has not only been implemented in the member states[2] of the BCBS but in a majority of countries across the world. However, the continuous development and change in the financial industry demanded amendments of the Basel I Accord. Therefore, on June 26th, 2004 a revised framework formally referred to as “International Convergence of Capital Measurement and Capital Standards”[3], more commonly known as Basel II Accord replaced the former Basel I agreement. The new guidelines yield an extended and revised version of the former one with the overall objective of the promotion of banking stability.

As the Basel II regulation by itself is a non-binding standard of best practices, it necessitates its integration into the domestic laws of each country to become effective. Within the European Union this measure was taken by establishing the Capital Requirement Directive (CRD), containing EU Directive 2006/48/EC and Directive 2006/49/EC, which was formally adopted in June 2006[4].

This directive only enforces the need for national governments to implement Basel II but it does not include any strict regulations on how to implement the framework.

Austria amended its Banking Act and issued two additional regulations, the Solvability Regulation (Solvabilitätsverordnung) and the Disclosure Regulation (Offenlegungsvereinbarung) in August 2006 to integrate the new EU directives into domestic law[5]. The new regulations have become effective on January 1st, 2007.

In 1994, the Austrian Banking Act (Bankwesengesetz) replaced the previous Banking Act (Kreditwesengesetz) which assigns the most important legal provisions for the banking sector in Austria. One of the major aims of this new act was to ensure its compatibility with the governing European Union legislation[6].

In 2002, by establishing the Financial Market Supervision Act (Finanzmarktaufsichtsgesetz – FMAG) and the simultaneous alteration of the Austrian Banking Act, an autonomous and legally independent supervisory institution named Financial Market Authority (Finanzmarktaufsicht – FMA) was formed[7]. The FMA assumed all responsibilities[8] from the federal ministry of finance and is now in charge of the supervision of banks, insurances, pension funds and securities.

At the same time, the modifications of the Austrian Banking Act led to a reinforcement of the Austrian National Bank’s (Österreichische Nationalbank - OeNB) role concerning its participation in banking supervision. The key responsibilities of the OeNB include the conduct of “on-site inspections regarding credit and market risks of credit institutions”[9], analyses of individual banks and the overall financial system, provision of expert opinions on any issues related to banking supervision and the participation in the financial market committee as well as in international supervising cooperations.

Furthermore, the results of all OeNB’s analyses and inspections must be communicated to the FMA, which bears the final responsibility for all subsequent manoeuvres.

At this point, efficient communication and coordination is absolutely essential to ensure an effective supervision process. The consequences of a lack in cooperation have become evident in 2006, when the biggest Austrian banking scandal, the BAWAG case, occurred.

1.2.2. The BAWAG bank – most important facts & dates

The bank was founded in 1922 by Federal Chancellor Dr. Karl Renner. At that time called “Arbeiterbank”, its main business activity was the “financial administration for unions and cooperative societies”[10].

In 1934, the bank had to file for bankruptcy due to political turbulences. Thirteen years later, in 1947, the bank was reopened by the Austrian Trade Union (Österreichischer Gewerkschaftsbund - ÖGB) and continued its operations under its current name “Bank für Arbeit und Wirtschaft (BAWAG)” from 1963 on. Since then it has focused its business on the private banking sector, considering itself as the “bank of the little man”[11].

The amendments of the Austrian Banking Act in 1979 enabled banks to open branch offices. BAWAG took advantage of the new regulation and rapidly expanded its network from twenty-six offices in 1979 to hundred-twenty by 1982, becoming a market leader in the private banking sector.

In 1994, BAWAG became the target of investigations conducted by the Austrian financial authorities concerning its Caribbean investments[12]. Due to the pressure applied by the authorities, BAWAG had to close its controversial Caribbean deals which were initiated by then-CEO Wolfgang Flöttl and his son, Wolfgang Flöttl junior.

Only one year later, the new CEO Helmut Elsner reopened the Caribbean deals, which led to enormous losses in the subsequent years[13]. Nevertheless, the bank was able to keep the deficits undetected and to attract a new investor. In 1996 the Bayerische Landesbank acquired forty-six percent of BAWAG’s shares, becoming the second biggest shareholder of the bank.

A milestone in the bank’s history represents the acquisition of the Österreichische Postsparkasse (P.S.K.) in the year 2000[14]. Due to this step BAWAG became the third biggest banking group in Austria. Moreover, this acquisition assisted the bank’s management in concealing its tremendous depletion of several hundred million Euros incurred by the highly speculative Caribbean deals and other dubious swap transactions. The majority holder, the ÖGB, issued a guarantee of one billion Euros to cover the losses and to secure the financial stability of the bank. In 2004, the ÖGB repurchased the forty-six percent stake of Bayerische Landesbank, holding hundred percent of the shares from then on[15].

In the following year, as promulgated by the OeNB[16], BAWAG granted a loan of four hundred twenty-five million Euros to its joint venture partner Refco, an US-American broker company. Shortly after the money for the loan had been transferred, Refco filed for insolvency and BAWAG’s loan emerged to be uncollectible. The US Securities Exchange Commission initiated an extensive examination of the Refco case, charging the company with falsification of its financial statements and breach of trust.

The commission also scrutinized BAWAG’s involvement which led to a law suit against BAWAG in the USA. BAWAG was able to settle the law suit outside the court[17] ; however, it could not prevent the Austrian authorities from launching their own investigations.

During this inspection it became apparent that BAWAG was not only assisting Refco in covering its fraudulent activities. The authorities revealed that the bank had been falsifying its financial statements of the past years to conceal the losses caused by highly speculative and therefore risky investments.

As reported by the media[18], sixteen suspects including the former CEOs Helmut Elsner and Johann Zwettler, the chairman of the supervisory board Günter Weninger, the former ÖGB president Fritz Verzetnitsch and investment banker Wolfgang Flöttl junior have been charged with breach of trust and manipulation of financial statements. The first hearings and interrogations of the BAWAG law suit have already started and the case is expected to be settled by the end of 2007.

As announced by the bank[19], the complete management and supervisory board of BAWAG has been replaced, introducing Ewald Nowotny as the new CEO. As a consequence of the ÖGB’s involvement and the financially difficult situation of the bank, the union decided to sell BAWAG. Therefore, the Morgan Stanley investment bank was hired to administer the sales process which was finalized by the end of 2006 when BAWAG was purchased by Cerberus, an US-American hedge fund and its Austrian partners Wüstenrot and Generali.

1.3. Problem statement

Globalization has become an important aspect of our every day’s life. It affects us as soon as we go shopping, turn on the television or travel abroad. Therefore, it is little surprising that globalization also impacts financial markets. It allows banks to spread their banking activities around the world by liberalizing many financial markets.

Due to this liberalization, financial markets evolve and the historical role of banks as primary source of financial intermediation begins to change. Consequently, banking sectors worldwide have been deregulated to allow banks to diversify their businesses into other financial areas.

This trend, also known as the formation of financial conglomerates, raises important considerations for the implementation of Basel II’s supervisory review process. Singhal and Vij[20] argue for instance that the increasing number of such groups will trigger severe problems in the multinational supervisor coordination and multi-sectored supervision. Due to the global operations of such conglomerates, different jurisdictions apply in different countries requiring the supervisors of each country to closely cooperate with each other.

Moreover, financial conglomerates operate in different sectors of the financial market, forcing supervisors to monitor the group’s activities not only in one business sector but several. That fact causes considerable concerns for countries that employed a sectored rather than an integrated supervision approach[21], which means that there are several supervisors for each sector in lieu of one authority that supervises the whole market.

Austria decided in favor of the single supervisor approach, transferring all the responsibilities regarding supervision to the FMA which is assisted by the OeNB. Unfortunately, the description of the tasks and responsibilities for both authorities concerning banking supervision are rather vague in Austrian law, leaving plenty of space for interpretation.

These imprecise definitions, at least partially, contributed to the failure of supervision in the case of the BAWAG scandal.

1.4. Goals of the thesis

The next two sections will define the main goal and the two sub-goals targeted throughout this paper.

1.4.1. Main goal

The main goal of the paper is to research whether the imposition of the Basel II Accord in Austria could have empowered the supervising authorities to detect or even prevent the BAWAG scandal earlier.

1.4.2. Sub-goals

The first sub-goal is to examine the reasons for the failure of the Austrian supervisors to accurately monitor BAWAG. The second sub-goal is to determine whether the new framework would have helped to detect the scandal earlier.

1.5. Research questions & hypothesis

Based upon the goals outlined in the above paragraphs, the following research questions and hypothesis can be formulated.

RQ 1: Why did the Financial Market Authority and the Austrian National Bank not manage to detect the fraudulent behavior of BAWAG’s management at an earlier point in time?

RQ 2: If already implemented at that time, could Basel II’s framework have helped the authorities to detect or even prevent the fraud?

H1: If already enforced at that time, the Basel II guidelines would have enabled the Austrian supervisors to discover and accurately cope with the BAWAG fraud case.

1.6. Methodology

Due to the nature of the topic, this paper is predominantly based upon a qualitative empirical approach, employing desk research and content analyses of existing literature. The main reason for choosing this approach constitutes the fact that the Basel II enactment has just started recently[22] and as a consequence, it would be unreasonable to try to assess its real impact so far. Similarly, the investigations concerning the BAWAG case have not been finalized yet and on that account it is demanding to accurately examine the degree of supervision failure in that case. Hence, this paper does not claim complete totality for this subject.

1.6.1. Methods/approaches applied

The following paragraphs will highlight the different methods utilized in each phase of the thesis.

The first phase required thorough desk research including the collection and systematic analysis of relevant literature to illustrate the landscape of the problem[23] and to formulate appropriate research questions.

Consequently, the next step entailed the phrasing of a hypothesis based upon the research questions by applying the deductive approach. The aim of this measure was to establish causality between the failure of supervision and the BAWAG case on the one hand, and the hypothetical impact of Basel II on the BAWAG case on the other hand.

Accordingly, the next stage was characterized by the statement and interpretation of arguments leading to the falsification or verification of the hypothesis. For this purpose the qualitative empirical procedure was exercised.

The fourth phase covered the testing of the hypothesis by employing the deductive method. Finally, stage five and six focused on the formulation and the review of the statement derived from the result of the hypothesis testing.

1.6.2. Structure of the paper & sources

The thesis is divided into four main parts, beginning with an introduction, followed by a review of literature, the results and discussion section, the executive summary and final thoughts.

The introduction provides a short insight into the motives for choosing this topic, some fundamental knowledge about the theory discussed in the literature review section, the goals, research questions and hypothesis of the thesis as well as the methodology applied.

Following the introductory section, the review of literature entails four main chapters. The first section of the literature review entails a short excursion into the topics of supervision and auditing in general. The aim of this chapter is to provide the reader with the basic knowledge about these subjects to better understand the implications of Basel II. The publications of James R. Barth and his colleagues Gerald Caprio jr. and Ross Levine contribute the core literature for this part. Additional sources include the BCBS, the Committee of European Banking Supervisors (CEBS), the European Central Bank (ECB), the International Monetary Fund (IMF) as well as several individual papers[24].

Chapter two introduces the Basel II Accord, highlighting and explaining the most important aspects, additional regulations, strengths and weaknesses. The key information for this chapter is published by the Bank for International Settlements (BIS) and the BCBS. Supporting materials are supplied by the CEBS, different books[25], publications of internationally known journals[26] and newspapers[27].

The third chapter presents the current supervisory situation in Austria, examining the Austrian Banking Act and its additional regulations, the key supervisory authorities and responsibilities. The publications of the FMA and the OeNB form the primary source for this part.

Finally, the fourth part delivers the most essential facts about the BAWAG case, focusing on the most important events and people surrounding it. The annual reports and other publications of the bank supply the core information for this section, supplemented by a broad range of articles from national[28] newspapers and magazines.

The results and discussion chapter will yield the resolving of the two research questions and the rejection/approval of the hypothesis by applying the deductive approach.

Finally, the executive summary and final thoughts chapter will supply a résumé of the main points as well as some personal impressions regarding the topic of the thesis.

2. Review of Literature

The following four chapters will provide a summary of literature on the topics of supervision and auditing, the Basel II framework, the current supervisory situation in Austria and the BAWAG case.

2.1. Supervision & Auditing

This chapter delivers a brief introduction into the subjects of supervision and auditing. Section one entails the most relevant facts about supervision, such as the contrasting approaches towards supervision, its influence on the regulation and stability of financial systems as well as the key supervising authorities and their competences. Moreover, this part also includes a comparison of the so-called “integrated versus sectored supervision” and a brief analysis of the central bank’s role in supervision. Section two focuses on the trends and issues in supervision, whereas the last section (section three) highlights the essentials of auditing related to the cooperation with supervising authorities.

2.1.1. Supervision – a short introduction

“When banking or, more generally, financial systems temporarily break down or operate ineffectively, the ability of firms to obtain funds necessary for continuing existing projects and pursuing new endeavors is curtailed”[29]. This statement clearly indicates the importance and the need for proper regulations and supervision of the banking sector. Therefore, it is little surprising that the banking sector is among the most vigorously regulated industries.

As discussed by Barth et al.[30], such regulations do not necessarily exercise a positive influence upon financial markets. They argue for instance, that countries where regulations prohibit banks to participate in other business segments of the financial market appear to have less stable financial systems. This point of view is supported by Hellmann et al.[31] who believe that since numerous changes in prudential regulation have taken place, “[…] financial crises have become more frequent”[32]. However, other economists[33] claim the opposite, namely that deregulations lead to a higher systematic risk due to the increased competition after the liberalization.

The dismissive approach of Barth et al. towards governmental supervision is related to the “the grabbing hand view”[34] which assumes that politicians do not act in the interest of the society and that supervision should therefore not be pursued by a government agency. Contrary to this idea is the “helping hand view”[35] which implies that the government should directly monitor and regulate banks in order to enhance the stability of the banking system. This viewpoint is based on the argument of market failure[36], suggesting that private agents by themselves are not capable of effectively supervising banks[37].

According to Shleifer and Vishny (1998) there is a third, alternative model – the “invisible hand model”. This model is based on the assumption that markets function very well without governments and that government’s involvement should be limited to the supply of public goods. This laissez-faire view obtains the same opinion on governments as the grabbing hand view[38]. However, the grabbing hand model tends to better describe what governments actually do and therefore to be more constructive.

Regardless of the approach considered, the central goal of supervision remains the same, namely “to promote the safety and soundness of the financial system in order to prevent a systematic crisis that would threaten not only the financial system, but also the economy as a whole”[39]. Key competences & authorities in supervision

The next sections will examine the most important tasks and responsibilities of national as well as international supervisory agencies, followed by an overview of the relevant supranational supervisors and a discussion of whether Europe needs a central supervisor.

The most important tasks & responsibilities of supervisors

The main responsibility of any national supervisor is to supply financially troubled banks, whose failure would intimidate the whole banking system, with sufficient financial support to prevent it from insolvency. The two main tools available are a government take-over/rescue or the acting as “lender of last resort”[40]. The conflict arising from this kind of support is that it creates an incentive for large banks to engage in riskier business since these banks are aware of the fact that they are too big to fail.

This is exactly where the main tasks of national supervisors come into play. Supervisors are obliged to monitor bank activities and to enforce regulations to detain banks from assuming risks that could threaten the stability of the entire system[41]. Moreover, they are compelled to protect the deposits of investors and to preserve consumer confidence since banks do not function properly without it.

The tasks and responsibilities of international supervisors differ from the ones of national supervisors in several aspects. Firstly, there is no single authority in charge of supervision[42] but several institutions. Secondly, there is no lender of last resort on an international basis. Finally, none of the international supervisory institutions has the competence to legally enforce any regulations[43]. Nevertheless, national and international supervisors pursue the same goal which is to rather prevent bank failures from occuring than providing costly emergency support afterwards.

Supervisory authorities

Apart from the national supervisors in each country, there are several important supranational institutions as the ones described in the following paragraphs.

The Basel Committee on Banking Supervision (BCBS)

As a consequence of international banking problems[44], the central bank governors of the G10 countries founded the BCBS in 1974. Since then the committee operates as an organ of the BIS, reporting to the governors of its member countries[45]. The committee is supported by several sub-groups such as the Accord Implementation Group or the Core Principle Liaison Group.[46]

As highlighted by Nout Wellink[47], the current chairmen of the BCBS, the committee adheres to the following objectives. Firstly, to accommodate a platform for communication and cooperation among supervisors, secondly to enhance advancements in the risk management of banks and frameworks for supervision and finally to support tools for the sensible enactment of guidelines or principles published by the committee.

Over the last decades the main focus of the BCBS work has been on the development of accurate capital requirements in order to improve the stability of banking systems around the world[48]. The two major achievements in this area constitute the release of the Basel I and Basel II Accord[49], which will be examined in greater detail in the upcoming chapter of this paper.

What should be kept in mind is the fact that the committee only dispenses recommendations and best practice guidelines that are legally non-binding. Only the transition of such guidelines into national law makes them enforceable.

The Committee of European Banking Supervisors (CEBS)

This committee was initiated in 2004 with the goal to “ensure consistent realization and application of the Capital Requirement Directive[50] and to promote convergence of supervisory practices across the EU”[51]. The CEBS assists the BCBS by issuing guidelines and recommendations on the execution of the Basel II framework, especially in the area of supervision. Moreover, it contributes to an “improved cost efficiency of EU supervisory systems”[52] by providing standardized reporting frameworks.

The Banking Supervision Committee (BSC) of the European System of Central Banks (ESCB)

The BSC and the ESCB have both been established in 1998[53] and since than they have closely cooperated with the CEBS. The committee consists of representatives of the EU banking supervisory authorities and members from national central banks as well as from the ECB[54].

Consequently, one of the major aims of this committee is to promote cooperation between the distinct national banks and the supervisory authorities concerning any topics related to banking supervision.

Moreover, the BSC is required to assist the ESCB and the ECB with their duties towards financial stability and prudential supervision. Finally, the BSC also contributes to the control and evaluation of developments in the area of financial stability.

Other international supervisory institutions

Apart from the European institutions mentioned before, there are also several non-European associations such as the Association of Supervisors of Banks of the Americas, the Association of Financial Supervisors of Pacific Countries or the Islamic Financial Services Board. For more information on the different institutions and their work, please see the “Report on International Developments in Banking Supervision”[55].

Is there a need for a European banking supervisor?

As discussed earlier in this chapter, international supervisory institutions such as the BCBS, do not possess any legal authority nor do they act as a lender of last resort. However, the continuous convergence of financial markets within the EU with more and more banks operating on an international level, has raised the question whether national supervisors are still capable of monitoring such international banks sufficiently or if there is a need for one central supervisory authority for the whole EU instead.

Proponents of the centralized supervisory authority argue that the main benefit would be the possibility of rapid intervention when a European wide crisis occurs, since all the powers would lie within one institution.

Some economists go even further and concretely suggest that the ESCB and ECB should assume this responsibility by acting as a lender of last resort and a supervisor at the same time[56].

Rather contrary to this view, is the opinion of the former ECB president Duisenberg[57] who pointed out that the ECB would only act as a lender of last resort in a liquidity crisis affecting the entire EU. The responsibility of supplying financial aid to individual banks facing insolvency should remain with the national authorities. According to Duisenberg, this would limit the moral hazard problem arising from the knowledge of large banks believing that they are too big to fail since they would only receive financial support when their difficulties would also affect other banks.

Another interesting contribution to this debate is supplied by Josef Christl[58], a member of the OeNB. He proposes to leave the supervisory tasks for the short- and mid-term with the national authorities and to aim for a centralized supervision only in the long run since the development of such an institution would require several preliminary steps[59]. Moreover, he highlights the necessity of further cooperation, convergence and consistency concerning supervisory practices under the guidance of the CEBS in order to achieve the goal of a centralized supervisory authority for the EU.

What has become obvious from this debate is the fact that there is a consensus concerning the need for a European-wide supervisor. At the same time there is considerable disagreement as to which institution should assume this role and when. Integrated versus sectored supervision

Due to the ongoing convergence of financial markets and the occurrence of severe financial system crises, many countries decided to adapt their supervision approaches[60]. Traditionally, most countries employed a sectored (also referred to as sector-by-sector or solo approach) supervisory strategy meaning that there is at minimum one supervisor for each segment of the financial market.

Contrary to this strategy is the integrated (or unified) approach which demands an “agency that is in charge of (micro)prudential supervision of at least the three main segments of most financial sectors – banking, insurance, and securities”[61].

As indicated in the following chart, the number of integrated supervisory agencies worldwide has increased significantly over the last years.

illustration not visible in this excerpt

Fig. 1. Number of Integrated Supervisory Agencies, 1985-2004 (Source: Čihák and Podpiera 2006, 4).

Among the first countries implementing this approach were Singapore (1982) and Norway (1986), whereas other countries such as Austria (2002) anticipated this change at much later point in time[62].

What becomes evident from the next graph is the fact that the majority of all integrated agencies by the end of 2004 were located in Europe. Out of the twenty-nine fully integrated agencies worldwide, approximately half are located in European countries.

illustration not visible in this excerpt

Fig. 2. Regional Distribution of Integrated Supervisory Agencies in 2004 (Source: Cihák and Podpiera 2006, 4).

Another interesting observation of Čihák and Podpiera[63] concerns the variety of countries implementing the unified approach. According to their findings, countries ranging from having very small and simple financial systems to very large and complex systems adopted this strategy. No overall conclusion can be drawn upon the benefits and costs of integrated supervision, since the potential (dis)advantages vary considerably across countries. Nevertheless, the next two sub-sections will highlight the potential benefits and disadvantages of integrated supervisory practices.

Benefits of integrated supervisory agencies

The two major advantages relate to improved efficiency and economies of scale achieved through shared infrastructure as well as decreased administrative and personnel expenses[64]. Moreover, the integrated approach appears to be more suitable for the supervision of financial conglomerates and “competitive neutrality”[65] since it does not allow financial institutions to engage in supervisory arbitrage arising from inconsistent regulations applying to different sectors.

As similarly discussed by Abrams and Taylor (2000) and Čihák and Podpiera (2006), the integrated approach facilitates more flexible regulations and faster responses to developments in the market since all the necessary competences are possessed by a single authority. A final benefit stems from the improved accountability of supervisors since there is only one supervisory agency responsible for the entire financial market.

Disadvantages of integrated supervisory agencies

The major criticism of this practice relates to the unclear objectives arising from the broad range of purposes a unified agency has to pursue. Consequently, this might lead to a decrease in accountability because of the difficulty to create a precise array of responsibilities[66].

Further arguments against this approach correlate to the potential diseconomies of scope and scale[67] caused by the integration. Whenever a lack of harmonization in regulations between the different financial sectors occurs, it will be extremely challenging to achieve cost synergies (economies of scope). Moreover, the further the agency grows the more bureaucratic and more difficult to effectively manage it gets. Another risk constitutes the fact that moral hazard problems arising in one sector might be spread across the whole system due to the lack of separation of responsibilities. The final disadvantage is represented by the risk involved in changing the supervisory practice itself.


Even though convincing arguments against the unified supervisory approach exist, Čihák and Podpiera (2006) conclude that integrated supervision is generally highly correlated with higher quality and consistency of supervision.

Abrams and Taylor (2000) on the other hand claim that the trade-off between benefits and disadvantages is dissimilar for each country and that therefore it should be determined on an individual basis which approach appears to be more beneficial. The role of central banks in supervision

As set out by De Haan and Osterloo[68], the core responsibilities of central banks cover the maintenance of monetary and financial stability. Apart from this two core functions the central banks perform a range of other tasks such as the lender of last resort function, the design and enforcement of monetary policies, the regulation and monitoring of payment and settlement systems and finally banking supervision[69].

Many economists agree that central banks should be independent[70] and that they should be involved in banking supervision[71]. Disagreement arises when it comes to the degree of involvement. Part of the problem stems from the lack of clear definitions of financial stability objectives that have been observed in most OECD countries[72]. The absence of precise objectives impedes proper evaluation of their execution and this leads to a lack of accountability[73] of central banks in the area of financial stability.

Further arguments against a high degree of central banks’ participation in banking supervision emerge from the conflict of interest between the goals of monetary policies and banking supervision. As indicated by Čihák and Podpiera[74], a central bank might be reluctant to effectively control inflation due to the fear that higher interest rates might lead to bank failures which would then be blamed on the supervisor.

As a consequence, bank failures may undermine the credibility of central banks[75] not only as a supervisor but for all other functions as well.

Supporters of a greater extent of involvement argue that clear synergies between the information needed for banking supervision and the information needed for monetary policy purposes exist and that this overlap of expertise should be utilized[76]. Moreover, in some countries central banks appear to be much more independent than any individual supervisor.

Once again there is no “one-size-fits-it-all” solution to this problem. Countries have to evaluate on an individual basis whether the entanglement of central banks leads to a desirable outcome or not.

2.1.2. Trends & issues in supervision

The next paragraphs will offer clarification on the issues of home-host supervisor cooperation, the treatment of financial conglomerates and finally the idea of employing market information for supervisory purposes. Home-host supervisor cooperation

Additionally to the publications of the “High-level Principles for cross-boarder implementation of the New Accord” and the “Core Principles of Effective Banking Supervision”, the BCBS issued another consultative paper called “Home-Host Information Sharing for Effective Basel II Implementation” in June 2006. The common purpose of these publications is to support the harmonized cross-boarder imposition of Basel II and to promote communication and coordination among supervisors.

The core objective for effective home-host information sharing is to supply a framework for consolidated supervision[77] of globally operating banks so that no bank can escape from supervision[78]. Pursuing this objective requires enhanced cooperation and exchange of information between the home and host supervisor as well as a clear differentiation of responsibilities[79].

This objective is only partially satisfied through the so-called Memoranda of Understanding which are bilateral agreements clarifying the exchange of information. Holthausen and Rønde[80], for instance, assert that these agreements are not sufficient since they only prescribe the exchange of hard information such as financial figures but not the soft facts[81] which are vital for assessing the financial health of banks. Moreover, they do not solve the “cheap talk game”[82] problem which suggests that supervisors solely communicate the information that suits their own interests.

Therefore, the most important aim of any regulation should be the alignment of interests of supervisors to ensure effective cooperation and exchange of information. Furthermore, Holthausen and Rønde proclaim that “asymmetries of interest”[83] exist between the home and host supervisor arising from different costs and benefits of closing a bank. According to their view, a bank might be of much greater importance to the banking system of the home supervisor country so that the home supervisor might be more reluctant to close down such a bank than a host supervisor.

However, the BCBS expects to attain consistent supervisory practices for internationally active banks as well as a decrease of the regulatory burden faced by banks. The trend towards financial conglomerates

Due to the convergence of financial markets, many financial institutions increased their scope of business and diversified their products and services into other segments of the financial system. A financial conglomerate is defined as a “conglomerate whose regulated entities engage to a significant extent in at least two of the principal financial segments”[84]. As stated by De Nicoló et al.[85] the number of financial conglomerates among the top five hundred financial institutions worldwide augmented from forty-two percent in 1995 to sixty percent in 2000.

Usually, financial conglomerates occur either in the form of “Bancassurance or Assurfinance”[86]. The first denotation refers to banks that sell insurance products, whereas the second term applies to insurance companies that offer financial products and services.

Strengths of financial conglomerates

As pointed out by Singhal and Vij[87], conglomerates can achieve improved efficiency and effectiveness due to economies of scale and cost synergies. Moreover, conglomerates are capable of diversifying their sources of revenue and risks arising from their divergent business sectors. The diversification of products and services provided might also create a competitive advantage over the more specialized market participants.

Weaknesses of financial conglomerates

Conglomerates might be exposed to inefficiencies due to their size as well as to “contagion risk”[88] or “intra-group contagion”[89]. This risk represents the danger of spreading problems occurring in one sector to other segments of the entities’ business.

Implications for supervision

Financial conglomerates appear to be much more difficult to monitor than stand-alone companies. Their supervision might proof to be especially demanding for countries employing a sectored-supervision approach since conglomerates usually participate in cross-sector and cross-boarder business[90]. Moreover, the absence of harmonized supervisory standards and the non-identical treatment of conglomerates worldwide create the opportunity of regulatory arbitrage[91]. Furthermore, it remains questionable whether Basel II will sufficiently cover regulations for financial conglomerates, since the framework mainly focuses on banking activities and not on any other areas of financial market activities. So far no satisfactory solution for the effective supervision of financial conglomerates has been delivered, but the CEBS is developing a framework to do so[92]. The usage of market information for supervisory purposes

Usually, supervisors obtain necessary data either by conducting a so-called off-site or on-site analysis[93]. The former refers to the review of financial reports produced by the banks, whereas the latter relates to the inspection of individual banks. These two forms of scrutiny contribute complementary information, since the off-site analysis provides data about the complete banking system, while the on-site inspection offers detailed information about single banks.

However, throughout recent years discussions as to whether the usage of signals from financial markets should be employed as supplementary information have taken place. The central argument in favor of this idea derives from the believe that “market participants have an incentive to look through reported accounting figures to the real financial condition of a bank and to price a bank’s securities based on their best estimates of the distribution of the security’s future cash flows”[94].

Based on this argument, Cannata and Quagliarello[95] conclude that supervisors possess a significant amount of insider data, but that financial market variables could enable supervisors to speed up the evaluation process. Moreover, they specify that equity markets provide the most reliable information on banks’ risk profiles compared to any other variables[96].

A different point of view on that topic is presented by Berger et al.[97] who explain that information prepared by external rating agencies deliver the most suitable complementary data since they follow the same objective as supervisors, the impediment of default risk.

In conclusion it can be said that information from financial markets generally appears to be suitable for supervisory purposes, but that some variables such as equity prices or external ratings produce more accurate information than other variables, such as stock prices which do not accurately reflect the risk profile of a bank due to their exposure to market trends and changing consumer prices[98].

Finally, it should be mentioned that the idea of utilizing the knowledge of market participants is at least partially recognized in the third pillar of the Basel II framework which will be investigated more thoroughly in chapter 2.2.3.

2.1.3. Auditing

The following subdivisions will entail the essential tasks and responsibilities of internal and external supervisors and an analysis of their cooperation with banking supervisors. Tasks & responsibilities of internal auditors

As defined by the Institute of Internal Auditors, “internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes”[99].

Moreover, the BCBS defined the most important principles of internal audits to ensure its proper functioning. The first principle relates to the “permanent function”[100] of the internal audit, meaning that an operating audit department must exist at any time. The second principle covers the “independence, objectivity and impartiality”[101] of internal auditors. These three objectives shall be attained through the establishment of an audit charter that ensures the independence of internal auditors from the management and the audited activities.

Finally, the BCBS addresses the “professional competence”[102] of internal auditors stating that it is especially important for large banks to employ highly trained auditing personnel to ensure high-quality work.

Adhering to these principles, the BCBS determined the following tasks for internal auditors[103]. Firstly, the investigation and assessment of the internal control systems in terms of effectiveness and efficiency. Secondly, the review of risk management and risk assessment procedures, the management of the financial information system and the financial reports of the bank. Moreover, the internal audit is responsible for evaluating the capital adequacy of the bank as well as the monitoring of legal and regulatory conformity.

Thirdly, the auditor is also in charge of testing the internal control procedures and transactions of the bank. Related to this task is the responsibility of conducting special investigations and the execution of the so-called whistle-blowing whenever the auditor detects fraudulent behaviour within the bank.

Finally, the broad scope of tasks and responsibilities also includes consulting since the internal auditors possess a high level of knowledge about the bank’s business which may be utilized to improve different systems and procedures. Tasks & responsibilities of external auditors

External auditors conduct an audit and issue and auditor’s report according to the relevant ethical and auditing standards[104]. The aim of the audit is to ensure that the financial statements of the bank have been prepared in adherence to the applicable accounting standards[105]. However, the auditor is not capable of ensuring that the statements are free from any material misstatements due to several limitations.

Firstly, the auditor can not review every single transaction of the bank, since this would be extremely time-consuming and therefore not practical[106]. Consequently, the scope of the audit is determined by the “inherent risk of material misstatement, the assessment of control risk and testing of the internal controls designed to prevent or detect and correct material misstatements, and on substantive procedures performed on a test basis”[107].

Secondly, many decisions, such as the definition of what exactly constitutes a material misstatement, are based upon the professional judgement of the auditor and not on any unified criteria.

Thirdly, misstatements due to fraud may be very difficult to detect since fraud often involves “sophisticated and carefully organized schemes designed to conceal it”[108].

Whenever the external auditor detects a material misstatement he must inform and inquire the management to correct it. If the management refuses to do so the auditor issues a qualified or adverse opinion on the financial reports[109]. Since the publication of such a negative opinion would have a serious impact on the credibility of the bank, managers usually agree to take the necessary steps demanded by the auditor. Cooperation between the banking supervisors, internal & external auditors

The next paragraphs will provide insight into how the three parties interact with each other to improve the effectiveness and efficiency of their work.

Cooperation between banking supervisors & internal auditors

The first area of common interest relates to the work of the internal auditor, which is evaluated by the banking supervisor[110]. This evaluation usually takes place in the form of on-site inspections and/or regular meetings. Secondly, the supervisor does not only assess the work of the internal auditor, but defines potential problems and risks concerning control issues within the bank[111].

Finally, in some countries banking supervisors invite internal auditors for “sector-based discussions”[112] to exchange views on issues of common interest.

Cooperation between banking supervisors & external auditors

The participation of external auditors in supervision varies significantly across countries[113]. Nevertheless, there are several areas where the work of both sides supplies useful information to each of them. The report prepared by the auditor delivers data on various aspects of the bank’s operation and condition that are of interest to the supervisor, too[114]. On the other hand, results from the inspections of banks carried out by the supervisor are communicated to the bank and also available for external auditors. What should be noted here is the fact that banks must at least be informed whenever banking supervisors and external auditors exchange confidential information about the bank[115].

Cooperation between internal & external auditors

In many countries external auditors make use of the internal auditor’s work under the condition that the reliability of the internal auditor’s performance has been determined in advance[116]. The coordination of work leads to an avoidance of duplication which is beneficial for both sides. Finally, consultation on an on-going basis forms the prerequisite for effective cooperation[117].

2.2. The Basel II Accord

The upcoming chapter will entail a section on general information such as the legal basis for Basel II, its scope and application dates, followed by a summary of pillar one and pillar three and a more detailed description of the second pillar, since this part is most influential on supervision. Additionally, the most relevant supporting guidelines and their implications will be discussed. The chapter concludes with discussing several implementation issues and an analysis of the strengths and weaknesses of the accord.

2.2.1. General information

The main difference between the former Basel I Accord and the new Basel II Accord stems from the extension of only comprising minimum capital requirements under Basel I to also covering the supervisory review process and market discipline under the new framework[118] as presented in the following illustration.

illustration not visible in this excerpt

Fig. 3. Basel II's three pillar concept (Source:

The new concept appears to be much more flexible and risk-sensitive[119] than the former framework. The three mutually reinforcing pillars as well as the positive and negative aspects of Basel II will be described in greater detail later on in this chapter. The legal basis

As mentioned before, Basel II is a non-binding framework that only becomes enforceable when integrated into domestic law. Within the EU this necessary measure was taken by the formal adoption of the CRD in June 2006, representing an update of the current framework. This directive consists of the EU Directive 2006/48/EC and 2006/49/EC which must be applied in all member states from the beginning of 2007[120]. Through Directive 2006/48/EC the requirements of pillar two and three of the Basel Accord will be transferred into domestic laws of the member states, whereas Directive 2006/49/EC enforces the minimum capital requirements described in pillar one.


[1] „The Committee provides a forum for regular cooperation on banking supervisory matters. Over recent years, it has developed increasingly into a standard-setting body on all aspects of banking supervision”. BIS 2006b, 1.

[2] Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America, BCBS 2007, 2.

[3] BCBS 2006e.

[4] Euroactiv 2006, 1.

[5] FMA 2007a, 1.

[6] OeNB, Legal Framework, 1.

[7] Pribil 2002, 1.

[8] Including such tasks as granting market entry, licensing, approvals, supervisory procedures, etc. FMAG §1.

[9] BWG 2006, 54 §70.

[10] BAWAG P.S.K. Group 2004b: “year 1922”.

[11] BAWAG P.S.K. Group 2004b: “year 1963”.

[12] Der Standard 2006a, 1.

[13] Der Standard 2006a, 1.

[14] BAWAG P.S.K. Group 2004b, “year 2000”.

[15] BAWAG P.S.K. Group 2004b, “year 2000”.

[16] OeNB 2006, 1.

[17] Neumeister 2006, 1.

[18] Fritz 2006, 1.

[19] BAWAG P.S.K. Group 2005b, 2.

[20] Singhal and Vij 2006, 52.

[21] Such as Australia, Germany, Latvia or Korea. Barth et al. 2001, 33.

[22] The Basel II implementation in Austria commenced on January 1st, 2007.

[24] Including publications from de Haan and Osterloo, Singhal and Vij or Hellmann, Murdock and Stiglitz.

[25] Becker, Gaulke, Wolf, 2005. Bruckner, Schmoll, Stickler, 2003. Gup, 2004. Tietmeyer, Rolfes, 2002.

[26] Such as from The Banker: „Capital Accord or Discord?“ by Michael Imeson or the Journal of Banking Regulation: “Basel Committee on Banking Supervision: Compliance and the Compliance Function” by Dalvinder Singh.

[27] Der Standard, Die Presse, Salzburger Nachrichten, etc.

[28] Der Standard, die Presse, Salzburger Nachrichten, Profil and Wirtschaftsblatt Online.

[29] Barth et al. 2000, 2.

[30] Barth et al. 2003, 3.

[31] Hellmann et al. 2000, 148.

[32] Hellmann et al. 2000, 148.

[33] For instance Fischer and Chennard 1997.

[34] Shleifer and Vishny 1998.

[35] Shleifer and Vishny 1998.

[36] Musgrave 1959 and Coase 1960.

[37] Atkinson and Stiglitz 1980.

[38] Shleifer and Vishny 1998, 3.

[39] Wood 2005, 5.

[40] Wood 2005, 5.

[41] Wood 2005, 7.

[42] Wood 2005, 7.

[43] BCBS 2007, 1.

[44] Such as the breakdown of the Bretton Woods system.

[45] The Committee currently has thirteen member countries, with Luxembourg, Switzerland and Spain joining the G10 countries. BCBS 2007, 1.

[46] For a full list of all sub-groups please turn to BIS 2006b, 2.

[47] Wellink 2006a, 1.

[48] BCBS 2007, 2.

[49] Wellink 2006b, 4.

[50] The CRD has been formally adopted by the EU in June 2006 in order to integrate the Basel II Accord into domestic legislation of all member countries. Euroactiv 2006, 1.

[51] Roldán 2005c, 1.

[52] BCBS 2006a, 50.

[53] BCBS 2006a, 36.

[54] BCBS 2006a, 36.

[55] BCBS 2006a, 27-58.

[56] Vives 2001, 11.

[57] Duisenberg 1999.

[58] Christl 2005, 71-72.

[59] Such as the establishment of a clear chain of command when a crisis occurs or the requirement for further political integration. Christl 2005, 71-72.

[60] Čihák and Podpiera 2006, 3.

[61] Čihák and Podpiera 2006, 5.

[62] For a worldwide comparison of sectored versus integrated supervision, please proceed to Appendix A.

[63] Čihák and Podpiera 2006.

[64] Abrams and Taylor 2000, 10.

[65] Abrams and Taylor 2000, 11.

[66] Abrams and Taylor 2000, 17.

[67] Čihák and Podpiera 2006, 10.

[68] De Haan and Osterloo 2006, 255.

[69] Frisell et al. 2004, 2.

[70] For instance Elfinger and De Haan 1996 or Berger et al. 2001.

[71] Čihák and Podpiera 2006, 13.

[72] De Haan and Osterloo 2006, 267.

[73] „an obligation owed by one person (the accountable) to another (the accountee) according to which the former must give account of, explain and justify his actions or decisions against criteria of some kind, and take responsibility for any fault or damage“. Lastra 2001, 70.

[74] Čihák and Podpiera 2006, 14.

[75] Abrams and Taylor 2000, 20.

[76] Čihák and Podpiera 2006, 14.

[77] BIS 2006a, 1.

[78] Kapstein 2006, 7.

[79] Holthausen and Rønde 2004, 5.

[80] Holthausen and Rønde 2004, 5.

[81] e.g. market rumours about problems of the bank, information on the borrowers of a bank, etc.

[82] Holthausen and Rønde 2004, 8.

[83] Holthausen and Rønde 2004, 8.

[84] Singhal and Vij 2006, 49.

[85] De Nicoló et al. 2003.

[86] Singhal and Vij 2006, 49.

[87] Singhal and Vij 2006, 50.

[88] Stöffler 2004, 109.

[89] Flannery 1999.

[90] Singhal and Vij 2006, 52.

[91] Stöffler 2004, 112.

[92] Roldán 2005a, 2.

[93] Cannata and Quagliarello 2005, 139.

[94] Flannery 2001.

[95] Cannata and Quagliarello 2005, 140.

[96] Cannata and Quagliarello 2005, 160.

[97] Berger et al. 1998.

[98] Cannata and Quagliarello 2005, 159.

[99] Source:

[100] BCBS 2002a, 4.

[101] BCBS 2002a, 5.

[102] BCBS 2002a, 6.

[103] BCBS 2002a, 2-3.

[104] BCBS 2002a, 1.

[105] BCBS 2002b, 4.

[106] BCBS 2002b, 6.

[107] BCBS 2002b, 6.

[108] BCBS 2002b, 7.

[109] BCBS 2002b, 7.

[110] BCBS 2002b, 8.

[111] BCBS 2002b, 8.

[112] BCBS 2002b, 8.

[113] BCBS 2002b, 9.

[114] BCBS 2002b, 13.

[115] BCBS 2002b, 13.

[116] BCBS 2002b, 8.

[117] BCBS 2002b, 8.

[118] Becker et al. 2005, 10.

[119] Gup 2004, 5.

[120] EU 2006c, 1.

148 of 148 pages


Basel II's supervisory review process guidelines and its potential impact on Austria's financial market supervision
Illustrated through the BAWAG case
University of Applied Sciences Wiener Neustadt (Austria)
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Basel, Austria
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Miriam Schützenhofer (Author), 2007, Basel II's supervisory review process guidelines and its potential impact on Austria's financial market supervision , Munich, GRIN Verlag,


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