pages: 6/size: 25KB Elements of the German Regulatory and Supervisory System and Possible Lessons for the Microfinance Sector in LDCs]

Stefan Staschen, February 11, 2000

Although the German regulatory and supervisory system is one of the most sophisticated in the world, one can nevertheless identify some elements which are of general relevance even for the microfinance sector of a developing country. I would like to highlight some of these elements in a loose order and try to derive some possible implications for LDCs.

THE DIVISION OF LABOUR BETWEEN THE FEDERAL RESERVE BANK (BBK) AND THE FEDERAL SUPERVISORY OFFICE FOR THE CREDIT SYSTEM (BAK)

The German Federal Reserve Bank, Bundesbank, legally plays a minor role in banking supervision. Especially through its State Reserve Banks (Landeszentralbanken, LZBs) located in the German Federal States (Länder) it supports the Federal Supervisory Office for the Credit System (Bundesaufsichtsamt für das Kreditwesen, BAK). This Office is not part of the Bundesbank, but a federal office which is directly subordinated the Ministry of Finance. 90 percent of its budget is financed by the banks itself, only the rest is paid out of the government budget. In contrast to the Bundesbank, which normally earns a profit through the seignorare and high-yielding financial investments, it has to operate under a very tight budget constraint. The rationale for this construction was that the task of banking regulation and supervision is part of the trade supervision (Gewerbeaufsicht) and therefore cannot be carried out by the Bundesbank that is responsible for the monetary policy and therefore has to be independent. The BAK in contrast is subject to parliamentary control via the Ministry of Finance. With the foundation of the European Central Bank this argument is not valid any longer since the Bundesbank has lost its responsibility for the monetary policy.

In theory this seems to be a reasonable institutional structure. In practice, it requires a lot of coordination between the Bundesbank and the BAK. The staff of the Bundesbank are predominantly economists, while the one of the BAK has a strong legal background. The Bundesbank comprises the Head Office in Frankfurt and 9 Landeszentralbanken (LZBs, as main branches of the Bundesbank) in the Länder. With this decentralized structure it has a strong presence in the field. On every monthly report and annual statement is first worked on in the LZBs. After having been evaluated in the LZBs these data together with specific recommendations are sent to the BAK in Berlin (soon to be moved to Bonn) where it is decided whether one has to take action or not. Only there sovereign decisions like giving a warning or ordering compulsory measures can be made. However, the LZBs are much closer to the individual bank then the BAK. There is no clear limitation between the responsibilities of the Bundesbank and the BAK. A lot of double work and inefficiency seems to be involved.

In the wake of the introduction of the Euro the whole structure of the German supervisory system is under consideration. The BAK would like to create its own audit department to get closer to the banks to be supervised. But it seems not to be very realistic to get the required funds from the Ministry of Finance. The Bundesbank is looking for new jobs after the transfer of a lot of responsibilities to the European Central Bank. It is under pressure to straighten the regulatory structure and to improve its efficiency. At the same time there is a move from quantitative supervision to qualitative supervision (see below). This will have a strong influence on the necessary qualification of the supervisors. Where this process will lead to is still open. But one can already say that the BAK is dependent on the personnel of the Bundesbank in carrying out the task of banking supervision.[ 1 ]

What can we learn from the German system? It seems to be more efficient to have only one supervisory institution that stretches out into the rural areas and at the same time has the power to sanction misbehavior and mismanagement. Whether the supervisory authority is part of the central bank (as in Uganda) or an independent office is another question not to be dealt with here. But it should be ensured that the central bank has access to the bank statistics compiled by the supervisory authority so that it can use it for its monetary policy.

THE INDIRECT REGULATION BY THE BUNDESAUFSICHTSAMT (BAK)

The philosophy of the German supervisory authority is not to intervene in the decisions of banks but to leave them as much independence as possible. It does neither have the capacity nor the interest to control the day-to-day-decisions of credit institutions. The overall goal is to protect the interests of depositors and to ensure the stability of the financial system. Except for some very specific requirements (e.g. the "Minimum Requirements for Credit Institutions for the Performance of Trading Transactions" and money laundering instructions) where it carries out its own inspections (or employs the LZBs to do so) the BAK uses independent private auditors to conduct on-site-supervisions.

This holds true for any kind of financial institution. In addition, in the case of credit cooperatives and savings banks the external auditors are members of the respective umbrella body, the federation of cooperatives or the federation of savings banks. In either case this can be called "delegated supervision": The supervisory authority has delegated the task of supervising cooperative and savings banks to the federations and only rarely employs independent auditors to countercheck the results of their audits.[ 2 ] However, the BAK is still responsible for the definition of regulatory requirements and can take actions against credit cooperatives or savings banks without the consent of the federations.

How can the quality and objectivity of these audits be ensured? In the case of financial institutions which are not inspected by members of the federations but by independent auditors or auditing companies there seems to be a tendency of choosing the auditor for once and for all. This is due to the fact that the first on-site-inspection is always the most expensive. Obviously, this can lead to a close relationship between the auditor and "its" bank. He or she is interested to remain auditor and therefore not to be too harsh in evaluating the bank's performance. There were some cases of banks that ran into financial trouble without adequate prior announcement by the audit reports, so that the reputation of the auditors has suffered. Possible sanctions of the BAK are not to allow the auditor to carry out the on-site-inspections in this particular bank any longer or even to withdraw the license. In addition, the auditor is liable for negligence up to DM 8 Mio. and for intent even unlimited.[ 3 ]

In the case of cooperative or savings banks the auditor is member of the respective federation. The credit cooperatives only have to hand in the auditing reports to the BAK on demand. Therefore there must be a strong reliance on the accuracy of these reports. The federation itself is in a hermaphroditic role: It is advisor for its members and at the same time auditor of the banks it probably has advised before. This could lead to a strong conflict of interests on the part of the federation. One precaution against this is the separation of the auditors' department and the advisors' department. In fact, sometimes the federations hire staff from independent auditing companies since they do not have the necessary knowledge or capacity to carry out any audit by themselves.

Another incentive not to be too lax is the claim to support any credit cooperative that gets into trouble. In a critical situation, the responsible federation has either to support the bank with additional funds or to find another bank for a merger. So far not a single credit cooperative in Germany went bankrupt. In the end the federation has to answer for its member banks anyway and therefore is good advised not to conceal arising problems.

What are the pros and cons of this German system of indirect regulation via private auditing firms? One substantial advantage is the reduction of the work load for the supervisory authority. Only some twenty or thirty years ago there was a multiple of credit cooperatives in Germany with mostly only a very small size. These huge amount of very small institutions would have implied a heavy work load on the part of the BAK. By delegating the supervisory task to the federations or to private auditing companies the BAK could confine itself to the control of the audited statements and once in a while of a special audit report according Section 44 KWG. This seems to be a model for the microfinance sector, too. A precondition is, however, that the auditors have a strong incentive to monitor the compliance with the regulatory requirements in an efficient and unbiased manner. In the case of credit institutions audited by federations (still by far the bigger amount of credit institutions in Germany) this can be achieved by the organizational separation of the advisory and auditing department, by holding the federation responsible for the accuracy of its auditing report and by threatening it with possible sanctions. In addition, the supervisory authority should have the possibility to carry out on-site-inspections by itself or by a specific auditing firm without further explanations.[ 4 ]

Another advantage of the German system is that private auditors have to visit financial institutions anyway to check the annual statement. So they only have to fulfill some additional requirements the supervisor needs for its off-site supervision.

A possible drawback of the indirect regulation-approach could be that the supervisory authority is not directly involved in the supervision of the banks and therefore could lose the feeling for the problems the banks will face it they translate the regulatory requirements into action. Besides, as already mentioned above, auditing companies have a strong interest in getting a contract the next year, too, and incentive problems can arise because of their twin-role as consultant and auditor.

ONE SINGLE ACT FOR ANY KIND OF FINANCIAL INSTITUTION

In Germany there exists one single law that is valid for any kind of credit institution, the Banking Act (Gesetz über das Kreditwesen, KWG)[ 5 ]. Although one can distinguish at least three general kinds of financial institutions - credit institutions, credit cooperatives and savings banks - they are all subject to the regulation by this Act and referred to by the generic term "Bank"[ 6 ]. Since the last amendment of the Act even the so-called Financial Services Institutions (Finanzdienstleistungsinstitute, FDIs) are included. Thereby one tries to bring the gray market under control.

Section 1 of the Banks Act defines the different kinds of banking businesses. According to this, not only deposit-taking, but also credit-granting institutions are subject to the Banks Act.[ 7 ] According to the precedents there are certain limits up to which deposits can be taken or credits granted without having a banking license. This approach of having a unique Act for any kind of financial institution will be only useful if there are exemption clauses for some requirements. E.g., the start-up capital has to vary depending on the kind of institution. It has to be lower for financial services institutions than for commercial banks. The same is true for the extent of the required documentation and publication. One example of this is Section 33 No. 1 KWG where the minimum start-up capital depends on the kind of financial services the institution offers. There can be trifle thresholds (Bagatellgrenzen) defined under which specific requirements have not to be met.[ 8 ]

In the microfinance sector one can find examples for both, the inclusion of microfinance institutions (MFIs) into the existing banking legislation and the promulgation of another law especially for MFIs. But to have a special MFI law seems to be the preferred solution (examples are Bolivia, Peru, West Africa and Uganda). The rationale for this is that the existing banking law does not take the specific requirements of MFIs into consideration and therefore would not be appropriate for them. The German experience could contradict this reasoning or at least shows that a differentiated treatment of different kinds of institutions will also be possible if one has a single law for any kind of institution. This could be a contribution to the simplification of the regulatory framework and create a level playing field. At the same time, the transition from one institutional structure to another (e.g. the development of a MFI into a fully-fledged bank) could be made more fluent and therefore the opportunities for regulatory arbitrage be reduced.

QUANTITATIVE VS. QUALITATIVE SUPERVISION

In accordance with the philosophy of the German regulatory system not to intervene with the day-to-day business of financial institutions, the supervisory authority does not have the power to control each single financial transaction. It has to rely on the aggregated data it (respectively the auditors) finds in the files of the banks. What it can do to control the accuracy of these data is to make spot checks. Here applies the rule: Off-site controls trigger on-site controls. Besides it can have a close look at the management techniques the bank uses. Important questions one could ask are: Who reports to whom, who is responsible for internal audits, how is the management informed, are there detailed work instructions for every employee in the bank, etc. This is what van Greuning/Gallardo/Randhawa call 'risk management' instead of 'ratio management'[ 9 ]. The problem is not to conduct high-risk businesses, but not to charge an adequate risk premium for it. At least in theory, the supervisory authority should not be interested in the level of risk, but in the risk management techniques which cope with these risks.[ 10 ] The German supervisory system seems to overemphasize the importance of the risk-weighted capital ratio which still not takes operational and other risks into account, but only credit and market risks. The BAK has some scope for its decisions, but only seldom seems to use it.[ 11 ] The so-called "Minimum Requirements for Credit Institutions for the Performance of Trading Transactions" (MAH) fit into this development from ratio management to risk management.[ 12 ] Another peculiarity of this MAH-audits is that they are carried out by private auditors and by Bundesbank-staff, alternately. Thereby the Bundesbank starts to build up its own pool of auditors.

The single most important factor contributing to the financial performance of a MFI is the quality of its management and the management techniques it uses. Policies, practices and procedures seem to be more important than the compliance with certain ratios. For the supervisory authority it is still important to control some ratios as for example the capital adequacy or liquidity ratios, but even more important is to know that in the case of arising financial difficulties the management will take the right actions.[ 13 ]

SOME BASIC REGULATORY REQUIREMENTS FOR MFIS

• Internal control: Responsibilities of board, multiple eyes principle
• Internal audits: in very small institutions by mutual control of the managers, better would be independent auditor without involvement in operational business
• Precautions against bribery and fraud
• Organization: Written instructions (Ablauforganisation), clear responsibilities (Aufbauorganisation)
• Qualification: CVs of employees and managers, certificate of conduct (if available), possibly personal interview
• Reports: monthly (quarterly) balance, asset quality, growth rate, big loans, liquidity (stock approach easier than maturity-mismatch approach), balance of interest rate maturities (Zinsbindungsbilanz)