CONFIDENTIAL

RESTRICTED USE ONLY (NOT FOR USE BY THIRD PARTIES)

OFFSHORE FINANCIAL CENTER ASSESSMENT PROGRAM

ANDORRA
MODULE 2 ASSESSMENT

DETAILED ASSESSMENT OF COMPLIANCE WITH THE BASEL CORE PRINCIPLES FOR EFFECTIVE BANKING SUPERVISION
JANUARY 2007

INTERNATIONAL MONETARY FUND

MONETARY AND FINANCIAL SYSTEMS DEPARTMENT

Contents

Page

I. Introduction ...........................................................................................................................3 General...............................................................................................................3 Information and methodology used for assessment...........................................3 Preconditions for effective banking supervision................................................4 Tables 1. Detailed Assessment of Compliance of the Basel Core Principles........................................6 2: Summary Compliance with the Basel Core Principles........................................................26 3. Recommended Action Plan to Improve Compliance with the Basel Core Principles.........27

I. INTRODUCTION General 1. The assessment of Observance with the Basel Core Principles for Effective Banking Supervision (BCP) is based on the Core Principles Methodology (Basel Committee on Banking Supervision, October 1999). The assessment was undertaken in the context of the Offshore Financial Center (OFC) Assessment Program, Module 2. This assessment took place in September 2006 and was carried out by Messrs. Ruben Mendiolaza (Superintendency of Banks and Insurance Companies of Peru) and Walter Zunic (formerly with the Federal Reserve Bank of New York). The assessors benefited from the full cooperation of the authorities and received all necessary information. Their cooperation is gratefully acknowledged. Information and methodology used for assessment 2. The assessment is based on the following sources: (i) the legal and regulatory framework, contained mainly in the four laws applicable to all financial institutions and the directives issued by the Institut Nacional Andorr de Finances (INAF); (ii) the SelfAssessment of compliance with the Core Principles as of August 2006 prepared by the INAF; (iii) the 2002 BCP assessment conducted by the IMF in the context of the assessment of Andorras financial system; (iv) external audit reports, including a sample of Complementary Reports1; (v) various reports prepared by INAF; and (vi) extensive discussions with the senior and supervisory staff of the INAF, as well as meetings with bankers, external auditors and other market participants. 3. This assessment of compliance with each Principle has been made on a qualitative basis. A five-part assessment system is used: compliant, largely compliant, materially noncompliant, noncompliant, and not applicable. To achieve a compliant assessment with a Principle, all essential criteria generally must be met without any significant deficiencies. There may be instances where a country can demonstrate that the Principle has been achieved through different means. Conversely, due to specific conditions in individual countries, the essential criteria may not always be sufficient to achieve the objective of the Principle, and, therefore, one or more additional criteria and/or other measures may also be deemed necessary by the assessor to judge that compliance is achieved. A largely compliant assessment is given if only minor shortcomings are observed, and these are not seen as sufficient to raise serious doubts about the authoritys ability to achieve the objective of that Principle. A materially noncompliant assessment is given when the shortcoming is sufficient to raise doubts about the authoritys ability to achieve compliance, but substantive progress has been made. A noncompliant assessment
1

Complementary Reports (Informes Complementaris) are prepared by external auditors following the requirements issued by INAF, and they cover assessments of a broad range of issues including internal controls, risks management and compliance with key prudential requirements.

is given when no substantive progress towards compliance has been achieved, or when insufficient information was available to allow a reliable determination that substantive progress has been made towards compliance. An assessment of not applicable is rendered for a Principle deemed by the assessors not to have current relevance. Institutional and macroprudential setting, market structure, and overview 4. INAF is the sole authority of the Andorran financial system, and the law grants it operational and budgetary independence, as well as powers to regulate, supervise, and apply corrective actions to financial institutions. Only insurance companies are outside of INAFs oversight responsibilities, but plans to transfer this responsibility to INAF are underway. INAF is governed by an Executive Board of six members all with wide experience in economy, finance, and law. Board members are appointed by parliament, upon the proposal the government. They are appointed for a six year period, nonrenewable. Half of the board members are renewed every three years. The day to day operations of INAF are conducted by a director general, appointed by the government, upon the proposal of INAFs Board. The appointment of the director general is for six years, renewable indefinitely. The director general participates in INAFs Board, with voice but no vote. 5. There are seven banks operating in Andorra, which are the core of five banking groups. These banking groups generally control a collective investment entity and a life insurance company. Bank related entities conduct 99 percent of the life insurance business (measured by gross premiums) and 99 percent of the collective investment business. In sum, the financial system is dominated by banking groups which control all the institutions accounting for the quasi-totality of their markets. Banking total assets and customer deposits amounted to 11.3 billion euros and 9.3 billion euros in 2005, respectively. About 2.7 billion euros of total loans in 2005 were loans to nonresidents, mostly from Europe and North America, and a significant share of deposits from nonresidents, primarily from the European Union.2 Andorran banks have branches in Bahamas and Uruguay and a representative office in Panama, but these operations represent a very small share of the business of the banking groups. Preconditions for effective banking supervision 6. The preconditions for effective banking supervision in Andorra are generally in place. There are no identifiable macroeconomic vulnerabilities and risks that could have implications for the structure and financial performance of the banking industry or the effectiveness of prudential safeguards or the stability of the financial system. 7. The public infrastructure provides for an environment that fosters the honoring and enforcement of financial contracts. The small size of the local economy facilitates assessment of credit risk in the loan portfolio, and the absence of a credit bureau does
2

Figures on resident and nonresident deposits are expected to be available starting on 2007.

not seem to have affected loan evaluation, as evidenced by the low level of past due loans (about 0.2 percent of total loans in 2005). Nevertheless, the authorities have mentioned their intentions of working with the industry toward the implementation of a credit bureau. While there is no public registry in Andorra, the notaries perform the task of recording liens on real estate and other property suitable for collateral. The court system is effective and efficient, and the execution of collateral reportedly takes less than one year. 8. The flow of information on banking institutions to market participants is considered adequate, albeit disclosure of higher frequency data would be desirable. While there is no publicly available official information on the financial strength and performance of the banking industry, banks publish their annual audited financial statements both electronically and in printed form, and the Andorra Bank Association (ABA) publishes an annual report, which contains a section on the financial environment including financial indicators of individual banks and the banking system. 9. There are no official accounting standards in Andorra, except the Chart of Accounts (CA) of the financial system issued by the INAF in 1999. These standards, inspired by the Bank of Spain accounting standards of that time, are generally adequate but an updating is warranted in the context of International Financial Reporting Standards (IFRS). The authorities are preparing a draft accounting law by which all Andorran companies would adopt standards consistent with IFRS, with implementation estimated by 2008. The INAF favors the adoption of IFRS by all banks, once draft legislation is passed by the Counsel General and plans to adapt prudential regulations as needed to narrow the accounting choices available for banks. 10. Andorra has a legal and regulatory framework with flexible power for the government to effect a resolution of problem banks. Nevertheless, an immediate challenge for the authorities is to carry out modifications to the current regulation to empower the INAF as the only authority in Andorra to undertake all types of remedial actions, including the revocation of a banks license. 11. There is no deposit insurance in place nor is there a lender of last resort. However, all banks are required to participate in a guarantee fund. The funds are deposited in banks, and would be available to facilitate resolution of a troubled financial institution. Whether and how the fund could be used in the event that there were a problem with one of Andorras banks has not been defined. In the medium term, the authorities foresee the implementation of a fully defined deposit and investments insurance fund. Throughout its 75 years of banking history, Andorra has not experienced a banking crisis. One banking institution failed in 1968 (Sobanca), and the remaining banks stepped up to honor its liabilities in order to preserve the confidence in the system.

Table 1. Detailed Assessment of Compliance of the Basel Core Principles

Principle 1. Objectives, Autonomy, Powers, and Resources An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banks. Each such agency should possess operational independence and adequate resources. A suitable legal framework for banking supervision is also necessary, including provisions relating to the authorization of banking establishments and their ongoing supervision; powers to address compliance with laws, as well as safety and soundness concerns; and legal protection for supervisors. Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place. An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banks. The Law governing the creation of the Andorran National Institute of Finance (INAF) was issued in June 1989 and amended in September 1993. In October 2003, Law14/2003 was enacted. This Law (referred to as INAFS charter hereupon) redefines the INAF functions and grants more independence and in general brings its jurisdiction in line with bank supervisory entities of other countries. Article 3 of the charter indicates that the INAF is the Authority of the Andorran financial system and promotes and sees to the proper working and stability of the financial system. A Law regulating the operational functions of the different components of the financial system was issued in December 1996 and establishes four components: (i) banking entities; (ii) nonbanking financial institutions for specialized credit; (iii) financial investment entities; and (iv) financial entities offering various services. Decrees and Comunicats (Communications) issued periodically by the INAF complement and update the INAF Law. Article 5 of INAFs charter indicates that the INAF exercises disciplinary and sanctioning powers over the institutions integrated in the financial system. The INAF has the authority to issue regulations that provide a framework of prudential standards that banks must meet. The charter indicated that the Communications issued by the INAF carry a weight similar to a law. The above laws, supported by the regulations provide a framework of minimum prudential standards that banks must meet and establish the participation of the INAF in deciding when and how the necessary measures have to be taken to address a problem bank, including the intervention of the bank. INAF has not had a reason to intervene a bank, so laws and regulations in this area have not been tested. INAFs senior management indicated that in the one case when a bank had to be liquidated, the other banks of the Andorran banking system assumed its obligations and the depositors did not incur any losses. The Andorran banking system has over 75 years of experience in this activity; and the case of liquidation of the one bank occurred before the creation of the INAF. The INAF is the only financial agency in Andorra and there is a defied mechanism for exchanging information between the INAF and the Unitat de Prevenci del Blanqueig (UPB Laundering Prevention Unit), which is the independent body for the promotion and coordination of money laundering prevention measures in Andorras (see CP1 (6)). Currently, the INAF does not ensure that the information on the financial strength and performance of the banking industry is publicly available. However, the ABA publishes an annual report, which contains a section on the financial environment including financial indicators of the banking system.

Principle 1(1) Description

INAFs charter includes the requirement that the INAF publish a periodic review of its performance against its responsibilities and objectives. This review is presented to parliament through the minister of finance, however, it is not made public. The INAF has included in its 2007 budget the necessary funds to ensure a transparent reporting and assessment process of its activities. Assessment Comments Principle 1(2) Description Compliant Each such agency should possess operational independence and adequate resources. Article 1 of the INAFs charter establishes the operational independence of INAF. Specifically, the charter mentions that the INAF acts with independence with respect to the government and parliament. Article 27 of the charter establishes the right of INAF to prepare its own budget and submit it to the government (the president and the various government ministers) that forwards it to the counsel general (parliament) without making any changes. The INAF is funded by the revenues derived from investment income of a fund provided for by the Andorran Government. The size of the fund is approximately 12 million euros. The present level of revenues derived from the fund can sustain the current level of staffing, but provides little flexibility for an increase as needed to fulfill supervisory responsibilities. Government representatives indicated that, to the extent that additional resources are required to operate INAF, such resources will be made available through the government budget. This statement is supported by Article 26.2 of INAFs charter, which stipulates that INAF can be also funded by resources explicitly assigned to it in the government budget. The INAFs senior management has indicated that since the inception of bank supervision activity in 1994, there has been no attempt by the government authorities to interfere in the operational matters of the INAF and its ability to deploy the resources needed to carry out its mandate. The INAF is financed in a manner that does not undermine its autonomy or independence and permits it to conduct effective supervision and oversight. This includes salary scales that is comparable to market; the ability to hire outside experts to deal with special situations; a training budget and program that provides regular training opportunities for staff; and a budget for equipment sufficient to equip its staff. Conversations with representatives of the banking industry and a rating Agency disclosed that the supervisory agency and its staff have good credibility based on their professionalism and integrity. The director general and the sub-director general of the INAF and all the members of its board of directors are appointed for a term of six years and in the event the director general is removed from office, the reasons must be publicly disclosed. Compliant A suitable legal framework for banking supervision is also necessary, including provisions relating to authorization of banking establishments and their ongoing supervision. The Law regulating the financial system, issued in 1993 and the INAFs charter, (discussed in CP1(1)) provide for the oversight functions by INAF of banks, specialized credit and other financial institutions including investment and fund management companies. In accordance with its charter, the INAF has the authority to sanction banks for minor and serious infractions. Currently, the activities of insurance companies do not come under the supervision of INAF.

Assessment Comments Principle 1(3) Description

Article 2 of the Law regulating the Creation of New Banking Institutions issued in June 1998, establishes the requirements for the authorization of new banking entities in Andorra. The government has the final authority to approve or deny permits for the issuance of new banking licenses. A report by INAF is required to make these decisions. The government so far has always rendered his decisions based on the technical recommendations of the INAF. The approval of a change in ownership of currently operating institutions is within the authority of the INAF. The existing laws authorize the government to issue prudential norms without requiring a change in the laws. Additionally, as indicated in CP 1(1), the INAF has the authority to issue regulations (comunicados) that provide a framework of prudential standards that banks must meet and over the years has issued a number of operational regulations to the financial system. Article 24 of INAFs charter empowers it to request information from the banks in the form and frequency it deems necessary. Largely Compliant In order for this CP to be considered compliant, the INAF should be the final authority to render a decision covering the entry of a new institution in the country. A suitable legal framework for banking supervision is also necessary, including powers to address compliance with laws, as well as safety and soundness concerns. A number of laws, including the 1996 Law of regulations of the Solvency and Liquidity Criteria, the 1997 Law regulating the Disciplinary System of the financial system, and the 1998 Bank Administration Law, enable the supervisory authority to address compliance with laws and the safety and soundness of the banks under its supervision. Articles 18 and 20 of its charter grants INAFs Board of Directors and its General Manager, among others, the authority to issue Communications that must be implemented by the financial institutions; issue recommendations and requirements to financial institutions and to its board of directors; carry out onsite inspections, when required, in order to verify compliance with the laws and regulations; initiate and implement prudential measures and impose disciplinary measures; and, allow the supervisors complete access to banks files in order to review compliance with internal rules and limits as well as external laws and regulations, impose a range of sanctions (including the revocation of the banking license). The charter permits the supervisor to apply qualitative judgment in forming his opinion. However, the implementation of very severe remedial measures such as the revocation of the license of the bank is proposed by the INAF to the government who has the authority to act on the proposal. See CP 22Remedial Actions-for additional details. Largely Compliant The Law of November 1997, regulating disciplinary rules of the financial system provides a range of powers to the INAF to bring about corrective action for noncompliance with laws. While INAFs charter, issued in October 2003, empowers it to take prompt remedial action, it can only recommend the revocation of banking license which, under the law, requires the approval of the government. Full compliance of this principle can only be reached when INAF is empowered to undertake all types of remedial actions, including the revocation of a financial institutions license. A suitable legal framework for banking supervision is also necessary, including legal protection for supervisors. Legal protection for the INAF employees is provided for through its charter, which makes a reference to Chapter V of the Administrative Code (Articles 58 to 64), passed by law on July 13, 1987. The protections of the INAF employees are the same as those available to all officials, civil servants, and agents under employ of the government. Generally, the administration is held

Assessment Comments Principle 1(4) Description

Assessment Comments

Principle 1(5) Description

liable for the actions of its employees, including INAF employees, when they are acting in an official capacity. In the event of a lawsuit, it would be in almost all circumstances an action taken against the government. Article 61 of the Administrative Code specifies that any complaint by the public must be made within one year of the date of the initiation of the act by the government employee. In exceptional circumstances, there is the potential that an INAF employee could be personally liable for damages, however exceptional circumstances would need to consider damages caused by the employee due to an action or failure to act for reasons of malice or gross negligence. The supervisory agency and its staff are adequately protected against the costs of defending their actions while discharging their duties. Compliant Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place. Monthly meetings of the Director of the UPB, the INAF, the Ministry of Finance (MF) and Interior are held to discuss anti money laundering measures. In addition, Article 53 of the Law of International Penal Cooperation and the Fight Against Money Laundering requires the exchange of information in this area. INAFs charter requires that regulation be issued transferring the responsibility of the supervision of insurance companies to the INAF. Currently, INAF has information covering the insurance companies through the information received on a consolidated basis from banking groups, and the indirect supervision done through an analysis of the financial statements of life insurance companies that are subsidiaries of the banking groups. In addition, if and when necessary the INAF can ask the MF specific details covering an insurance company. The exchange of information between the INAF and the UPB is established in Article 53 of the Law of December 2000. From time to time the INAF releases confidential information to other supervisors upon ensuring that such information will be used for supervisory purposes and treated confidentially by the receiving party. Compliant Permissible Activities 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 term bank is clearly defined in the law, along with the operations and services that may be provided by banking institutions supervised by the INAF. The definition of banking activities and the proper use of the name bank are established in the 1996 Law regulating the operational activities of the financial system institutions. Article 2(a) defines a bank as an institution whose primary activity consists in receiving money from the public in the form of deposits or any other repayable funds, and to provide loans of any kind of its own funds. It also defines the nature of the other financial institutions to be supervised by the INAF.

Assessment Comments Principle 1(6) Description

Assessment Comments Principle 2.

Description

10

Article 2(b) of the noted law list the permissible operations that banks may provide, and Article 9(a) prohibits any other nonbanking financial institutions from carrying out functions or activities of banks such as receiving ordinary deposits and other repayable funds. Similarly, Article 15(a) of the 1997 Law regulating the disciplinary regime for the financial system (Disciplinary Law) clearly establishes that reception of money from the public in the form of deposits or other repayable funds without legal authorization will be subject to disciplinary measures. The INAF is required to intervene in the premises where it is presumed that the aforesaid unauthorized activities are carried out by any individual or entity. Compliant Licensing Criteria 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 organizations 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 organization is a foreign bank, the prior consent of its home country supervisor should be obtained. The 1998 Law regulating the creation of new banking institutions establishes the criteria (Articles 15 and 16) and the requirements for new banking licenses (Articles 13 and 14). The criteria are consistent with the applied for ongoing supervision. The final decision to approve or withdraw licenses is taken by the government (Article 2). It has to be based on the analysis and the recommendations of the INAF (Article 8). Chapter III of the above law sets the conditions required for authorization, including the constitution of a deposit in INAF as a guarantee of commitment during the process of evaluation; Chapter IV specifies the (i) information required to the shareholders, who must pass fit and proper test; (ii) the list of the members of the first Board of Directors that the organizers have to submit including the personal and professional records of each of them; and (iii) the technical and economical conditions demonstrating the viability of the project. This includes financial and management feasibility studies that should include the business plan, the organizational and administrative structure, general policies on internal control and internal audit and the projected general balance sheet and income statements for the next three years. The 1998 Bank Administration Law sets specific requirements for the general management (Article 4) and for the external auditing (Article 10). The minimum capital of approximately 30 million euros (5 billion pesetas) is established in the unique article of the 1998 Law regulating the minimum capital requirement for banking institutions. Regulation allows foreigners to acquire up to 51 percent of the ownership in Andorran banking institutions. Currently, foreign participation in the total capital of the banking system accounts for approximately 2 percent. Compliant From a supervisory point of view, considering that INAF is the institution that will supervise the new bank, it would be more appropriate if the final decision in the licensing process is made by the supervisory authority instead of the government. Ownership Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties. The Regulation has a clear definition of qualified ownership and requires the INAF approval in any change in ownership of a bank to be valid.

Assessment Comments Principle 3.

Description

Assessment Comments Principle 4. Description

11

Article 29 of the Bank Administration Law clearly defines qualified participation in the capital of an institution as those owning 5 percent or more of the total capital. The INAF has the power to obtain information on individuals and legal entities that purchase stock of a banking institution at any amount. Its charter modifies Article 12(e) of the Bank Administration Law establishing that to be fully effective, from the administrative point of view, changes at any level in the shareholders of a bank should be informed and approved by the INAF. In Andorra, bank owners are not allowed to hold bearer shares. Article 18 of the Bank Administration Law gives the INAF the powers to deny authorization to become a shareholder to any individual or to the shareholders of any legal entity. Compliant Investment Criteria Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision. The Regulation sets the criteria and various types of limits on investments that banking institutions may carry out in relation to their own capital and in relation to the capital of the nonfinancial institutions. Article 12(f) of the Bank Administration Law has been modified by INAFs charter to the extent that changes in the banks participation in other companies must be approved by the INAF in order to be registered in the Andorran Commercial Registry. Article 2(e) of the 1996 Law regulating the operational activities of the financial system institutions limits banks investments up to 25 percent of the capital of a nonfinancial institutions and Article 2(f) establishes a limit of 40 percent of banks capital on the aggregate investments in nonfinancial institutions. There are no limits for banks investments in financial institutions. According to Article 7 of the same law, nonlife insurance companies are not considered part of the financial system. The Bank Administration Law establishes the investment criteria as those applied for new banking licenses. Compliant Capital Adequacy Banking supervisors must set minimum capital adequacy requirements for banks that reflect the risks that the bank undertakes, and must define the components of capital, bearing in mind its ability to absorb losses. For internationally active banks, these requirements must not be less than those established in the Basel Capital Accord. Prudential regulations and requirements are considered adequate and the INAF is legally empowered to enforce them. Capital requirements in Andorra are consistent with the Basel Capital Accord. Article 6 of the 1996 Solvency and Liquidity Law requires a minimum capital ratio of 10 percent. Communication n 159/04 approved in October 2004 requires additional capital to cover market risks, extending the definition of regulatory capital (own funds) in Article 3 of the Solvency and Liquidity Law and therefore changing the calculation method of the solvency ratio. This ratio includes off-balance sheet exposures. Capital requirements apply also on a consolidated basis.

Assessment Comments Principle 5.

Description

Assessment Comments Principle 6.

Description

12

Assessment Comments Principle 7.

Articles 15(d) and 16(e) of the 1997 Disciplinary Law establishes disciplinary measures, such as sanctions and other corrective actions, which are available to INAF should a bank fall below minimum capital adequacy ratio. The INAF receives periodic information on the solvency situation and capital adequacy of banks. Compliant Credit Policies An essential part of any supervisory system is the independent evaluation of a banks policies, practices, and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios. The regulatory center piece related to the granting of loans is the Communication n157/03 (Complementary Audit Report) issued by the INAF in December 2003. This communication is meant to verify the requirement of on-going management of the loan and investment portfolios and the policy of loan provisioning and investment provisioning. It also requires that banks must have in place management information systems, although it is not explicit in the complementary audit scope that it should be done for the loan and investment portfolios. According to its charter, INAF has full access to information regarding credit risk exposures. It has also the authority to assess credit granting and investment policies and procedures, ensuring adequate controls over credit policies. However, the INAF does not perform on-site examinations and relies on the external auditors to prepare the Complementary audit report, which has to be submitted to the INAF on an annual basis and is discussed in a tripartite meeting with the bank and the auditors. This delegated revision of credit policies may not necessarily provide the supervisory authority with sufficient time to take prompt corrective actions regarding deficiencies observed in the banks management of the loan and investment portfolios. INAFs senior management has indicated that it will commence to undertake regular on-site inspections by the end of 2007. Compliant Loan Evaluation and Loan-Loss Provisioning 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 reserves. The main regulation related to the adequacy of loan provisions and the quality of assets is the CA for the Financial System and the Communication n 104 issued in April 2000, respectively. The CA states that banks subject to credit risk must charge the profit and loss account with the necessary general or specific loan loss provisions. It also defines the classification of loans in four categories from lower to higher risk: (i) Pass; (ii) Past Due; (iii) Doubtful; and, (iv) Very Doubtful (loss). Provisioning is in accordance to these categories. Banks do not allocate specific provisions for Pass loans and Past Due loans (from 1 day to 6 months in arrears). Specific provisions required for Very Doubtful loans are at full scale (100 percent). Banks must allocate specific provisions for Doubtful loans according to the following table: Months in Arrears Provisions (In percent) From 6 to 12 months 25 From 12 to 18 months 50 From 18 to 24 months 75 From 24 months 100

Description

Assessment Comments Principle 8.

Description

13

General provisioning for credits to international banks are at 0.5 percent of net loans as the portfolios are largely deposits to highly rated OECD-based financial institutions (a significant part of the assets). For nonbank credit portfolios, general provisioning are at 1 percent (depending on collateral support). Classification and provisioning considers off-balance sheet exposures. The INAF does not perform on-site examinations and relies on the external auditors to verify the Complementary Report for loan loss provisioning and quality of assets. Communication n 104 requires the banks to provide INAF with detailed quarterly reporting on the quality and composition of the loan and investment portfolios and information of collateral and provisioning. This information is evaluated by the off-site supervisors of INAFs Department of Analysis. In the Complementary audit report, external auditors are required to assess, on a sample basis, the quality of loans and investments, the adequacy of the allocations of provisions and the valuation of collaterals to reflect the net realizable value. In this regard, it is a practice of the industry but not required in the regulation- to register collaterals at 80 percent of the net realizable value. The INAF has the authority to require a bank to increase its level of provisions and to correct any deviations from the above regulation if a noncompliance statement regarding asset quality is stressed in the external auditors complementary report. While the level of past due loans at year end 2005 is low, INAF should review the adequacy of its provisioning policy for Past Due Loans regarding the months in arrears of a loan before requiring a specific loan loss allocation. The level of past due loans at year end 2005 is approximately 0.2 percent of total loans. Compliant Large Exposure Limits 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. A related group is defined in the CA. Chapter XII defines an economic group of entities as one where: (i) there is direct or indirect control, (ii) business interrelations among entities as in the cases of common ownership, common control or administration, (iii) assumptions that credits granted will benefit all others; and (iv) there are assumptions based on the fact that various parties have relationships which in fact constitute one economic interest unit. According to Article 12 of the 1996 Solvency and Liquidity Law banks must avoid risk concentration exposures. Article 13(a) of the same law establishes a limit on large exposures to a single borrower or related group of borrowers at 20 percent of the banks own funds. Article 13(b) sets an aggregate limit of 400 percent of the own funds for those operations with individuals over 5 percent of the own funds of the bank. The Communication n 104 provides the INAF to quarterly reporting on concentration limits on a consolidated basis, including sectoral and geographic risks. In the Complementary report, external auditors are required to verify, on a sample basis, the validation of the information reported by banks on all reports of the Communication n 104, which includes a specific report on concentration limits (Article 13 of the Solvency and Liquidity Law). Compliant

Assessment Comments Principle 9.

Description

Assessment Comments

14

Principle 10.

Description

Connected Lending 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 arms length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. As mentioned in BCP 9, the CA contains a definition of an economic group (related parties) as one where there is direct or indirect control by one of them over the others, business interrelations and assumptions that credits granted to one will benefit all others entities. Additionally, Article 14 of the 1996 Solvency and Liquidity Law has a definition of related party transactions as those asset operations with various parties that have relationships that in fact constitute one economic interest unit. The INAF has the authority to dictate the necessary technical procedures and to apply the disciplinary measures to enforce the compliance of the accuracy of this information. According to the Communication 163/05 issued in February 2006, banks must comply with the guidelines and principles set in the Ethic Code. However, there is no clear evidence that banks credits to insiders and related interests should not be granted at preferential rates. Article 15 of the 1996 Solvency and Liquidity Law establishes an aggregate limit of 15 percent of bank capital over any kind of exposure with its board of directors. However, there is no clear evidence in this norm or in any other regulation issued by the INAF that credits to insiders, senior management or their respective related interests should always receive the approval of the banks board of directors. In the Complementary audit report, it is required to the external auditors to verify, on a sample basis, the validation of the information reported by banks on all reports of the Communication n 104, which includes a specific report on exposures to connected lending (Article 15 of the Solvency and Liquidity Law). The Communication n 104 is reported to the INAF on a quarterly basis. Largely Compliant The INAF must ensure that credits to insiders and related interests should not be granted at preferential rates, and that transactions to insiders, such as the credits to the members of the banks board of directors, require the approval by the Board. Country Risk 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. The INAF's Communication 122/00 issued in 2000, covering country risk, establish the procedures for monitoring and controlling country risk and transfer risk. Country exposures are identified and monitored by bank management. The external auditors of the financial institutions verify on behalf of the INAF information systems, risk management systems and internal controls to comply with the policies and the Department of Analysis of INAF obtains and reviews information on country risk on a quarterly basis. Detailed quarterly reports are forwarded to the INAFs Department of Analysis by the financial institutions. The reports cover their exposure in each country and the rating agencies rating of the country. In addition, the quarterly reports provide information regarding on and off-balance sheet items that may be affected by country risk, transactions subject to hedging, and country exposure data for off-site analysis.

Assessment Comments Principle 11.

Description

15

The instructions in the Pla Comtable (Chart of Accounts) authorize INAF to request specific provisions on a country by country basis. Currently, Andorran banks exposure to country risk is not material. The INAF obtains and reviews information on a quarterly basis covering country risk/transfer risk of individual banks. The INAF has indicated that it will establish minimum provisioning for each country in the near future. Compliant Market Risks 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 exposure, if warranted. Communication 104 issued in April 2000, Communication 104b is issued in April 2004, and Communication 59/04 issued in 2004, cover policies and procedures related to the identification, measuring, monitoring and controlling risks in interest rates and foreign exchange rates. The above communications require financial institutions to supply detailed information on the character and volume of market risk transactions on a quarterly basis. These reports enable INAF to monitor open positions in futures markets and instruct banks to supply balances of assets and liabilities accounts and contingent accounts broken down in five maturity buckets and for the following currencies: EUR, US$, YEN, GBP and CHF. External auditors review compliance with above communications, as part of the complementary yearly audit that is prepared for each one of the banks. As previously indicated, the complementary audit details to the INAF the adequacy of market risk controls at financial institutions and those positions are revalued frequently using current market data. Comments made by the external auditors indicate that there is staff at the external auditors companies that have the expertise to monitor the actual level of complexity in the market activities of the banks. The INAF management, in accordance with Communication 159/04, has the authority to impose specific market risk limits, but has not taken this measure. This is because INAF is monitoring on a quarterly basis the interest risk and foreign exchange risk incurred by the banks and does not consider it excessive. Further, as part of the minimum risk-based capital calculation, financial institutions are required to factor in a 50 percent market risk weight on futures operations with balances adjusted by maturity and type. Compliant Other Risks 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. Under the authority of the Disciplinary Law, the INAF has established prudential standards that require individual financial institutions to limit, monitor, and report on various types of risks including credit concentrations, connected lending, credit classification and loan loss provisioning, capital adequacy, liquidity, interest rates, and foreign exchange rates. The INAF has the authority to require financial institutions to submit information on their financial condition on a periodic basis, including information on related interests and has the authority to require financial institutions to hold additional capital against material risks. Communication 152/03 issued in May 2003 requires bank management to submit comprehensive information covering internal controls and internal audit, that among other includes details on the board of directors, senior management, internal control systems, assets

Assessment Comments Principle 12.

Description

Assessment Comments Principle 13.

Description

16

and liabilities committee information and internal audit systems. Based on the information received, the INAF actively monitors compliance with risk limits covering liquidity, interest rate and operational risks , the accuracy of which is validated by the annual complementary external audit Communication 157/03, issued in December 2003, requires the external auditor to submit a detailed assessment to senior management of the bank of all the weak points uncovered during the complementary audit and recommendations for their improvement. The primary objective of the complementary report is to describe and analyze the financial and operational features that the external auditors cover in their annual audit review. In the complementary report, the external auditors evaluate, among others, liquidity, interest rate and operational risks and legal risk and the risk management processes involved in these areas. In the complementary audit report, external auditors are required to assess, on a sample basis, the quality of loans and investments, the adequacy of the allocations of provisions and the valuation of collaterals to reflect the net realizable value. Compliant Internal Control and Audit 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. Communications 152/03 of May 2003 and 157/03, establish the information required from the banks covering internal controls and internal audit functions. Communication 126 /01 covers the attendance of the senior management in yearly meetings conducted with representatives of INAF and the external auditors responsible for the preparation of the annual reports and the complimentary audit reports. The complementary reports prepared by the external auditors include reviews of banks internal controls and internal audit arrangements, the quality of systems, the quality of accounting and reporting systems and related matters and the resources of the back office relative to the business origination area. The INAF evaluates the composition of senior management and directors to determine that they have the necessary skills for the size and nature of the activities of the bank and that they can address external market developments. The INAF has the legal authority to request changes in the composition of the board and management when in its opinion such measures are required. The external auditors indicate in the annual complementary reports that banks have an appropriate internal audit function responsible for reviewing that policies and procedures established by management of the bank are complied with, and reviewing whether the existing policies, practices and controls are sufficient and appropriate for the banks business. Also, the external auditors provide information on the internal audit function. This information includes among other: the independence of the internal auditors, their access to all the banks business lines, and the resources of the internal audit department.

Assessment Comments Principle 14.

Description

17

Assessment Comments

On a quarterly basis, INAF requires the financial institutions to submit reports covering their activities as specified in Communication 152/03. This communication emphasizes the separation of the functions of internal control and internal audit. The above communication requires information as to the involvement of the board of directors in the areas of internal control and internal audit. Largely compliant The INAF should issue a communication indicating that members of the board of directors should participate in the yearly meetings conducted by senior representatives of INAF with senior management and external auditors. The INAF needs to: (a) describe the standards against which the banks performance can be measured, so that the auditor can report whether or not they have been achieved; (b) reach some understanding with the external auditors regarding the concept of materiality; (c) ensure that it is requesting that external auditors perform activities that are within the auditors competence since without clear and specific guidance the auditor will not be in a position to make judgments. Enhancement of current communications regarding banks external audits is needed. Dispersed Communications should be combined into a single decree. Money Laundering 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. The anti-money laundering (AML) Law, issued in December 2000, established the creation of the UPB as an independent body for the promotion and coordination of money laundering prevention. This unit is responsible for the oversight of banks implementation of know-yourcustomer policies and internal controls and procedures to prevent susceptibility to criminal elements. The INAF has been divested of a role in this area. The 2000 AML Law requires banks to verify identity through an official government document with a picture, obtain domicile and professional activity information. For legal entities, banks must obtain certification of the registration in the registry of corporations and to obtain identity information from the individuals empowered to represent the entity. Information on beneficial ownership is also required. Since 2002, the UPB requests external auditors to submit annual complementary audit reports where they must: (i) indicate the composition of the bank's internal control structure and frequency of meetings of its top officers; (ii) detail control procedures in place for opening accounts, identifying customers, controlling operations and updating transactions and their adequacy; (iii) indicate the number of suspicious transactions reported by employees; (iv) indicate training given on AML to employees; (v) give an opinion about the degree of efficiency of all the procedures applied by an entity for preventing, identifying and communicating transactions that might involve money laundering or financing of terrorism as well as measures taken to improve the system. Also, the external auditors at the annual complementary audit determine that a bank has established lines of communication to a bank senior officer with explicit responsibility for ensuring that the bank's policies and procedures are, at a minimum, in accordance with the 2000 AML Law. For the complementary audit reports of 2006 (which will be due by March 31, 2007), auditors are also required to (i) indicate accounts with no identification or other identification problems and (ii) verify, by testing 30 numbered accounts, 15 accounts of companies (personas juridicas)

Principle 15.

Description

18

and 10 accounts of individuals (nominadas) -at random- that minimum documentation is kept in the customer's file and that the customer's operations coincide with that declared at the time of opening the account. The UPB also requests external auditors to inform what are the procedures and systems that banks have in place to assess fit-and-proper of their key staff. The UPB conducts on-site inspections in bank, nonbank financial institutions and insurance companies. Three inspections have been conducted to banking institutions. During these exams, the UPB reviews the banks money laundering controls and systems for preventing, identifying and reporting fraud, and the methodology that identifies the key risks run by the bank in this area. UPB staff has access to the banks business lines and support departments and assesses the lines of communication to senior management and to the internal security function for the reporting of suspicious transactions. In addition, the UPB periodically checks that banks money laundering controls and their systems for preventing, identifying and reporting fraud are sufficient. The UPB has adequate enforcement powers to take action against a bank that does not comply with its AML obligations. Also, UBPs management has indicated that, after a slow start, currently banks report to the UBP very minor suspicious activities and incidents of fraud material to the safety, soundness or reputation of the bank. Under Articles 57 through 59 of the 2000 AML Law, UPB has authority to initiate a sanctioning process for three levels of compliance violations: very serious, serious and minor violations. Very serious violations include the failure to satisfy reporting requirements, tipping off, refusal, excuse or resistance to furnish information to the UPB and repetition of a serious violation in the same year. Serious violations include the failure to confirm the identity of clients, failure to demand client identification documents required under Article 51, insufficient verification of the true beneficial owner of a transaction, lack of vigilance and failure to verify identity, failure to retain documents for the 10 period established in Article 51, insufficient internal procedures and failure to carry out the specific audit on AML compliance, and repetition of a minor violation in the same year. Minor violations include any violation of the standards of the Law not mentioned previously. UPB makes recommendations on the sanction to the Council of Ministers, which administers the sanctions. Sanctions include fines of 600 to 600,000 euros and temporary or permanent suspensions of directors or the person involved, or suspension of the capacity to carry out certain transactions. As indicated in Articles 53 and 55 the UPB is empowered to directly share with domestic judicial authorities, INAF, and foreign FIU counterparts information related to suspected or actual criminal activity. In addition, the Director of the UPB, senior management of INAF, the Ministers of Finance and Interior hold a formal monthly meeting in order to discuss AML measures. INAFs management has indicated that cooperation, including the exchange of information on matters covering know your customer is carried out on a constant basis between the staffs of INAF and UPB. Officers of the UPB enjoy legal protection and the central government is responsible for paying all claims when resulting from the faithful exercise of UPBs supervisory work. A minimum reporting limit for suspicious transactions has not been established. Banks staff has been instructed to report any transaction that in their opinion is suspicious. The UPB has the authority to meet directly with external auditors as deemed needed, usually, in the presence of the entitys compliance officer, and the authority to inquire about changes of auditors; require that auditors follow-up on recommendations they have given in previous audit reports (Informes de Cumplimiento) or request that auditors perform special audits/reviews, ad hoc.

19

For foreign counterparts the information is provided subject to reciprocity, a commitment to use the information only for the purpose requested, and commitment to maintain professional secrecy (Article 56). Assessment Comments Compliant. The INAF has been divested of a significant role in the anti money laundering process. The UPB, with the assistance of external auditors, conducts the review of the AML policies, procedures and practices of banks. The external auditors prepare special reports for the UPB covering AML compliance at the financial institutions. The INAF relies on the external auditors complementary report in order to ensure compliance by the bank in the area of know your customer. On-Site and Off-Site Supervision An effective banking supervisory system should consist of some form of both on-site and offsite supervision. Due to the growth of the banking system and the increased complexity of a number of financial transactions entered into by the banks, the INAF has increased the supervisory staff from 8 persons to 12, of which 4 were hired within the last year. All the professional staff has a University degree. INAF is headed by two experienced senior executives, and is divided in two major units: Department of Analysis which consists of three persons. Department of Supervision and Control which consists of four persons. In addition there is a staff member responsible accounting and administrative work of INAF and two secretaries.

Principle 16. Description

The mission is satisfied that there is an appropriate mix of on-site and off-site supervision and the two departments function in a way to maximize the synergy and avoid supervisory gaps. INAF's supervision of the financial sector consists of off-site compilation and analysis of quarterly data submitted by financial institutions in accordance with the CA. This task is conducted by the Department of Supervision and Control. INAF has not conducted its own onsite examinations since its creation in 1993, and has relied on the on-site work of external auditors who, since 2000, prepare complementary reports according to INAFs requirements. Over the years the audit work has been instrumental in confirming the reliability of quarterly bank data submitted to INAF, and has provided an important measure of independent verification on the existence of risk management and internal controls, in credit underwriting and the evaluation of treasury activities, and off-balance sheet operations. However, A review of various complementary audit reports reveals their uneven quality. The staff of the Department of Supervision and Control is responsible for the review of the annual onsite complementary external audits conducted by the large international accounting firms pursuant to INAF's complementary audit requirements. The supervisors conduct an annual meeting with each individual bank and the banks external auditors to discuss, among other, the developments in the financial institution, the extent of its risks, its compliance with the laws and regulations and the scope of complementary audits. In addition INAFs officers and supervisory staff has formal and informal communications with bank managers, directors and bank association leaders during the year to discuss the condition and risks affecting their institution. The staff of the department of Supervision and Control is in frequent contact with the banks, and at times visits management of banks in order to verify the quarterly information submitted by the banks, and to review the information reported in the complementary audit report. Largely compliant

Assessment

20

Comments

Principle 17. Description

INAFs staff is very lean and management should take steps to gradually increase the number of its supervisors in order to be able to conduct onsite inspections of the financial institutions with its own supervisory staff, thus placing less reliance on the external audit firms to conduct complementary audits on its behalf. In order to insure the reliability of risk management controls, INAF should hire an IT specialist to support the activities of the onsite and offsite supervisors. Bank Management Contact Banking supervisors must have regular contact with bank management and a thorough understanding of the institutions operations. Communication 126/01 issued in 2001 establishes INAFs authority to require financial institutions and their auditors to hold an annual meeting with INAF in order to discuss the scope of the external audits, the contents of the external auditors complementary audit report, and the quarterly information on the financial institutions condition, submitted by the financial institutions. In addition, financial institutions submit on quarterly basis information on related interests. The financial information submitted by the financial institutions is used to compile quarterly monitoring reports and statistics which provide, among other, detail on the evolution of banks' balance and off-balance sheet activities, earnings performance and movements in capital accounts, asset quality, liquidity and market risk positions, solvency and liquidity ratios and other useful information on individual institutions as well as the financial sector as a whole. Article 15 (g) and 16(h) of the Disciplinary Law provide penalties for banks failing to provide the information on a timely basis or if they knowingly provide inaccurate or misleading data. INAF requires that financial statement information be submitted quarterly both on an individual and a consolidated basis. The CA, implemented in 2000, delineates the accounting principles for Andorran financial institutions as well as the reporting requirements. Financial statements may be requested on a solo or consolidated basis. Information on solvency, liquidity, large borrowers, market risks, loan classification and provisioning are submitted on a consolidated basis. INAF has a good understanding of the activities of its banks. In addition, INAF requires banks to notify it of any substantive changes in their activities or any material adverse developments, including breach of legal and prudential requirements. As required by Communication 126 issued in September 2001, INAF has implemented a policy to conduct in October of each year a meeting with each one of the banks of the system and their external auditors. The banks senior management members attend the meetings. Members of the board of directors do not attend the annual meetings. INAF management presents major conclusions of the off-site analyses prepared by the supervisors and discusses the complementary external audit reports. In addition, the performance of the financial institution, and strategic plans and strategies affecting the risk profile of the institutions are discussed. At any time, when deemed necessary, the INAF has requested meetings with the members of the board of directors of the financial institutions. Due to the small size of the population of Andorra, the small size of the capital and the proximity of all the financial institutions to the headquarters of INAF, there are very frequent personal contacts between the management of the INAF and members of the board of directors and senior management of all the local financial institutions. While INAF does not document its assessment of management of the six local banks, senior management of INAF is familiar with the strengths and weaknesses of the senior management of all the Andorran banks. Compliant

Assessment

21

Comments Principle 18. Description

Members of the board of directors should attend the Annual meetings established by Communications 126 issued in September 2001. Off-Site Supervision Banking supervisors must have a means of collecting, reviewing, and analyzing prudential reports and statistical returns from banks on a solo and consolidated basis. The INAF has the authority to require financial institutions to submit information on their financial condition on a periodic basis, including information on related interests. Article 15(g) and 16(h) of the Disciplinary Law provide for penalties for banks failing to provide the information on a timely basis or if they knowingly provide inaccurate or misleading data. INAF requires that financial statement information be submitted quarterly both on an individual and a consolidated basis. The CA, implemented in 2000, delineates the accounting principles for Andorran financial institutions as well as the reporting requirements. Financial statements may be requested on a solo or consolidated basis. Information on solvency, liquidity, large borrowers, market risks, loan classification and provisioning are submitted on a consolidated basis. Article 15(g) and 16(h) of the Disciplinary Law provide penalties for banks failing to provide the information on a timely basis or if they knowingly provide inaccurate or misleading data. INAF requires that financial statement information be submitted quarterly both on an individual and a consolidated basis. The CA, implemented in 2000, delineates the accounting principles for Andorran financial institutions as well as the reporting requirements. Financial statements may be requested on a solo or consolidated basis. Information on solvency, liquidity, large borrowers, market risks, loan classification and provisioning are submitted on a consolidated basis. The technical communications issued by the INAF complement and update the legislation relating to the CA. so that it does not become outdated. The quarterly information submitted by financial institutions is used by INAF to compile quarterly monitoring reports and statistics which provide, among other, detail on the evolution of banks' balance and off-balance sheet activities, earnings performance and movements in capital accounts, asset quality, liquidity and market risk positions, ratios on capital solvency and liquidity, on individual institutions as well as the financial sector as a whole. Compliant Validation of Supervisory Information Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors. INAF relies on external auditors to conduct the on-site independent validation of information. INAF has issued policies and procedures in place to ensure that the complementary annual audits are conducted on a thorough and consistent basis with clear responsibilities, objectives and outputs. This process is reviewed each year at the October meetings with senior management of all banks. Articles 15(g) and 16(h) of the Law governing the disciplinary system of the financial system issued in November 1997 establish the sanctions to be levied against banks that do not provide in a timely manner the requested information or that supply inaccurate information purposely. The information is supplied by the financial institutions to the INAF on a quarterly basis, and contains a number of key supervisory returns, such as that for capital adequacy, and is analyzed by the INAFs Department of Analysis.

Assessment Comments Principle 19. Description

22

Throughout the year, if deemed necessary, INAF holds meetings with banks management, and in October of each year holds a large and formal meeting with senior management of each bank and with their external auditors to discuss, among other items, the supervisory information submitted in the complimentary audit reports and the information remitted by the banks. The Department of Analysis, on an ad hoc basis, visits the banks in order to verify the accuracy of the quarterly information submitted by the banks, or to clarify comments made by the banks management. INAF has the legal right of access to all bank records for the furtherance of its supervisory work, and its supervisors have visited each financial institution to discuss with management discrepancies in the quarterly reports they submit. INAF monitors the quality of work done by the external auditors through the quarterly reports it receives from the financial institutions. INAF has the authority to directly appoint external auditors and the authority to oppose n external auditor that is deemed to have inappropriate expertise or independence. As established in Law 14/2003, INAF has the legal right of full access to all banks records required in its supervisory work and has access to the board, senior management and staff, when required. Assessment Comments Principle 20. Description There is a constant evolution in the scope of information requested by the INAF. Compliant Consolidated Supervision An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis. The INAF carries out off-site consolidated supervision by requesting the quarterly submission of balance sheets and other financial information on a consolidated basis. Based on the quarterly information received, INAF has an understanding of the material activities of a group. According to its charter, the INAF has the authority to perform on-site inspections though this has been delegated to the external auditors through the annual verification of the process of consolidation of the banking groups in the Complementary audit report. In this report, external auditors are required to furnish details on each one of the subsidiaries of a bank including, among other, the method of consolidation, the percentage of participation and financial details of the subsidiaries. The INAF has a supervisory framework for banking groups that evaluates the risks of its nonbanking activities. The CA, implemented in 2000, clearly establishes that Financial Statements of banks periodically reported to INAF must be prepared on a solo and at consolidated basis. Banking groups are required to submit financial information for each of their subsidiaries for off-site analysis, including life insurance companies and other financial institutions. The charter empowers the INAF to undertake any necessary action to implement consolidated supervision. The INAF has periodic meetings with the MF, to discuss common interest matters, including the condition and adequacy of risk management of insurance companies. However, it does not have the authority to act directly on insurance companies, mainly life insurers, if any specific risk from their non-banking activities may affect the condition and solvency of a banking group. The Law of Solvency and Liquidity and Communication n 104 requires banks to comply with capital requirements on a consolidated basis and to submit periodic reports on credit exposures and concentration limits, respectively. Largely compliant

Assessment

23

Comments

The supervision of insurance companies should come under the direct control of the INAF. While the quarterly reports and the Complementary audit report provide the INAF with a useful tool for assessing consolidated risks of banking groups, an effective consolidated supervisory framework requires the INAF to have access to and responsibility for the insurance subsidiaries. Accounting Standards Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the bank and the profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition. The charter empowers the INAF to set up bank accounting standards, including consolidated financial statements, in accordance with generally accepted accounting principles, and allows the INAF to carry out on-site inspections. Currently, the INAF does not conduct onsite inspections and relies on the work done by the external auditors. Accounting standards in Andorra are satisfactory though they may require updating in some aspects such as the accounting for derivatives, which are currently reported as off-balance sheet items. The CA, implemented in 2000, delineates the accounting principles for Andorran financial institutions as well as the reporting requirements. Financial statements must be reported on a solo or consolidated basis. Information on solvency, liquidity, large exposures and concentration, market risks, loan classification and provisioning are submitted on a consolidated basis. External audit firms must audit the financial institutions (Communication 24 issued in February 1997). External auditors are required to evaluate the reasonableness of the financial statements in accordance with the guidelines issued by the INAF in the CA. As indicated previously, the INAF has the authority to revoke the appointment of a banks auditors. Article 10(a) of the Bank Administration Law require banks to work on a permanent basis with an external auditor. Article 10(e) of the same Law sets the scope of sanctions that can be imposed to external auditors if they do not comply with the requirements of the INAF. The disciplinary measures may include the revocation of the license of the external auditor. The INAF is in favor of all banks adopting IFRS issued by the International Accounting Standards Board (IASB). The aim is to adopt and implement IFRS in all banks in Andorra as soon as draft legislation is passed by the Counsel General and to adapt prudential regulations as needed to narrow the accounting choices available to banks.

Principle 21.

Description

Assessment Comments Principle 22.

Compliant Remedial Measures Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking license or recommend its revocation. The charter grants the INAF the authority to issue Communications and to initiate and implement prudential measures and impose disciplinary measures. The 1997 Disciplinary Law provides a wide range of powers to INAF to bring about corrective actions for noncompliance with laws and regulations.

Description

24

Under the terms of the above law, the INAF has the authority to impose sanctions upon banks in accordance with the seriousness of the transgression committed. These sanctions include fines applied to the bank or to the staff responsible; suspension, dismissal or disqualification of the banks board members or staff responsible; prohibition from distributing dividends; among other type of disciplinary measures. The Disciplinary Law establishes three types of sanctions: mild, severe and very severe disciplinary measures. The INAF has the authority to issue mild and severe sanctions and ensures that remedial actions are taken in a timely manner. However the implementation of very severe disciplinary measures is proposed by the INAF to the government who has the authority to act on the proposal. Largely Compliant The sanctions in the category of very severe related to the compliance of solvency, liquidity, concentration risk, among other prudential regulation, that currently are within the authority of the government, should be within the jurisdiction of the INAF. Globally Consolidated Supervision Banking supervisors must practice global consolidated supervision over their internationally active banking organizations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these banking organizations worldwide, primarily at their foreign branches, joint ventures, and subsidiaries. Article 12(b) of the Bank Administration Law (modified by INAFs charter) requires banks to inform the INAF of the establishment abroad of foreign branches and subsidiaries. The INAF has the authority to deny the constitution of the foreign branches or subsidiaries of the local bank, as stated in Article 18 of the abovementioned law. The INAF ensures the adequacy of banks management review of consolidated risks through the analysis of the financial information obtained from banks quarterly reports on a consolidated basis, which includes financial information of subsidiaries; and through the evaluation made by the external auditors on this respect. Communication 152/03 issued May 2003 requires banks to assess the internal control and auditing procedures of foreign subsidiaries of Andorran banks, and external auditors are required to validate, on an annual basis, the information submitted to the INAF in compliance with Communication 152/03. The INAF has the authority to require any prudential measure to its supervised banking groups, with the only exception of the measures defined as very severe in the law, that are under the jurisdiction of the government, as set in the Disciplinary Law. Compliant Host Country Supervision A key component of consolidated supervision is establishing contact and information exchange with the various other supervisors involved, primarily host country supervisory authorities. Article 9 of its charter grants the INAF the authority to establish relations and cooperation agreements within the scope of its functions and powers with central banks and financial supervisory authorities in other countries and with international official bodies. Article 12b) of the Bank Administration Law (modified by the Law 14/2003) requires banks to inform the INAF of the establishment abroad of foreign branches and subsidiaries.

Assessment Comments Principle 23.

Description

Assessment Comments Principle 24.

Description

25

The INAF has the authority to deny the constitution of the foreign branches or subsidiaries of the local bank, as stated in Article 18 of the above mentioned law. Andorran banks have branches in Bahamas and Uruguay and a representative office in Panama. Though these operations represent a very small share of the business of the banking groups, the INAF has initiated formal contacts with the banking supervisory authority of Uruguay in order to enter into an MOU that would allow the INAF to have full access and capacity to supervise the foreign activities of an Andorran banking group. Largely compliant To fully implement the supervision of foreign subsidiaries of local banks, the INAF must set formal agreements with the host country supervisor. The INAF should enter into an MOU with the Banking Supervisory authority of Uruguay and other relevant supervisory authorities to set the scope of information sharing, in order to have the necessary information for an adequate supervision of foreign subsidiaries. Supervision Over Foreign Banks Establishments Banking supervisors must require the local operations of foreign banks to be conducted with the same high standards as are required of domestic institutions and must have powers to share information needed by the home country supervisors of those banks for the purpose of carrying out consolidated supervision. Under its charter, the INAF applies a similar supervisory framework to all banking and nonbanking financial institutions regardless the origin of the capital (foreign or domestic). Similarly, for purposes of licensing, the INAF takes into consideration if the home country supervisor practices consolidated supervision. Further, the INAF considers in its opinion to the governmentas the authority to have the final decision in the licensing process- if the home country supervisor has approved the establishment in Andorra of the foreign bank, as it was the latest case of a Spanish bank, where a written communication was submitted to INAF by the Bank of Spain on this regard. Over the last few years, the INAF has actively tried to sign MOUs with the French and Spanish bank supervisors. However, the efforts have not been successful. The French supervisory authorities indicated that French financial institutions have no presence in Andorra and therefore in their opinion there was no need to enter in an MOU. The Central Bank of Spain proposed to the INAF some specific requirements on transparency of information on customer accounts that the Andorran authorities considered onerous to meet. The INAF has indicated that it is willing to facilitate nominative information of large exposures and that it would welcome the opportunity to conduct joint on-site inspections with foreign supervisors. Lately, some Spanish institutions have sold their interest in local institutions to Andorran interests. Currently, the foreign banks presence in the financial system is represented by one Spanish bank that accounts for approximately 2 percent of the total capital of the banking system. Materially noncompliant The INAF should intensify its efforts to enter into a formal agreement with various banking authorities that will allow full compliance of Andorra as a host country supervisor. This should include sharing information with the relevant home country supervisors about the local operations of the foreign banks, provided INAFs confidentiality is protected.

Assessment Comments

Principle 25.

Description

Assessment Comments

26

Table 2: Summary Compliance with the Basel Core Principles

Core Principle 1. Objectives, Autonomy, Powers, and Resources 1.1 Objectives 1.2 Independence 1.3 Legal framework 1.4 Enforcement powers 1.5 Legal protection 1.6 Information sharing 2. Permissible Activities 3. Licensing Criteria 4. Ownership 5. Investment Criteria 6. Capital Adequacy 7. Credit Policies 8. Loan Evaluation and Loan-Loss Provisioning 9. Large Exposure Limits 10. Connected Lending 11. Country Risk 12. Market Risks 13. Other Risks 14. Internal Control and Audit 15. Money Laundering 16. On-Site and Off-Site Supervision 17. Bank Management Contact 18. Off-Site Supervision 19. Validation of Supervisory Information 20. Consolidated Supervision 21. Accounting Standards 22. Remedial Measures 23. Globally Consolidated Supervision 24. Host Country Supervision 25. Supervision Over Foreign Banks Establishments X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X C1/ LC2/ MNC3/ NC4/ NA5/

27

Table 3. Recommended Action Plan to Improve Compliance with the Basel Core Principles
Reference Principle CP1 (2) Independence CP1 (3) Legal Framework Recommended Action Publish a periodic review of INAFs performance against its responsibilities and objectives. Amend INAFs charter to empower INAF to issue licenses and conduct an orderly resolution of a problem bank. Introduce a legal supervisory framework that covers insurance companies. Amend INAFs charter to empower INAF to undertake all types of remedial actions, including the very serious sanctions and the revocation of a bank license. The INAF must ensure that credits to insiders and related interests should not be granted at preferential rates and that transactions to insiders, such as the credits to the members of the banks Board of Directors, should be required to be approved by the Board. Members of the Board of Directors of financial institutions should participate in the yearly meetings with auditors and the INAF. INAF should gradually increase the number of its supervisors in order to be able to place less reliance on the external audit firms that conduct complementary audits on its behalf. INAF should have a system specialist on its staff to support the on-site and off-site areas. The activities of insurance companies should come under the supervision of the INAF. Amend INAFs charter to empower INAF to undertake all types of remedial actions, including the revocation of a financial institutions license. The INAF should enter into an MOU with the Banking supervisory authority of Uruguay and set the scope of information sharing, in order to have the necessary information for an adequate supervision of foreign subsidiaries. The INAF should intensify its efforts to enter into a formal agreement with the banking authorities of Spain that will allow full compliance of Andorra as a host country supervisor. The INAF should share with the home country supervisor information about the local operations of the foreign banks, provided its confidentiality is protected.

CP1 (4) Enforcement Powers CP 10 Connected Lending

CP 14 Internal Control and Audit CP16 On-site and Off-site supervision

CP 20 Consolidated Supervision CP 22 Remedial Measures CP 24 Host Country Supervision

CP 25. Supervision Over Foreign Banks Establishments

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Authorities response to the assessment 12. First of all, we wish to thank the members of the IMF assessment team for their work to produce this report and for their constructive recommendations to further enhance implementation of international standards. We welcome that the assessment recognises that the Andorran supervisory system is broadly sound and that efforts have been made to address several of the IMFs recommendations made by 2002 mission. We want to continue improving the financial sector supervision and this is why several draft laws and regulations are at the time of the IMFs assessment in the way of been approved. We wish to comment the IMFs assessment. Main findings Objectives, Autonomy, Powers, and Resources (CP 1) and Licensing and Structure (CPs 2-5) Remedial Measures (CP 22) 13. We consider that the current legal framework has demonstrated its efficacy along years due to the good cooperation between the MF and the INAF. Currently, the competences of the government and the INAF are clearly delimited by law: the INAF, once its examination has been completed, makes its decision on dossiers opened if sanctions are imposed for lesser and serious offenses. For very serious offences, INAF makes its examination and proposes sanctions to the government who decides. INAFs opinion is always taken into account. The MF will take into consideration the recommendation of empower the INAF to undertake all sanctions and remedial measures, including those classified as very serious. However, we point out that excluding the government from the decision of revoking a banking license does not seem consistent with the fact that the government is the one who grants banking licences. Indeed, according to the Andorran legal system, the power to license and revoke all sort of establishments belongs to the public administration. Therefore, what seems to be necessary in our view is to strike a balance between the INAFs technical decision and the approval of the government related to revocation of a financial institutions license, but not to exclude government from this decision. Prudential Regulations and Requirements (CPs 6-15) 14. INAFs Communication n 163/05 includes provisions related to rules for the behaviour of staff and the board of directors of financial groups. Said rules provide a regulation governing procedures to be followed by the bank's staff and representatives when carrying out their own operations and the checks put in place at this level. INAF has checked internal codes governing the actions of their staff and those of their board of directors in order to comply with these regulations and has noted that banking establishments put in place some mechanism to ensure that credits to insiders and related interests are not granted at preferential rates and that transactions to insiders, such as loans to the members of the banks board of directors, are required to be approved by the Board. However, as the IMF team

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recommends that it would be convenient to issue a rule prohibiting preferential treatment in transactions to insiders, we will consider issuing a communication on this matter. 15. Regarding the recommendation on yearly meetings with auditors, members of the Board of Directors and INAF, the Andorran authorities consider more useful to have meetings with members of the Board of Directors without external auditors in order to treat matters related to the management of the banking establishments that may not affect the technical work of the external auditors. Methods of Ongoing Supervision (CPs16-20) 16. INAFs staff increased by four during the last year in order to conduct onsite inspections of financial institutions with its own supervisory staff. External auditors provide an important support for bank supervision and, for this reason, INAF is constantly communicating to external auditors its requirements for the auditors work. Each meeting with external auditors is used to clarify those requirements. It is also important to note that reports that do not comply with INAFs requirements must be modified. Information Requirements (CPs 21) 17. With the adoption of the CA related to Andorran financial entities in 1999, Andorran entities adopted European accounting standards. Those standards have been used until now in Andorran financial accounts and were used in Spain until 2005 (International Accounting Standards (IAS) were adopted in Spain in 2005). While IAS have not yet been implanted in Andorra, accounting rules used are consistent with what has been the standard in Europe for many years and what is used in many financial entities not quoted in a stock exchange (no Andorran financial institution is quoted in a stock exchange). Because of this, we think that the IMF assessment seems not to take into account the practise used in Europe for many years. However, as mentioned in this report, Andorran authorities plan to adopt IAS in a near future. 18. The 2003 INAF law includes a provision regarding the transfer to INAF of the responsibility for supervising insurance companies and it commands the government to present to the General Council a new insurance regulation law. For the government, the new insurance regulation law is a priority and once this text will be approved, the responsibility for supervision of insurance will be carried out by INAF.