bank of mauritius · and foreign exchange dealers 88 bank of mauritius. 3 statement from the...

Annual Report onBanking Supervision 2003

B A N K O FM A U R I T I U S

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CONTENTSPages

Statement from the Governor 3-4

1. Overview of Supervisory Developments 5-9

2. A Review of the Performance of Banks 10-35

3. The Proposed New Capital Adequacy Framework 36-41

4. IAS 39 - The implication of its implementation 42-47

5. Financial Soundness Indicators 48-53

6. Realisation and Securitisation of Assets 54-57

Appendix I

1. List of Guidelines/Guidance Notes 60

2. Guidance Notes on Fit and Proper Person Criteria 61-70

3. Guideline on Credit Risk Management 71-80

Appendix II

1. Legislative Changes and Regulatory Measures 82-83

2. Communiqué - Fraud at The MCB Ltd 84

3. Press Release - Atlantic Trust Bank 85

4. Press Release - Trans Intercontinental Finance 86

5. Public Notice - Armstrong Group 87

6. List of Authorised Banks, Non-Bank Deposit Taking Institutions, Money-Changersand Foreign Exchange Dealers 88

B A N K O F M A U R I T I U S

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Statement from the GovernorThe year 2003 witnessed sustained growth and

strengthening of our regulatory and supervisorycapacity. The Bank of Mauritius issued several newguidelines to assist the banking industry inupgrading and controlling its operations.Simultaneously, the internal infrastructure forconducting financial institutions’ inspections andoff-site monitoring was significantly enhanced inthe form of new manuals and guides for thesupervisory staff. The Bank continued to emphasizestaff training comprising on-the-job training andattendance at courses and conferences of directinterest.

The normal flow of our supervisory work wasunexpectedly disrupted by an unwelcomeoccurrence, which put our supervisory capacity to amajor test. Irregularities entailing hundreds ofmillions of rupees loss were uncovered at TheMauritius Commercial Bank Limited, perpetratedover several years. This incident not only required adeployment of our supervisory resources to thebank but also required well considered strategicinitiatives to maintain public confidence in thebank and the banking sector generally.

Public confidence is critical to the properfunctioning of the banking system in a country.Banks have a fiduciary relationship with the public.Loss of confidence in one bank can have acontagion effect on others, thus rocking the entirebanking system and the overall economy withundesirable welfare consequences. In our case, thesituation became critically urgent when a bank ofthe size of The Mauritius Commercial Bank Limited,representing around fifty per cent of the bankingsystem of the country, faced a crisis of confidence.We deemed it vitally important to proceed quicklybut in a cool and composed manner even at the riskthat the stand we might take would not beappreciated in various quarters. The regulator hasthe responsibility to investigate and take to task thefinancial institution that strays away from prudentialnorms. However, it needs to work with theinstitution and encourage it, as appropriate, toensure that fundamental changes are brought aboutin its structure and governance practices to preserveits financial health and prevent any similaroccurrences in the future.

The Bank of Mauritius enlisted the services of anindependent forensic accounting firm, nTanCorporate Advisory Pte. Ltd. of Singapore, toinvestigate into the irregularities at The MauritiusCommercial Bank Limited. Several officers workedwith the team of nTan forensic experts. At the sametime, it provided them with an opportunity tobenefit from the experts in methodologies used inthe investigative work.

The Bank of Mauritius views corporategovernance as a factor of critical importance inensuring safety and soundness of financialinstitutions. To foster good governance, it hasissued a network of Guidelines, dealing with theoverall issue of governance as well as thespecifically targeted areas of related partytransactions, public disclosure of information andthe role of external auditors. In 2003, we furtherextended the network by issuing Guidance Noteson Fit and Proper Person Criteria, which place theresponsibility for implementation of the criteriasquarely in the hands of an institution’s Board ofDirectors. These Guidance Notes were issued inrecognition of the fact that an institution cannot berun on sound governance principles unless itsmanagement is adequately skilled, competent,honest and ethical. Market participants and thepublic need assurance that the persons at the helmare and are perceived to be fit and proper at alltimes.

Credit constitutes by far the biggest part of thebanking industry’s business in Mauritius and itsmismanagement has been responsible for seriousproblems in certain institutions. Right from the firstmeeting held with banks’ Chief Executive Officersin July 1999, I have impressed upon them the needto have in place a sound credit risk policy tominimize and manage credit risk. Over the years,our on-site inspection teams have uncoveredinstances where either no credit risk policy existedor, if it did, was not applied consistently andeffectively. In 2003, the Bank decided to deal withthis critical subject by issuing the Guideline onCredit Risk Management. The Guideline outlines,in very clear terms, the accountability of the Boardof Directors and, through it, the Chief ExecutiveOfficer, in managing the credit risk activity of the

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Statement from the Governor

financial institution with integrity, using strictly andexclusively prudential credit criteria. It also insistson the establishment of effective internal controls,covering the entire credit spectrum and their fullestimplementation.

We are now coming to the stage where ournetwork of guidelines to assist financial institutionsin prudential management of their operations, isbecoming increasingly wide ranging. We fullyexpect them to diligently implement thoseguidelines. We look forward to receivingassurances through our monitoring work andotherwise, that they are indeed being implementedin their true spirit.

We want our financial institutions to remain inthe forefront of the economic development of thecountry. To this end, we have always taken a longterm, futuristic view of the development of thefinancial industry. The Bank of Mauritius iscurrently working on certain important newinitiatives. These pertain to the establishment of acredit bureau and seeking changes to the existinglegislative framework to obtain expeditiousrealization on collaterals taken against creditsgranted.

Financial institutions need up-to-date andaccurate information on creditworthiness ofborrowers in order to carry out their creditappraisal. For some time now, an urgent need hasbeen identified for the establishment of a creditbureau which will collect, consolidate, store anddisseminate credit information on borrowers.Further to the report of the sub-committee of theBanking Committee on this subject, a delegationled by the Managing Director of the Bank ofMauritius visited the National Bank of Belgium,which has a modern and efficient credit bureau.The visit was highly enlightening and will help inmoving forward the project.

The credit bureau concept will have anotherapplication, in the implementation of the Basel IIAccord. In order to measure and mitigate credit

risk, Pillar I of the Accord requires borrowers to berated according to their creditworthiness. The ratingcan be done by external credit rating agencies orsuch other agencies, as may be approved by thesupervisory authority. In this project, theexperience of the Banque De France, which hasoperated a credit bureau since 1946, and of theNational Bank of Belgium, is of considerableinterest and will be drawn upon as we proceed.

Financial institutions in Mauritius experiencelengthy delays in the liquidation of securities takenagainst credits that become impaired. Someborrowers, having the capacity to repay their loans,deliberately go into arrears because they know thatthe loan recovery process prescribed in the existinglegislation is prolonged and cumbersome. Usuallythe course available to banks is to foreclose thesecurity and dispose of the assets involved, by levy.But this is a very lengthy process and the proceedsrealized are frequently grossly insufficient todischarge the loan liability. As a result, banks arereluctant to embark on the process and therecalcitrant borrowers continue to pay little heed toany notices to settle the outstanding accounts. Atthe Banking Committee meetings, bankers haveraised the issue on various occasions. I have askedthem to put forward their proposals to resolve theproblem. I have also brought to their attention theapproach recently adopted in India through thepassing of a new legislation, The Securitisation andReconstruction of Financial Assets and Enforcementof Security Act 2002. In the meantime, work isprogressing at the Bank on legislative amendments.

The constantly emerging challenges in the realmof regulation and supervision necessitate regularupgrading of skills and solid teamwork for themaintenance of monetary and financial stability.The Bank of Mauritius has made considerableheadway in capacity building in recent years. Thebenefits from all the initiatives undertaken by theBank can only crystallize in the years to come.

Rameswurlall Basant Roi, G.C.S.K.

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INTERNATIONAL DEVELOPMENTS

International initiatives on the supervisory frontwere directed to promote transparency and marketdiscipline. Financial institutions are being urged toadopt best risk management practices and maintainthe combat against money laundering andfinancing of terrorism. Continued efforts to ensurethat international supervisory standards areconsistently applied and that banking supervision iscarried out evenly at the global level, were reflectedin the development of norms establishing theresponsibilities of home country and host countrysupervisors and the release of standards pertainingto cross-border initiatives. The followingparagraphs briefly outline such initiatives.

In order to provide a framework for the effectivemanagement and supervision of operational risk foruse by banks and by supervisory authorities whenassessing operational risk management policies andpractices, the Risk Management Group of the BaselCommittee on Banking Supervision (theCommittee) issued, in February 2003, a paperentitled ‘Sound Practices for the Management andSupervision of Operational Risk’. The paper laysdown the ground rules for a framework for effectivemanagement and supervision of operational risk foruse by banks and by supervisory authorities whenappraising the operational risk managementpolicies and practices. The innovative part of thepaper is that it formalizes the concept thatoperational risk management should form part ofthe comprehensive risk management strategy in thesame way as credit and market risk management.

In May 2003, the Committee published theresults of the 2001 disclosure survey as part of itssustained effort to promote transparency andeffective market discipline in the banking andcapital markets. The survey revealed that manybanks have continued to expand the extent of theirdisclosures. Disclosures on accounting andpresentation policies, other risks and capitalstructure were noteworthy, while a need for moredisclosures on credit risk modeling and creditderivatives was felt. In this respect, the Committeehas urged the few banks that do not disclose themost commonly provided information to improve

their disclosures. It is, however, expected that withthe forthcoming implementation of the New CapitalAccord with its Third Pillar based on MarketDiscipline, there will be further expansion in theextent of banks’ disclosure practices.

The combat against money laundering and thefinancing of terrorism is on-going. This itemremained high on the agenda of internationalsupervisory bodies such as the Basel Committee onBanking Supervision, International Association ofInsurance Supervisors (IAIS) and the InternationalOrganisation of Securities Commissions (IOSCO)during the year 2002/03. These institutions issued ajoint note in June 2003 describing the initiativestaken by each institution to combat moneylaundering and the financing of terrorism.

Whilst reckoning that each organization’s sectorof oversight has its particularities and that a uniformset of supervisory efforts cannot be applied to allthree segments, they stated their commitment toensuring that the standards of supervision appliedare consistent and coherent and that no particularsegment would offer the opportunity of arbitragingas a result of less stringent anti-money launderingand terrorism financing norms.

The ‘Customer Due Diligence for Banks’publication released in October 2001 was endorsedby banking supervisors from about 120 countries atthe International Conference of BankingSupervisors in Cape Town in September 2002. As asupplement to the publication, a Consultative paperentitled ‘Consolidated know-your customer (KYC)risk management’ was made available to thebanking industry in August 2003. The paperanalyses the essential components for effectivemanagement of KYC policies. One of therequirements of the paper is that jurisdictionsshould facilitate consolidated KYC riskmanagement by providing an appropriate legalframework that permits the cross-border sharing ofinformation and removes the legal restrictionsimpeding effective consolidated KYC riskmanagement processes.

Another issue dealt with by the Committee wasthe management and supervision of cross-borderelectronic banking activities. A paper on this issue

1. Overview of Supervisory Developments

was prepared by the Electronic Banking Group ofthe Committee and released in July 2003. Thepaper lays down supervisory expectations andprovides guidance to banks carrying out cross-border electronic banking activities as well as totheir home and host supervisors. It aims atsupplementing the publication on RiskManagement Principles for Electronic Banking byemphasizing the need for banks to incorporate theircross-border e-banking risks into their overall riskmanagement framework. It also highlights the needfor effective home country supervision of cross-border e-banking activities and for continuedinternational cooperation between bankingsupervisors respecting such activities.

Evolution of the Core Principles forEffective Banking Supervision

It is now six years since the Core Principles forEffective Banking Supervision were issued inSeptember 1997. This document serves as theinternational yardstick for the evaluation of theoverall quality of supervision in individualcountries.

The Core Principles Methodology whichprovides the necessary criteria for evaluating andjudging compliance with the individual principles,has revealed to be an important and effective tool inassessment exercises. The Financial SectorAssessment Programmes (FSAPs) carried out jointlyby the IMF and the World Bank to test therobustness of the financial system of individualcountries, have been based to a large extent on thecompliance with the Core Principles.

In order to keep the Core Principles ascomprehensive, relevant and up-to-date aspossible, the Committee will commence a thoroughreview of the Principles probably later this year.The exercise will help determine whether additionalPrinciples are needed or some essential criterianeed to be revised or new criteria added. Already,it has been decided in the course of theInternational Conference of Banking Supervisorsthat the principles of the ‘Customer Due Diligencefor Banks’ will be incorporated in the CorePrinciples.

Combat against Money Laundering andTerrorism Financing

The Financial Action Task Force, an internationalagency established by the G-7 in July 1989 toexamine measures to combat money laundering,adopted its revised Forty Recommendations in June2003. Together with the Eight SpecialRecommendations on Terrorist Financing, theyprovide a coherent and comprehensive frameworkof measures for anti-money laundering andcombating terrorist financing.

New Accord on Capital Adequacy

On 29 April 2003, the Committee issued a thirdconsultative paper on the New Basel CapitalAccord. Banks and other interested parties wererequested to send their comments by 31 July 2003.All comments received during the third consultativeperiod by the Committee were published andposted on its website. Comments made by banks inMauritius are also available in the Committee’swebsite (http://www.bis.org). The Committee isexpected to finalise its proposal for a new capitaladequacy framework in the light of the commentsreceived, with the objective to release the NewAccord in final form by December 2003, forimplementation by member countries by the end of2006.

In view of the forthcoming finalisation of theNew Capital Adequacy Accord in December thisyear and its proposed implementation by year-end2006, the Bank of Mauritius has set up a workinggroup with the objective of developing animplementation plan for the Accord. The proposalsput up by the working group include, inter alia, thepreparation of a draft Guideline to be issued to thebanking institutions and the active involvement ofbanks in the process.

DOMESTIC DEVELOPMENTS

Actions taken to combat Money Launderingand Terrorism Financing

The Financial Intelligence and Anti-MoneyLaundering Regulations 2003 made under section35 of the Financial Intelligence and Anti-MoneyLaundering Act 2002 became effective during the second half of June 2003. The Regulations prescribethe customer identification and due diligencerequirements to be observed by banks, financial

Overview of Supervisory Developments

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institutions and cash dealers when forming businessrelationships with clients. The Regulations alsorequire banks, financial institutions and cashdealers to implement internal controls andprocedures to combat money laundering andfinancing of terrorism. Those financial institutionsare henceforth required to appoint a MoneyLaundering Reporting Officer whose responsibilitiesare clearly laid down in the Regulations.

The Mutual Assistance in Criminal and RelatedMatters Act was adopted by the National Assemblyin August 2003. This legislation permits the countryto have and to provide, as well, the widest possiblemeasure of international co-operation promptly andto the fullest extent possible, in investigations,prosecutions or proceedings concerning seriousoffences and related civil matters.

A Convention for the Suppression of theFinancing of Terrorism Act was also enacted by theNational Assembly in August 2003. The Act laysdown the basis for the ratification by the Republicof Mauritius of the International Convention for theSuppression of the Financing of Terrorism. Theratification of the International Convention signedby the Government on 11 November 2001 istherefore imminent.

The Anti-Money Laundering (MiscellaneousProvisions) Act was enacted in August 2003. Themain object is to amend the Banking Act 1988, TheFinancial Intelligence and Anti-Money LaunderingAct 2002 and the Financial Services DevelopmentAct 2001 in order to permit the setting up of aNational Committee for Anti-Money Launderingand Combating the Financing of Terrorism and thereplacement of the Review Committee of theFinancial Intelligence Unit by a board. The Actremoves the existing ambiguity as to whether theBank of Mauritius was empowered to issueGuidance Notes on Anti-Money Laundering.

The Bank of Mauritius has reviewed andupdated its Guidance Notes on Anti-MoneyLaundering and Combating the Financing ofTerrorism. The Guidance Notes have beenreviewed in the light of the regulations made undersection 35 of the Financial Intelligence and Anti-Money Laundering Act 2002 which came into forceon 21 June 2003. The Guidance Notes encompassall the principles set out in the Eight SpecialRecommendations of the FATF on combating thefinancing of terrorism.

Other Legislative Changesin the Banking Sector

During the year under review, the Banking Act1988 was amended by the Finance Act 2003 toinclude a new section providing for derogationfrom articles 1659, 1660, 1661, 1673, 2087 and2088 of the Code Civil Mauricien for the purposesof conducting repurchase transactions among banksand other financial institutions.

Guidelines issued by Bank of Mauritius

In June 2003, the Bank of Mauritius issued on aconsultative basis to banks and non-bank deposittaking institutions a draft Guideline on CreditImpairment Measurement and Income Recognitionto render explicit the requirements of theInternational Accounting Standard 39 (IAS 39)which deals with the impairment anduncollectability of financial assets. This Guidelinewould supersede the existing Guideline on CreditClassification for Provisioning Purposes and IncomeRecognition. The need for the new Guidelinederives from the fact that the Companies Act 2001requires all companies to prepare their financialstatements in accordance with InternationalAccounting Standards issued by the InternationalAccounting Standards Board. Banks have forwardedto the Bank of Mauritius their representations on thedraft Guideline. The representations have been dulyconsidered and another version is contemplated forissue on consultation. It is expected that the finalversion would be issued before the end of the year.

As from June 2003, the Bank started toimplement the new framework for the compilationand reporting of monetary data by requiring allfinancial institutions falling under its purview toadopt a uniform reporting system along the lines ofthe Monetary and Financial Statistics Manual of theIMF. Accordingly, all financial institutions submit astandardised set of statements of assets andliabilities on a monthly basis, effective 30 June 2003.

The Bank has constantly impressed uponfinancial institutions the need for a sound creditpolicy in managing and mitigating credit risk.Uneven levels of treatment of processes for creditrisk policy were observed across financialinstitutions. In order to bring the credit processeswithin the institutions to a comparable level, theBank has issued a Guideline on Credit Risk 7

Management. The Guideline was finalised aftertaking into consideration the comments andsuggestions of the industry. It is not meant to be acomprehensive framework and only outlines theessentials for a well designed credit riskmanagement framework.

The Bank is presently working on otherguidelines, notably, on Operational risk, MarketRisk and Sovereign Risk. As usual, these will beissued to the industry on a consultation basis priorto their implementation.

In the wake of recent scandals which rockedfinancial institutions, both locally and abroad, theneed for financial institutions to employ officerswho are fit and proper is receiving increasedattention. Market participants as well as the publicin general need to be assured that officers holdingsenior positions in financial institutions arecompetent, honest and financially sound and enjoytotal integrity. With a view to providing some basicguidance to assess that their officers are fit andproper, the Bank issued to financial institutions on4 November 2003, Guidance Notes on Fit andProper Person Criteria.

Memorandum of Understanding

The Memorandum of Understanding enteredinto by the Bank of Mauritius with the FinancialServices Commission on 5 December 2002 has setthe stage for the exchange of supervisoryinformation and for promoting cooperationbetween the two regulatory bodies. It is expectedthat in the near future teams comprising officers ofboth the Financial Services Commission and theBank of Mauritius would be jointly carrying out on-site inspections of conglomerates.

Financial Sector Assessment Program

The final report of the Financial SectorAssessment Program in which Mauritiusparticipated during 2002 was delivered to theauthorities in August 2003.

According to the report, banking supervision isof a good standard, reflecting significant progressmade in building the capacity of the Bank ofMauritius in recent years. Certain legal deficiencieswere, however, identified. The report expressed theviews that those legal deficiencies would beaddressed if the current drafts of the new Banking

Bill and Bank of Mauritius Bill were enacted andthat this should be done as a matter of priority.

The mission is of the view that the prudentialguidelines are all of a commendable standard andthe capacity of the Bank of Mauritius to enforceguidelines has substantially increased in recentyears. However, the need is felt for additionalguidelines to address country and market risks andcredit policy and there is scope for furtherstrengthening in the areas of consolidatedsupervision and problem bank resolution.

The Bank of Mauritius is currently addressingthose issues. During the year 2002/03, variousGuides on supervisory issues such as Guide onConsolidated Supervision and Guide onIntervention by the Bank of Mauritius in FinancialInstitutions were developed for internal use by theSupervision Department.

The MCB/NPF Case

In February 2003, a fraud in hundreds of millionof rupees was discovered at The MauritiusCommercial Bank Ltd (The MCB Ltd). On14 February 2003, a Communiqué was issued byThe MCB Ltd relating to the fraud which wascommitted at the expense of one of its clients,namely the National Pension Fund (NPF). The Bankof Mauritius issued a Communiqué reassuringdepositors that their interests are positivelysafeguarded.

According to the audited interim accounts of TheMCB Ltd, the bank’s accumulated reserves stood atRs 5.7 billion as at 31 December 2002. In March2003, an amount of Rs 881.6 million representingthe estimated amount of the fraud was reimbursedto the NPF.

The Bank of Mauritius hired the services of nTanCorporate Advisory Pte Ltd (nTan), ForensicAccountants from Singapore to investigate into thefraud. Inspectors from the Bank of Mauritiusparticipated in the nTan investigation.

On 17 March 2003, the Governor of the Bank ofMauritius met with the Chief Executive Officers andthe Board of Directors of Category 1 banks with aview to critically appraising their managementpractices and their compliance with the ethos ofcorporate governance as stipulated in the CentralBank’s directives. The main issues raised during

Overview of Supervisory Developments

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those meetings were the need for the Board ofDirectors to carry out a fundamental review of theorganizational structure and in particular the topmanagement of their respective banks, the need toreview fundamentally the professional standards ofbank officers and management staff, that bankersshould comply with the Central Bank’s directivesand adopt an uncompromising focus on the issue ofcorporate governance. The Governor also urged theBoard of Directors to ensure that their auditcommittees were operationally efficient and fullyindependent of the office of the Chief Executive.

Proposed Establishment of a Credit Bureau

The assistance of the National Bank of Belgiumwas solicited for guidance on the proposedestablishment of a credit information bureau inMauritius. In this connection, a delegation headedby the Managing Director of the Bank andcomprising commercial bankers proceeded to theNational Bank of Belgium for a prospecting visit inNovember 2003.

Other Developments

In November 2002, Barclays Bank Plc acquiredthe banking activities of Banque Nationale de Paris

Intercontinentale which surrendered its Category 1and Category 2 banking licences to the Bank ofMauritius with effect from 5 December 2002.

In February 2003, a Fraud Forum was set up bythe Category 1 banks with a view to combatingfraudulent transactions involving credit cards. TheFraud Forum comprises six Category 1 banks,namely, The Mauritius Commercial Bank Ltd, StateBank of Mauritius Ltd, Barclays Bank Plc,Hongkong and Shanghai Banking Corporation Ltd,Bank of Baroda and First City Bank Ltd.

In May 2003, the undertakings of the New Co-operative Bank Ltd and Mauritius Post OfficeSavings Bank were transferred to the Mauritius Postand Cooperative Bank Ltd. Approval was grantedby the Bank of Mauritius under section 10(1)(a) ofthe Banking Act 1988.

The African Asian Bank Limited has, pursuant tosection 7(2) of the Banking Act 1988, has appliedto the Bank of Mauritius for the surrender ofits Category 2 Banking Licence and has ceasedto conduct banking business with effect from16 June 2003. �

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2.1 INTRODUCTION

The banking sector is constituted of the Category1 banking sector comprising ten banks holding aCategory 1 Banking Licence (Category 1 banks) andCategory 2 banking sector comprising twelve banksholding a Category 2 Banking Licence (Category 2banks).

Six Category 1 banks are locally incorporated.Of these, one is foreign owned. The remaining fourCategory 1 banks operate as branches of foreignbanks. Two locally incorporated Category 1 banksaccount for 68 per cent of the total assets of theCategory 1 banking sector.

Out of the twelve Category 2 banks, four arebranches of foreign banks, seven are subsidiaries offoreign banks and one is a joint venture between aCategory 1 bank and a foreign bank.

A list of the Category 1 and Category 2 banks asat 30 June 2003 is shown in Appendix II.

2.1.1 Surrender of Banking Licences byBanque Nationale de Paris Intercontinentale

In November 2002, following its decision todispose of its Category 1 and Category 2 bankingbusinesses to Barclays Bank Plc, Banque Nationalede Paris Intercontinentale (BNPI) applied forpermission from the Bank of Mauritius for thesurrender of its Category 1 and Category 2 BankingLicences under the provisions of section 7(2) of theBanking Act 1988.

The Bank of Mauritius made the necessaryinquiries into the conditions of the takeover of thebanking businesses of BNPI by Barclays Bank Plc.After being satisfied that the interests of depositorsand of the public were preserved and that BarclaysBank Plc would be responsible for safekeeping allthe records of the activities of BNPI in Mauritiusafter the takeover, the Bank of Mauritius acceptedthe surrender of the Category 1 and Category 2Banking Licences of BNPI with effect from5 December 2002. Accordingly, BNPI ceased toconduct banking business in Mauritius as from thatdate.

2.1.2 Surrender of Category 2 Banking Licenceby African Asian Bank Limited

In June 2003, African Asian Bank Limitedapplied to the Bank of Mauritius for permission tosurrender its Category 2 Banking Licence under theprovisions of section 7(2) of the Banking Act 1988.

The Bank of Mauritius has given permission forAfrican Asian Bank Limited to surrender itsCategory 2 Banking Licence with effect from theclose of business on 16 June 2003 after completionof certain requirements to its satisfaction.

Accordingly, African Asian Bank Limited ceasedto conduct banking business as from 16 June 2003.

2.1.3 Merger of the New Co-operative Bank Ltd with Mauritius Post Office Savings Bank

In April 2003, following the decision of theGovernment of Mauritius to merge the operations ofthe New Co-operative Bank Ltd with those of theMauritius Post Office Savings Bank, the New Co-operative Bank Ltd applied to the Bank of Mauritiusfor permission for the merger and to operatethereafter under the name of Mauritius Post andCooperative Bank Ltd.

In May 2003, the Bank of Mauritius gave itsapproval for the merger and for the change of thebank's name to Mauritius Post and CooperativeBank Ltd. A Category 1 Banking Licence was issuedin the name of Mauritius Post and Cooperative BankLtd on 3 June 2003.

On 4 June 2003, the Mauritius Post andCooperative Bank Ltd was granted an authorisationto carry on the business of foreign exchange dealerin Mauritius under section 3(1) of the ForeignExchange Dealers Act 1995.

On 19 June 2003, the Savings Bank (Transfer ofUndertaking) Act 2003 was enacted to provide forthe transfer of the business of the Mauritius PostOffice Savings Bank to the Mauritius Post andCooperative Bank Ltd.

2. A Review of the Performance of Banks

A Review of the Performance of Banks

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2.2 PERFORMANCE OF CATEGORY 1 BANKS

The activities of Category 1 banks continued toexpand during the year 2002-03. On-balance sheetassets of Category 1 banks, inclusive of the assets ofBNPI taken over by Barclays Bank Plc during theyear, rose by Rs19,880 million or 14.8 per centfrom Rs134,680 million at end-June 2002 toRs154,560 million at end-June 2003, compared toa growth rate of 13.9 per cent in the preceding year.On an individual basis, asset growth of Category 1banks for the year 2002-03 ranged between 1.4 percent and 89.6 per cent.

During the year under review, foreign currencyassets of Category 1 banks posted a 14.4 per centincrease, rising from Rs18,796 million at end-June2002 to Rs21,511 million at end-June 2003. Theshare of foreign currency assets in total assets ofCategory 1 banks declined marginally from14.0 per cent at end-June 2002 to 13.9 per centat end-June 2003. Category 1 banks had anoverall short foreign exchange position of Rs1,169million at end-June 2003 as compared to an

overall long position of Rs1,366 million at end-June 2002.

Off-balance sheet assets comprising acceptances,guarantees and documentary credits amounted toRs17,052 million at end-June 2003, up fromRs15,081 million at end-June 2002.

Chart 1 gives the year-on-year comparison ofassets and liabilities of Category 1 banks. At end-June 2003, the bulk of the assets of Category 1banks consisted of advances and investment inTreasury Bills and Government securities, which,respectively, made up 55.6 per cent and 21.5 persent of the total, compared to 60.3 per cent and16.7 per cent, respectively, a year earlier. Lesserdemand for credit translated into a shift towardsinvestment in Treasury Bills and Governmentsecurities. Deposits constituted 74.9 per cent ofCategory 1 banks' total resources.

A detailed review of the performance of banksover the past two years with respect to capitaladequacy, asset quality, management, liquidity andprofitability follows.

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2.2.1 CAPITAL ADEQUACY

The balance sheet structure of banks is uniqueas they have a relatively high gearing of outsidecreditors, mostly depositors, to shareholders’ funds.This structure makes banks vulnerable to variousrisks. In order to carry out a prudent managementof those risks, bank regulators have adoptedminimum capital adequacy requirements in linewith the Basel Capital Accord 1988.

An adequate capital base serves as a safety netfor a variety of risks as it provides a cushion againstlosses, which should be borne by shareholdersrather than depositors. Hence, the level of capitalmaintained by a bank should be consistent with itsoverall risk profile and business strategy. Board ofdirectors should ensure that at all times banks holdcapital which commensurate with their risk profile.Strong capital also reassures creditors and helps tomaintain confidence in a bank. Adequate capital,however, cannot by itself provide a safeguard againstfailure of banks that are not properly managed.

The Basel Capital Accord 1988 was adopted bythe Bank of Mauritius in December 1993 and theminimum capital adequacy ratio to be observed bybanks was initially set at 8 per cent. It wassubsequently increased to 10 per cent as from July1997 in line with the increase in the minimum paidup/assigned capital to be maintained by banks.

Capital, for supervisory purposes, is consideredin two tiers. Tier 1 or permanent capital comprisesthe highest quality capital elements. Tier 2, orsupplementary capital represents other elementswhich do not satisfy all the characteristics of Tier 1capital but contribute to the overall strength of abank as a going concern. A bank’s capital base isthe sum of its Tier 1 capital and Tier 2 capital net ofany deductions. On the other hand, the differentbroad categories of assets of the bank are assigneddifferent risk weights. The capital base is thenexpressed as a percentage to total risk-weightedassets.

On average, the risk weighted capital adequacyratio maintained by Category 1 banks fluctuatedbetween a low of 12.3 per cent in December 2002to a high of 13.5 per cent in September 2002 duringthe year ended 30 June 2003. Individual banks’ratio varied widely mainly on account of differencesin the attitude of banks to risk management.

2.2.1.1 Capital Adequacy Ratio of Category 1Banks in terms of their Total Asset Value

Chart 2 shows the capital adequacy ratiomaintained by Category 1 banks in terms of theirtotal asset value. Category 1 banks that reportedratios between 10 per cent and 12 per cent held inaggregate the biggest share of the banking sector’stotal on- and off-balance sheet assets at 55.6 percent and 58.2 per cent in June 2002 and June 2003,respectively. Although this may indicate that somebanks are making an optimum use of their capital,this ratio should, however, not be interpreted inisolation. Other ratios such as the ratio of non-performing loans to total capital base wouldindicate the extent to which a bank’s capital base iseither being properly managed or is subject to riskof erosion as a result of loan losses.

At end-June 2003, banks with capital adequacyratios ranging between 12 per cent and 15 per centheld the next biggest portion of the banking sector’stotal on- and off-balance sheet assets at 36.7 percent, as opposed to only 7.3 per cent within thesame category for June 2002. Banks with capitaladequacy ratios of between 15 per cent and 18 percent recorded a sharp decline in their aggregateshare of the banking sector’s total on- and off-balance sheets assets, which fell from 32.8 per centin June 2002 to 1.9 per cent in June 2003.


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2.2.1.2 Capital Base

The aggregate capital base of Category 1 banksincreased by Rs589 million, from Rs11,954 millionat end-June 2002 to Rs12,543 million at end-June2003. The average capital adequacy ratio of banksat end-June 2003 stood at 12.6 per cent, down from13.1 per cent at end-June 2002.

During the year under review, the aggregatecapital base growth of 4.9 per cent was lower thanthe growth of the total risk weighted assets of banksat 9.6 per cent, thus resulting in a decrease in theoverall capital adequacy ratio of the Category 1banking sector.

At end-June 2003, Tier 1 capital, whichcomprises the bulk of total capital accounted for83.4 per cent of total gross capital (Tier 1 and Tier 2)of Category 1 banks. During the year underreview, it grew slightly by 1.5 per cent fromRs12,717 million at end-June 2002 toRs12,905 million at end-June 2003. On the otherhand, Tier 2 capital representing 16.6 per cent oftotal gross capital at end-June 2003, grew by13.9 per cent from Rs2,251 million toRs2,563 million during the year. At end-June 2003,Tier 2 capital represented 19.9 per cent of Tier 1capital, up from 17.7 per cent in June 2002.

Chart 3 reflects the split between Tier 1 andTier 2 capital over the period of end-June 1996through 2003. A comparison of the actual capitalbase maintained by Category 1 banks with theirminimum required capital base, given their totalrisk-weighted assets , as shown in the chartindicates that, on average, the buffer of capitalmaintained by the banking sector is increasing over

the years. This may indicate banks' prudent attitudetowards risk or insufficient demand for more riskyassets.

2.2.1.3 Risk Profile of On- andOff-Balance Sheet Assets

Total on-balance sheet assets of Category 1banks grew by 14.3 per cent from Rs128,954million at end-June 2002 to Rs147,338 million atend-June 2003 while the corresponding riskweighted value rose by a lower percentage of6.8 per cent from Rs82,879 million to Rs88,546million.

Table 1 shows the comparative movement in theriskiness of Category 1 banks' total on-balancesheet assets as between end-June 2002 and end-June 2003. The 100 per cent risk-weighted assetsrepresented the bulk of Category 1 banks' total

Table 1 : Comparative Change in the Riskiness of Banks’ Portfolios of On-balance Sheet Assets

On-balance Percentage to Total On-balance Percentage to TotalSheet Assets On-balance Sheet Sheet Assets On-balance Sheet(Rs million) Assets (Rs million) Assets

Risk Weights (%) June 2003 June 2002

0 46,471 31.5 34,844 27.0

20 11,588 7.9 10,826 8.4

50 6,102 4.1 5,140 4.0

100 83,177 56.5 78,144 60.6

147,338 100.0 128,954 100.0 13

assets at 60.6 per cent and 56.5 per cent at end-June 2002 and end-June 2003, respectively. Duringthe year under review, high risk assets continued tomaintain a downward trend, with assets weighted at100 per cent and 20 per cent, respectively, beingshifted to low risk assets (zero-risk rated). This ismirrored in the substantial increase in banks’investment in Government securities and TreasuryBills, zero-risk rated assets, which rose by 56 percent from Rs22,046 million at end-June 2002 toRs34,388 million at end-June 2003.

A comparison of the total on- and off-balancesheet assets of Category 1 banks together with theircorresponding risk-weighted value and theiraverage combined risk weighting over the periodJune 1998 to June 2003 is given in Table 2.

As shown in Table 2, from June 2002 to June2003, total on- and off-balance sheet assets ofCategory 1 banks rose by Rs21,708 million or14.2 per cent while the corresponding total risk-weighted value grew by Rs8,680 million at a lowerrate of 9.6 per cent. The corresponding growth ratesfor the preceding year were 14.8 per cent and10.9 per cent, respectively.

As illustrated in Table 2, the average combinedrisk weighting (which is the ratio of the risk-weighted assets to the total on- and off-balancesheet assets) recorded a decline from 59.4 per centin June 2002 to 57.0 per cent in June 2003,indicating, on average, a slight shift to less riskyassets. Despite this overall decrease in the riskinessof banks’ total on- and off-balance sheet assets, theaggregate capital adequacy ratio of banksnevertheless fell from 13.1 per cent to 12.6 per

cent. This is mainly on account of a lowerpercentage growth of the capital base of thebanking sector resulting from a share 'buy back'carried out by two banks during the year ended June2003. This trend clearly indicates that some banksdo not wish to be over capitalised as capitalinvolves a cost which indirectly impacts on thepricing of banks’ products.

Chart 4 compares the percentage increase incapital base and risk-weighted assets over theperiod June 1997 to June 2003.

2.2.2 ASSET QUALITY

Banking business by its very nature is subjectedto a wide array of risks, which if not controlledproperly, can undermine the stability of the wholefinancial sector.

*B/A

Table 2 : Total On-and Off-Balance Sheet Assets of Category 1 Banks, Equivalent Risk-Weighted Assetsand Average Combined Risk Weighting

June 98 June 99 June 00 June 01 June 02 June 03

A Total On- and Off-Balance Sheet Assets (Rs million ) 97,186 111,064 125,884 133,244 153,023 174,731

B Total Risk-Weighted Assets(Rs million ) 56,772 68,403 75,264 81,986 90,927 99,607

C* Average Combined Risk Weighting (Per cent) B/A 58.4 61.6 59.8 61.5 59.4 57.0

D Capital Adequacy Ratio(Per cent) 12.5 12.9 12.2 13.1 13.1 12.6


14

Banks lie at the heart of the payment andsettlement system and are highly leveragedinstitutions with the bulk of their resources raised byway of deposits from the public. They are entrustedwith the fiduciary responsibility of managing publicfunds and safeguarding depositors' interests. On theother hand, banks' shareholders expect areasonable return on their equity. Banks aretherefore faced with the challenges of remainingsafe and sound as well as engaging in riskyproductive operations.

Asset structure building is the first step towardsensuring good performance of banks. At the veryoutset, banks should measure the risks inherent toeach asset item and have in place good riskmanagement systems. The share of each assetcomponent reflects the risk levels and types of riskto which the bank is exposed. Chart 1 comparesthe asset composition of banks' balance sheets atend-June 2002 and end-June 2003. The Bank ofMauritius has issued several guidelines andguidance notes to the sector with a view to guidingbanks to take risks which are commensurate withtheir resources.

An analysis of the asset structure of Category 1banks, the risks inherent to each type of asset andthe relative risk mitigation tools are given below.

Risk Weighted Assets

There is a strong relationship between riskmanagement and banks' performance. Improvingrisk management enhances both qualitative andquantitative performance of banks. The parametersset out in the Guidance Notes on Risk WeightedCapital Adequacy Ratio issued in accordance withBasel Capital Accord 1988, limit the riskiness ofbanks' activities in relation to capital held by themand call for proper balance sheet management.Banks should strike a balance between highearnings from very risky operations and safe andsound operations.

The riskiness of non-fund based and other off-balance sheet operations are also included in thecomputation of the risk-weighted assets ratio asthey represent potential risk for banks and carry acapital requirement.

Earning Assets

The soundness of a bank depends largely on themanagement of its balance sheet structure. The ratioof earning assets to total assets gives an insight intothe management of funds towards productiveassets, comprising advances, investment in TreasuryBills and Government securities, placement withother banks and other interest earning assets.Although a high ratio is desirable, banks shouldadopt a reward versus risk policy and build a well-planned asset mix taking into considerationinherent risks for individual types of assets.

The proportion of earning assets in total assetsremained unchanged at 83.0 per cent at end-June2002 and end-June 2003.

2.2.2.1 Advances

Banks' performance is dependent to quite anextent on quality of their advance portfolio, themore so as intermediation business remains theirmajor income generating activity. Advances(including investment in debentures) constituted thesingle most important asset item of Category 1banks. The proportion of advances in total assetsdropped from 60.3 per cent at end-June 2002 to55.6 per cent at end-June 2003. Nevertheless,banks continued to derive the major part of theirtotal income, about 62.7 per cent in 2002/03, fromadvances.

Total advances extended by Category 1 banksincreased by Rs4,643 million or 5.7 per cent, fromRs81,242 million at end-June 2002 to Rs85,885million at end-June 2003, compared to a highergrowth of Rs5,656 million or 7.5 per cent in thepreceding year.

Chart 5 compares the composition of advancesat end-June 2002 and 2003. During the year ended30 June 2003, there has been a shift fromdebentures and overdrafts in favour of loans in localcurrency and loans and other financing in foreigncurrency in Mauritius.

Investment in debentures dropped substantiallyby Rs3,498 million or 32.1 per cent from Rs10,890million at end-June 2002 to Rs7,392 million atend-June 2003 as these instruments were redeemedat maturity. 15

Advances, unless they are cash collateralised orextended as mortgage loans, are, for capitaladequacy purposes, considered among the riskiestassets held by banks. These assets are exposed tocredit risk, inherent to banks' lending activities dueto potential inability of debtors to repay their debtsin a timely manner. The high proportion of advancesin banks' balance sheet makes credit risk an area ofconcern for supervisors, the more so as credit riskhas been the root cause of many bank failures at theinternational level.

Banks transform their liabilities into assets ofdifferent maturities. Their projected cash flowsbased on maturities of their assets and liabilitiesprovide a baseline for liquidity management. Theuntimely or non-repayment of advances may, thus,affect the liquidity position of banks and also theirearnings.

The Bank of Mauritius has issued severalguidelines to the industry setting out basic standardsfor banks' lending activities. Banks are expected tohave in place sound credit management toolscomprising policies and procedures for credit riskmitigation, asset classification and provisioning.

Policies to limit or reduce credit risk are meant toaddress the various factors which may increase thelevel of normal credit risk associated with lendingactivities.

Concentration of Risks

Portfolio diversification is a pre-emptive measuretowards management of large exposures to singleborrowers or group of closely-related borrowers orrelated parties, an industry sector or a particularactivity. Such circumstances increase the complexityand the degree of risk to which banks are exposed.The incapacity of debtors, with large exposures oroperating in the same sector, to repay their debts ina timely manner may additionally expose banks tocash flow problems which may lead to liquidityproblems. The Bank of Mauritius has set down theparameters for large exposures in its Guideline onCredit Concentration Limits with a view to limitingbanks’ exposure to risks inherent in such advances.

Total credit facilities extended to any onecustomer/group of closely-related customers foramounts aggregating 15 per cent or more ofindividual banks’ capital base totalled Rs40,447million at end-June 2003, up from Rs36,283 millionat end-June 2002. At end-June 2003, theyrepresented 39 per cent of the overall on- and off-balance sheet commitments of banks. Overallbanks' large exposures in terms of capital baseincreased from 228 per cent at end-June 2002 to257 per cent at end-June 2003.

In addition to the normal risk of loss, excessiveconcentration by industry or particular activityexposes banks to business risk linked tounanticipated cyclomatic economic downturns.Such situations make banks vulnerable tosimultaneous failures of customers operating in thesame sector. The Bank of Mauritius closely monitorslendings of banks by industry sector through reportssubmitted by banks on a monthly basis.

As can be seen from Chart 6, the 'Tourism'sector accounted for the highest share or 16.4 percent of total credit to private sector at end-June2003. The share of credit to 'Manufacturing' sectorwhich includes the EPZ sector, 'Trade' sector and'Construction' sector stood at 15.4 per cent,14.5 per cent and 13.6 per cent, respectively. Thehigh concentration of advances in these four sectorswhich are very much exposed to macroeconomicfactors calls for a close scrutiny of those sectors bythe Bank of Mauritius.


16

Related Party Transactions

Related parties, comprising mainly subsidiaries,affiliates, major shareholders, executive and non-executive directors and senior executives, have adirect influence on banks' policies and decision-making. Related party lending may, therefore, besubjected to pressure regarding the terms andconditions of the facilities. To guard against suchsituations, the Bank of Mauritius issued a guidelinerequiring all transactions with related parties to becarried out on terms and conditions that are asfavorable to the financial institution as the marketterms and conditions. Banks are also required to setup a Conduct Review Committee from their boardmembers with the responsibility of monitoring andreviewing related party transactions.

Furthermore, the Guideline on PublicDisclosure of Information requires banks to provideaggregated data on their on-and off-balance sheetcredit exposures to related parties relative to thebanks’ exposure to all customers, stating also theproportions. The institution should also indicate theproportion of credit exposure to related parties thathas become non-performing.

Asset Classification

Quality of advances is a determinant factoraffecting the performance of banks. Deterioration of

asset quality not only reduces the earning capacityof banks but also exposes them to the complexity ofhigher risks. Banks are expected to have in place awell-defined procedure relating to credit granting,review and monitoring for the continuousassessment of their asset portfolio for the timelyrecognition of any impairment in assets andappropriate corrective measures.

Asset classification, the grading of assets withrespect to the associated level of credit risk, is yetanother step towards ensuring soundness andsustainability of banks. Although banks have theirown grading system, they are expected to satisfy theminimum requirements laid down in the guidelineissued by the Bank of Mauritius regarding assetclassification. The guideline considers the timeduring which advances remain in arrears as acriterion but, nevertheless, stress is laid oncounterparties' financial condition as the guidingfactor for classification. Banks should regularlyreview their advance portfolio in relation to debtservicing and the counterparties' continuousrepayment capacity.

The level of non-performing advances reflectsthe quality of assets held by banks and ultimatelytheir credit culture. Non-performing advances ofCategory 1 banks increased from Rs6,675 million atend-June 2002 to Rs7,269 million at end-June2003. Expressed as a percentage of total advances,the ratio increased from 8.2 per cent to 8.5 per cent.

Credit classification is also used as anunderlying factor for recognition of interest inbanks' income. Non-performing assets are thoseassets which have stopped generating income.Interest accrued thereon should not be recognisedto the institutions' profits. Proper classification ofassets therefore reflects the integrity of incomefigures.

Allowance for Loan Losses

Allowance for loan losses consists of specificprovision set aside in respect of identified impairedadvances and general provision. The generalprovision is prudential in nature and equivalent tonot less than one per cent of a bank’s standardadvances. Asset classification is used as a basis fordetermining the level of provision which representsa bank's capacity to absorb future loan losses. 17

Table 3 : Provision for Loan Losses by Industry Sector

End-June 2001 End-June 2002 End-June 2003

Non- Non- Non-Specific Specific Specific

performing performing performingProvision Provision Provision

Advances Advances Advances

(Rs million)

Agriculture andFishing 234 42 103 20 96 16

Manufacturing(including EPZ) 2,073 474 2,560 722 2,481 970

Tourism 160 15 202 25 278 30

Transport 50 7 68 17 63 12

Construction 1,169 121 1,171 195 1,680 356

Traders 1,345 364 1,288 378 1,197 431

Financial andBusiness Services 93 7 68 9 146 21

Personal (includingcredit card advances) 606 141 735 150 939 216

Professional(including creditcard advances) 37 2 118 28 58 17

Others 394 45 362 112 331 153

6,161 1,218 6,675 1,656 7,269 2,222

The Guideline on Credit Classification forProvisioning Purposes and Income Recognition setsout the factors to be considered for theestablishment of the level of provisioning in respectof impaired advances. The collectibility of debtwhich is largely dependant on underlyingcollateral, is the major determinant for the level ofprovision. Assessment of collateral could turn out tobe a very subjective exercise when it comes to thestatement of collateral value. The Guidelineaccordingly prescribes conditions in which theassessment of collateral value should be carried out.

Specific provisions for bad and doubtful debtson delinquent advances went up from Rs1,656million at end-June 2002 to Rs2,222 million at end-June 2003. As a proportion of total non-performingadvances, these provisions increased from 24.8 percent to 30.6 per cent.

The Bank of Mauritius also closely monitorsdeterioration of advances by industry sector. Table 3

summarises non-performing advances by industrysector and the relative loan loss provision made inrespect thereof over the period end-June 2001 toend-June 2003.

2.2.2.2 Investments in Securities

This category of assets comprises holdings ofTreasury Bills and Government securities.

Treasury Bills and Government securities, thesecond most important aggregate assets of Category1 banks, are the most easily convertible non-cashliquid assets. Although there is no mandatoryrequirement to maintain non-cash liquid assets,banks are encouraged to maintain their ownthreshold as part of their liquidity risk managementprogram. Such investments, which are risk-free andzero-rated for capital adequacy purposes, alsorepresent a stable source of interest earnings forbanks. The past three years have witnessed anincrease in the share of banks' holdings of Treasury


18

Bills and Government securities in total assets from13.2 per cent at end-June 2001 to 21.5 per cent atend-June 2003. This is mirrored in the decrease ofthe proportion of advances in total assets fallingfrom 63.9 per cent to 55.6 per cent during thisperiod and a corresponding concentration of assetsin the category of claims on government.

During the period end-June 2002 to end-June2003, banks' investments in Treasury Bills andGovernment securities increased substantially byRs10,652 million or 47.3 per cent from Rs22,519million to Rs33,171 million.

2.2.2.3 Balances with Banks

Balances with banks consist of balances onnostro accounts which banks maintain with theircorrespondents, assigned capital of the overseasbranch of one bank, placements with banks abroadand Category 2 banks. Balances with banks, exceptfor those with banks incorporated in Group Bcountries and having a residual maturity exceedingone year, are considered as low risk assets andweighted at 20 per cent for capital adequacypurposes.

Balances with banks registered a 2.6 per centgrowth from Rs8,218 million at end-June 2002 toRs8,432 million at end-June 2003. At end-June2003, balances with banks constituted 5.5 per centof banks' total assets, down from 6.1 per cent atend-June 2002.

2.2.2.4 Investment in Corporate Shares

Investment in corporate shares consistsessentially of investments in equity of subsidiariesand associates and other quoted and unquotedcompanies. Even though these assets contribute tothe profitability of banks, they are not classified asearning assets as these investments do not provide astable and predictable source of income or assetvalue. Banks derive income from investment incorporate shares either in the form of dividendsand/or capital gains. While trading securitiesprovide potential for capital gain, they also exposebanks to higher risk of unfavourable market pricemovements. Section 22(1)(b)(iv) of the Banking Act1988 limits a bank's investments in undertakingswhose objects are other than insurance of deposits

or promotion of the development of a money orsecurities market in Mauritius and economicdevelopment of Mauritius, to 30 per cent of itscapital base.

Investment in equity of other companies whichare among the least liquid assets of banks increasedby Rs751 million, from Rs1,985 million at end-June2002 to Rs2,736 million at end-June 2003, mainlyon account of a change in the accounting policy ofone bank in relation to its equity investments in itssubsidiaries and associates following the adoptionby it of IAS 27 and IAS 28. The bank's investment inits subsidiaries and associates, which waspreviously stated at cost, is now accounted usingthe equity accounting method.

2.2.2.5 Fixed Assets

Fixed assets comprise mainly banks' premisesfrom which they operate, other immovableproperties, vehicles, furniture and equipment. Theseassets, although essential for the operations ofbanks, are not earning assets. Section 22(1)(c) of theBanking Act 1988 limits the purposes of banks'acquisition or purchase of immovable properties toconducting of their operations and housing orproviding amenities for their staff. These assetswhich are considered amongst the least liquidassets of banks, should not be financed bydepositors' money but instead out of banks' capitaland reserves. Banks' capital being a buffer againstpotential losses, cannot be tightly tied up inunnecessary fixed assets. An analysis of the ratio offixed assets to core capital gives an insight of theamount of capital tied up in such assets. Somejurisdictions set a limit to the ratio of fixed assets tocore capital. The ratio stood at 63.4 per cent at end-June 2003, up from 60.0 per cent a year earlier.

Some banks acquire immovable propertiesduring the course of realisation of collateral heldagainst advances. Banks are expected to dispose ofsuch assets within a reasonable delay, as stipulatedin section 22(2) of the Banking Act 1988, to preventthem from indulging in speculative transactionsthus exposing themselves to undue market risk.Lack of marketability of such assets also results inbanks’ funds being tied up and hinders their smoothoperations. 19

The ratio of fixed assets to total assets gives anindication of the amount of banks' funds tied innon-earning assets. The ratio fell from 5.7 per centat end-June 2002 to 5.3 per cent at end-June 2003.

2.2.2.6 Cash Reserves

Cash reserves consist of cash in hand andbalance with Bank of Mauritius. They are the mostliquid assets held by banks and are classified as riskfree assets for capital adequacy purposes. Cashreserves act as a buffer against balance sheetfluctuations and also serve as a monetary tool asthey are used to control the amount of money bankscan lend. Category 1 banks are required to maintaina minimum cash ratio equivalent to 5.5 per cent oftheir deposit liabilities inclusive of foreign currencydeposits, averaged on a weekly basis.

The monthly average cash ratio maintained byCategory 1 banks in 2002-03 ranged from 5.6 percent to 6.1 per cent compared to a monthly averagecash ratio varying between 5.6 per cent and 5.9 percent in 2001-02.

2.3 MANAGEMENT

The quality of management is one of the mostimportant elements in the successful operation of abank. The financial soundness and performance ofa bank depend largely on the quality of both themanagement team and the directors’ oversight ofthe bank. Global experience has shown thatbanking failures are more to be attributed to poorquality of management than to economic andfinancial crises. Hence, the experience, capability,judgement and integrity of both its seniorexecutives and board of directors are sine qua nonconditions for the success of a bank.

To that effect, the Banking Act 1988 lays muchemphasis on the necessity for banks’ directors tohave the skills, knowledge and experience toenable them to perform their duties effectively andefficiently. Section 3(4) stipulates that no licenceshall be granted by the central bank unless it issatisfied as to the technical knowledge andexperience of the applicant. The Bank’s Guidelineon Corporate Governance outlines the benefits for afinancial institution to have some board memberswho possess demonstrated expertise and

experience relevant to the principal issues that facea bank, such as matters relating to financialcontrols, capital management, banking risks andcorporate planning. Section 30 of the Actfurthermore insists on the probity and competenceof any person who is to be appointed as the ChiefExecutive Officer of a bank. In accordance withsection 31 of the Act, a director, a chief executiveofficer, a manager or any officer concerned with themanagement of a bank is disqualified to hold officeif he is convicted of an offence involving fraud orother dishonesty. Both the bank’s directors and theexecutive management must consequently adhereto high ethical standards and be fit and proper toserve. A Guidance Note on Fit and Proper Criteriahas already been issued by the Bank of Mauritius.The objective of the Guidance Note is to set aframework for fit and proper criteria to be observedby regulated institutions when appointing officers atthe senior management level. The integrity andcompetence of senior management are vitalconditions for a strong and sound institution.

The responsibility of the board is clearly speltout in the Bank’s Guideline on CorporateGovernance where it is stressed that the board isultimately responsible for the financial soundness ofthe bank though it can entrust the management ofthe day-to-day operations of the bank tomanagement. The same guideline sets out a cleardelineation of responsibilities of the board andmanagement in the interest of an effectiveaccountability regime. While management isaccountable to the board for day-to-dayadministration of the business and for theperformance of the bank, it is the board which isanswerable to shareholders for the safeguarding oftheir interests through the lawful, informed, efficientand able administration of the institution.

Transparency of information relating to existingconditions, decisions and actions enables marketparticipants to judge the efficiency of managementof a bank. It is difficult to assess the actions andperformance of the board of directors and seniormanagement when there is a lack of transparency.This happens in situations where the stakeholders,market participants and general public do notreceive sufficient information on the structure,objectives and performance of the bank with which


20

to judge the effectiveness of the board and seniormanagement in governing the bank. The Guidelineon Public Disclosure of Information has been issuedwith a view to enhancing market discipline throughcomprehensive, meaningful and accurateinformation provided in a timely manner to marketparticipants. The Guideline on CorporateGovernance also requires the board of directors toensure that the bank is satisfying its disclosureobligations and that the information disseminated istrue and accurate. According to the same guideline,every bank is requested to disclose on an annualbasis its approach to corporate governance.Transparency is also dealt with in the Guideline onRelated Party Transactions which makes it anobligation for a related party as defined in theguideline to disclose his interests or relationships tothe institution in a proactive manner. The sameobligation of disclosure of interests applies in thecase of a director of a bank at section 32(1) of theBanking Act. A director of a bank who is interestedin an advance, loan or credit facility from the bankhas the duty to declare the nature of his interest tothe board of directors of the bank before suchfacility is sanctioned by the Board in the absence ofthe interested director.

The ability of the board to make independentdecisions flexibly and effectively, its self-government and independence from executivemanagement are also indicative of a soundadministration. The Guideline on CorporateGovernance emphasises the importance for theboard to function independently of management. Inthis respect, the board should set up the appropriatestructure to reflect its independence. An adequatenumber of independent directors should form partof the board. A governance committee emanatingfrom the board should be constituted to manage theprocesses of the board in view of ensuring itsindependence from management. One of theprocesses would involve the holding of boardmeetings which would not be attended by membersof management. The ultimate objective is to createthe public perception that the board is independentand operates at a level higher than management.Section 30(2) of the Banking Act safeguards theindependence of not only the chief executive officerof a bank but also the board of directors against anyexternal influence which, if exercised, may bedetrimental to the interests of depositors.

Risk taking is an integral part of the bankingbusiness. As the environment in which financialinstitutions are evolving is becoming more complexand fast-paced, risk management should grow insophistication. The soundness of a financialinstitution depends on the aptitude of managementto establish an all-inclusive risk management policy,system and process for identifying, monitoring andcontrolling different types of risks. The Guideline onCorporate Governance emphasises the importancefor the board to ensure that the risk managementpolicies proposed by management are adequateand effective enough to strike a prudential balancebetween the risks and potential returns toshareholders. In order to fulfill this responsibility,the board should be very familiar with all the risksinvolved in banking activities. If it deems itnecessary, the board can even have recourse toprofessional support from outside the bank. Adedicated risk management committee can also beset up to appraise the adequacy of risk managementpolicies and systems.

Risk management cannot be effective within aninstitution if the basics of internal control areignored. In many of the recent corporate failuresthat have received public attention, basic principlesof internal control, particularly those pertaining tooperating risks, were not followed. Recent eventsshould remind boards of directors, managements,and auditors that internal controls and soundgovernance become even more important whenbanks' operations move into higher risk areas. TheGuidance Note on General Principles forMaintenance of Accounting and Other Records andInternal Control Systems stipulates that the internalcontrol systems of an institution should providereasonable assurance regarding the achievement ofthe effectiveness and efficiency of operations, thereliability of financial reporting and compliancewith applicable laws and regulations. Directors andmanagement are responsible for regularly assessing,monitoring and testing the institutions’ internalcontrol systems in order to warrant for theireffectiveness, efficiency, and their ongoingrelevance to the business. Internal auditors shouldconduct a regular review of the internal controlsystems. In accordance with the Guidance Note,the banks’ external auditors are also expectedto express their opinion on the effectiveness ofthe internal control systems. The Guideline on 21

Table 4 : Category 1 Banks - Consolidated Profit Performance

2000/01 2001/02 2002/03

(Rs million)

Interest Income from Advances 8,010 7,958 8,076

Interest Income from Investment in Treasury Bills andGovernment securities 1,858 1,730 2,184

Other interest income 406 405 312

Less: Interest Expense on Deposits 6,710 6,083 6,111

Other Interest Expense 215 329 260

Net Interest Income 3,349 3,681 4,201

Add: Non-interest income 2,022 1,927 2,104

Operating Income 5,371 5,608 6,305

Less: Staff Costs 1,222 1,275 1,350

Other Operating Expenses 1,321 1,287 1,602

Operating Profit before Bad and Doubtful Debts and Taxation 2,828 3,046 3,353

Less: Charge for Bad and Doubtful Debts 407 685 903

Exceptional Items 21 6 37

Operating Profit 2,400 2,355 2,413

Share of profits in subsidiaries and associates – 184 201

Profit before Tax 2,400 2,539 2,614


22

Transactions or Conditions respecting Well-Being ofa Financial Institution Reportable by the ExternalAuditor to the Bank of Mauritius underlines theheavy reliance placed on the work carried out byexternal auditors. The guideline elaborates on thereporting requirements of external auditors as laidout in section 25(11) of the Banking Act 1988 andsets out the broad categories of reportabletransactions or conditions that may affect the well-being of financial institutions, amongst whichtransactions which indicate that the financialinstitution has significant weaknesses in its internalcontrol and management processes that render itvulnerable to material risks and exposures. TheBank of Mauritius is empowered under section26(12) of the Banking Act to arrange trilateralmeetings with each bank and its external auditor todiscuss matters of supervisory concerns. These legalprovisions result in the convergence of interests ofthe external auditor and the supervisor who mustmonitor the present and future viability of thefinancial institution.

In keeping with the objective of maintaining asafe and sound financial system, the Banking Act(sections 26 and 27) confers powers on the centralbank to carry out regular inspections and

examinations of banks. Section 29(3) empowers thecentral bank to take appropriate actions in line withmatters of supervisory concerns highlighted duringan inspection or an examination.

The Bank of Mauritius has set up a BankingCommittee under the chairmanship of the Governorand comprising the chief executive officers of allbanks. This committee acts as a consultative forumon financial sector issues with the overall objectiveof enhancing the efficient functioning of thebanking system.

The need for alertness, initiation of timelycorrective action and ongoing consultation amongall interested parties cannot be overemphasized.

2.4 PROFITABILITY

Earnings represent a key source of fund forinternal capital growth and affect banks’ ability toraise external capital. They also provide a buffer forabsorbing losses.

However, the level of earnings in itself does notgive an insight of the risks taken by banks. Highprofits, though desirable, must be interpreted withcaution. Banks are profit-making institutions and

may indulge in excessive risk taking to achieve highprofitability. Supervisors expect banks to strike abalance between risks and rewards to ensurequality and stability of earnings.

The profitability figures are based on the auditedresults of the banks for the financial years ended30 June, 31 December and 31 March. Category 1banks posted an overall pre-tax profit of Rs2,614million in 2002/03 as compared to Rs2,539 millionin 2001/02.

The profit performance of Category 1 banks overthe past three years is summarised in Table 4 whileCharts 7 and 8 compare the main components ofincome and expenses, respectively, for the periods2001/02 and 2002/03.

2.4.1 IncomeTotal income of Category 1 banks increased by

Rs656 million during the year under review to standat Rs12,676 million. Both interest income and non-interest income were higher than in the previousyear. Category 1 banks continued to channel themajor part of their resources into advances andinvestment in Treasury Bills and Governmentsecurities. Interest income derived from thesesources accounted for an average of80 per cent of the total income of Category 1 banksthrough the years 1998/99 to 2002/03.

Table 5 compares the growth rate of interest tonon-interest income over the past three years.During the year 2002/03, interest income increasedby Rs479 million while non-interest income grewby Rs177 million.

Table 5: Category 1 Banks - Growth in Interest Income v/s Growth in Non-Interest Income

2000/01 2001/02 2002/03

Growth in Interest Income (%) 13.7 -1.8 4.7

Growth in Non-interest Income (%) 19.1 -4.7 9.2 23

The impact of the various components ofincome on operating profit over the past five yearsis displayed in Chart 9.

2.4.2 Net Interest Income

Chart 10 shows the increasing trend in netinterest income for Category 1 banks from 1998/99through 2002/03. Advances remained the mainsource of interest income for Category 1 banks withthe interest received thereon growing by Rs118million during the year under review. However, aslight shift in the composition of interest incomewas observed with the income from investment inTreasury Bills and Government securities

component rising from 17.1 per cent to 20.7 percent while the interest income contribution fromadvances fell by 2.4 percentage points to 76.4 percent. The growth rate in the main components ofinterest income of Category 1 banks is given inTable 6.

Interest expense fell by 0.6 per cent fromRs6,412 million in 2001/02 to Rs6,371 million in 2002/03. Interest expense on deposits went up byRs28 million as opposed to a decrease of Rs66million observed in the cost of borrowings fromother banks. The combined effect of the fall ofRs41 million in interest expense and the increase of

Table 6 : Category 1 Banks - Growth in Interest on Advances v/s Growth in Interest on Treasury Bills andGovernment Securities

2000/01 2001/02 2002/03

Growth in Interest on Advances (%) 12.5 -0.6 1.5

Growth in Interest on Treasury Bills andGovernment Securities (%) 19.5 -6.9 26.2

Table 7 : Category 1 Banks - Interest Spread

2000/01 2001/02 2002/03Rs

Interest earned on Rs100 of Advances 11.90 10.97 9.97

Cost per Rs100 of Deposits 8.05 7.02 6.23

Interest Spread 3.85 3.95 3.74


24

Rs479 million in interest income resulted in anoverall increase of Rs520 million in net interestincome of Category 1 banks in 2002/03 comparedto a lower growth of Rs332 million in 2001/02.

As can be seen from Table 7, interest earned onRs100 of advances and the cost per Rs100 ofdeposits fell by Re1.00 and Re0.79, respectively,during the year under review. As a result, theinterest spread fell by Re0.21 during the year.

2.4.3 Non-interest Income

Total non-interest income rose from Rs1,927million in 2001/02 to Rs2,104 million in 2002/03.Net fees and commissions and profit from dealingin foreign currencies remained the majorcomponents of non-interest income, and togetheraccounted for 87.2 per cent thereof in 2002/03.

2.4.4 Non-interest Expenses

Non-interest expenses, comprising staff costsand other operating expenses, stood at Rs2,952million in 2002/03, up from Rs2,562 million in2001/02.

Staff costs maintained an upward trend andincreased from Rs1,275 million in 2001/02 toRs1,350 million in 2002/03, representing a growthof 5.9 per cent.

Other operating expenses also rose sharply fromRs1,287 million in 2001/02 to Rs1,602 million in2002/03 as banks continued to invest in state-of-the-art technologies with a view to improvingservices to their customers.

The cost to income ratio, that is, the ratio of staffcosts and other operating expenses to grossoperating income (net of charge for bad anddoubtful debts), went up from 52.0 per cent in2001/02 to 54.7 per cent in 2002/03.

2.4.5 Operating Profit

Category 1 banks realised operating profitbefore bad and doubtful debts of Rs3,353 millionfor 2002/03, representing an increase of Rs307million or 10.1 per cent over the figures of 2001/02.The increase of Rs307 million was, however, partlyabsorbed by an additional charge of Rs218 million

in respect of bad and doubtful debts. Category 1banks together achieved operating profit beforetax amounting to Rs2,413 million in 2002/03,Rs58 million higher than Rs2,355 million realisedin 2001/02.

2.4.6 Return on Average Assets and Equity

Return on average assets and return on equityare important indicators of a bank’s profitability.They give useful insight as to whether a bank ismaking optimum use of available resources andalso reflect the quality of management.

Return on average assets dropped from 2.26 percent in 2001/02 to 2.04 in 2002/03 partly due to alarger asset base of Category 1 banks. Individualbanks’ return on average assets in 2002/03 rangedfrom negative 2.56 per cent to 3.20 per cent,compared to a range of negative 2.06 per cent to3.33 per cent in 2001/02. Two Category 1 banksrecorded negative returns on account of significantadditional provisions made for bad and doubtfuldebts, while three banks achieved ratios above2 per cent.

The return on equity must be analysed inrelation to profitability and capitalisation. A highratio may indicate high profitability as well as a lowcapitalisation while a low ratio can mean lowprofitability as well as high capitalisation.

Return on equity dropped from 17.5 per cent in2001/02 to 15.7 per cent in 2002/03. Such returnfor individual banks ranged from negative 25.9 percent to 20.5 per cent in 2002/03, compared tonegative 21.1 per cent to 24.3 per cent in 2001/02,with four banks achieving ratios of over 15 per cent.

Chart 11 reflects the evolution of banks' profitfor the years 1998/99 through 2002/03 whileChart 12 shows the variations in returns on averageassets and equity for the same period.

2.5 LIQUIDITY

Liquidity refers to the ability of banks to fundincreases in assets and meet their obligations asthey fall due. Shortfalls in liquidity and protractedfailure of banks to accommodate expected andunexpected fluctuations in their balance sheet arelikely to impact on their earnings, depositors’ 25

confidence in them and ultimately their solvency.Banks are therefore required to adopt a soundliquidity management framework. The liquiditymanagement framework should include, amongothers, a strategy for the ongoing management,measurement and monitoring of net fundingrequirements with a view to reducing liquidity risk,and the development of contingency plans forliquidity crises.

The level of liquidity risk of the individual banksis evaluated on a continuous basis by assessing theirdegree of compliance with the statutory cash ratiorequirement, the composition of their assets andliabilities, the marketability of their assets and on-site review of their liquidity management processesin place. As from June 2000, banks are required tosubmit a status report on their liquidity policy everysix months, based on the framework prescribed inthe Guideline on Liquidity. The adequacy andeffective implementation of the policy is monitoredby the Bank of Mauritius.

2.5.1 Cash Ratio

Category 1 banks in Mauritius are required tomaintain a minimum weekly average cash reserveconsisting of cash in hand and balance with Bank ofMauritius, of 5.5 per cent with respect to their totaldeposit liabilities inclusive of foreign currencydeposits. The degree of compliance with theprescribed limit gives an indication of the liquidityposition of individual Category 1 banks and

management’s effectiveness in forecasting its cashflows.

The monthly average cash ratio maintained byCategory 1 banks in 2002-03 ranged from 5.6 percent to 6.1 per cent as compared to a monthlyaverage cash ratio varying between 5.6 per cent and5.9 per cent in 2001-02. The fluctuations in themonthly average cash holdings of banks against theregulatory limit over the last year is depicted inChart 13.


26

2.5.2 Non-Cash Liquid Assets Ratio

There is no mandatory requirement for themaintenance of non-cash liquid assets but banksare advised to establish their own thresholds forcontrolling liquidity as part of prudentialmanagement.

Investment in Treasury Bills and Governmentsecurities represents the most readily liquifiablenon-cash assets available to banks. Suchinvestments expressed as a percentage of totaldeposits went up from 21.7 per cent as at end-June2002 to 28.6 per cent as at end-June 2003, as banksdirected a higher proportion of their funds towardsthose risk-free assets. During the year under review,Category 1 banks’ holdings of Treasury Bills andGovernment securities posted a 47.3 per centincrease to stand at Rs33,171 million or 21.5 percent of total assets at end-June 2003, as comparedto 16.7 per cent a year earlier.

2.5.3 Deposits

Deposits constitute the primary source offunding of Category 1 banks, comprising thehighest proportion of banks’ total liabilities and thusare a key factor in liquidity management. Thestructure and stability of deposit base are of primeimportance as liquidity issues can also stem from alarger-than-normal reliance on short-term non-coredeposits.

At end-June 2003, deposits accounted for74.9 per cent of total resources of Category 1 banks,

down from 77.1 per cent at end-June 2002. Duringthe year under review, total deposits went up by11.6 per cent, as against a 12.8 per cent growth inthe previous year, rising from Rs103,773 million toRs115,823 million. Savings and time depositstogether made up for Rs9,752 million of the totalincrease of Rs12,050 million.

As may be seen from Table 8, savings and timedeposits remained the major components of thedeposit mix and represented around 86 per cent oftotal deposits over the past three years. However,the proportion of term deposits in total depositsshowed a gradual decline during that periodfollowing higher growth rate in demand deposits.The foreign currency deposit component accountedfor 12.3 per cent of total deposits at end-June 2003as compared to 12.5 per cent at end-June 2002.

Concentration of Deposits

A high concentration of deposits from a fewcustomers may expose banks to liquidity risk asunexpected withdrawal of bulk deposits may erodebanks’ deposit base and destabilise their liquidityposition.

Table 9 reflects the degree of concentration ofbanking sector’s deposits according to their valuerange as at end-June 2003. It may be observedtherefrom that the banks’ deposit base comprisedlargely of low value range accounts thus providingthe banking sector with a cushion against potentialerosion through abrupt withdrawals from large

Table 8 : Deposit Structure

End of June2001 2002 2003

(Rs million)

Demand 12,041 13,617 15,915

(13.1) (13.1) (13.8)

Savings 39,221 46,528 51,573

(42.6) (44.9) (44.5)

Time 40,734 43,628 48,335

(44.3) (42.0) (41.7)

91,996 103,773 115,823

(100.0) (100.0) (100.0)

Figures in brackets are percentages to total27


deposit accounts. Moreover, the main source ofdeposits remained ‘Personal’ deposits. Thesedeposits, which dissipate withdrawal risk associatedwith corporate deposits, averaged 70 per cent oftotal deposits over the period.

Maturity of Time Deposits

Maturity of time deposits is relevant for financialstability from a liquidity viewpoint as it gives thevalue of liabilities falling due in the short-term andthus an indication to banks of their liquidity needsfor that period.

Time deposits inclusive of foreign currencydeposits represented 42 per cent of total deposits atend-June 2003 and had a wide-ranging maturityfrom 7 days’ notice to over 48 months. The maturityconfiguration of time deposits given in Table 10points to a slightly higher liquidity risk profile. As atend-June 2003, fixed deposits maturing within 12months represented 54.9 per cent of the total termdeposits compared to 52.2 per cent a year earlier.

Advances/Deposits Ratio

Advances to deposits ratio, which describes theextent to which banks’ lending has been financedfrom their deposits, is an important indicator of

liquidity management by banks. The advanceportfolio carries an element of liquidity risk, bothfrom the fact that it is amongst the least liquid ofassets and that the level of non-performing loanstherein will entail lower cash inflow than forecast.The ratio showed a gradual decline from 82.2 percent at end-June 2001 to 78.3 per cent at end-June2002 and further down to 74.2 per cent at end-June2003. This partly reflects the general slowdown indemand for credit, which impelled banks to investtheir excess funds in Treasury Bills and Governmentsecurities.

2.5.4 Interbank Transactions

An important aspect of liquidity managemententails banks’ access to funding options andreliance on those lines of funding to bridge short-term fluctuations in their resources. Interbankmarket operations provide for an efficientchannelling of liquidity from banks with excesscash to banks in liquidity needs through short termlending and borrowings and also give an indicationof the liquidity position of individual banks.Depending on the seriousness of the liquidityproblems, Category 1 banks may resort torepurchase transactions or to the Lombard facilitywhich is a stand-by overnight facility provided bythe Bank of Mauritius.

bTable 9 : Value Range of Deposits

End of June 2003

No of Accounts Amount Percentage of(Rs million) Total Deposits

Up to Rs1 million 1,623,696 66,224 57.2

Over Rs2 million to Rs5 million 11,917 22,371 19.3

Over Rs5 million 1,426 27,228 23.5

Table 10: Maturity Structure of Time Deposits

June - 2002 June - 2003

Amount % of Time Amount % of Time(Rs million) Deposits (Rs million) Deposits

Up to 12 months 22,759 52.2 26,506 54.9

Over 12 months to 48 months 16,178 37.1 16,305 33.7

Over 48 months 4,691 10.7 5,524 11.4

43,628 100.0 48,335 100.0

28

The daily average funds transacted on theinterbank market increased from Rs195 million in2001-02 to Rs213 million in 2002-03 and variedbetween Rs80 million and Rs580 million during theyear under review.

In order to effectively manage and monitortheir net funding requirements, banks should havein place an adequate management informationsystem, which provides timely and accurateinformation to the Board of Directors and seniormanagement. In addition, banks should also beaware of any information that could impact onpublic perceptions about their soundness. With aview to enhancing market discipline, the Guidelineon Public Disclosure, which has become effectiveas from 3 January 2003, requires banks to makeinformation publicly available on the risks related totheir activities, including among others, liquidityrisk.

2.6 ELECTRONIC BANKING TRANSACTIONS

Electronic banking services are presently beingprovided by six Category 1 banks. Transactionsusing electronic delivery channels recordedconsiderable growth during the past years,

crowning principally during the month ofDecember. Between end-June 2002 and end-June2003, the number of Automated Teller Machines(ATMs) in operation in Mauritius, inclusive ofRodrigues, increased by 15 from 242 to 257 and thenumber of cards in circulation went up by 102,807from 750,260 to 853,067. The number of creditcards and debit cards in circulation grew by 6.5 percent and 15.6 per cent, respectively.

The number of transactions involving the use ofcredit and debit cards at ATMs and Merchant Pointsof Sale increased from a monthly average of 1.8million for a monthly average amount of Rs2,853million in 2001-02 to a monthly average of2.0 million for a monthly average amount ofRs3,290 million in 2002-03.

At the end of June 2003, outstanding advanceson 164,030 credit cards in circulation amounted toRs807 million, indicating an average outstandingamount of Rs4,920 per card.

Table 11 shows the quarterly positions ofCategory 1 banks’ electronic banking transactionsfrom end-June 2002 to end-June 2003.

Table 11: Electronic Banking Transactions

Jun-02 Sep-02 Dec-02 Mar-03 Jun-03

At end of MonthNo. of ATMs in Operation 242 255 261 258 257

During the MonthNo. of Transactions 1,706,705 1,964,339 2,534,785 2,115,284 2,134,469

Value of transactions (Rs mn)(Involving the use of Credit Cardsand Debit Cards at ATMs andMerchant Points of Sale) 2,594 3,065 4,572 3,418 3,384

At end of MonthNo of Cards in Circulation

Credit Cards 154,063 156,658 159,674 161,034 164,030

Debit Cards and others 596,197 630,809 650,037 663,649 689,037

Total 750,260 787,467 809,711 824,683 853,067

At end of MonthOutstanding Advances onCredit Cards (Rs mn) 732 776 827 763 807 29


2.7 PERFORMANCE OF CATEGORY 2 BANKS

From the very outset, the objective ofGovernment of Mauritius has been to promoteMauritius as a reputable financial centre. Hence,section 14(4)(b) of the Banking Act 1988 whichembodies the legal framework for Category 2banks, requires Category 2 banks to be branches orrelated corporations of foreign banks of establishedreputation or banks incorporated locally. The Bankof Mauritius, the licensing authority as empoweredby the Bank of Mauritius Act and the Banking Act1988, has a policy of quality versus quantity and isvery selective in the granting of licence. Only bankshaving a physical presence in Mauritius andmeeting the licensing criteria laid down in section 3of the Banking Act have been granted a Category 2Banking Licence.

The Bank of Mauritius, with a view to preservingthe reputation of Mauritius as a soundly regulatedfinancial centre, continuously improves itsregulatory and supervisory framework in order tomeet international standards. The activities ofCategory 2 banks are closely monitored throughboth off-site surveillance and on-site inspections.Category 2 banks are subject to the same level ofstrict regulations as Category 1 banks. As part of itscontinuous programme of consolidating itssupervisory and regulatory framework, the Bank ofMauritius issued, during the year under review, twoguidelines which were addressed to both Category1 banks and Category 2 banks. With a view tofostering more transparency and market discipline,a Guideline on Public Disclosure, which becameeffective on 3 January 2003, requires banks toprepare and publicise quarterly comprehensivereports on their financial condition andperformance. A Guideline on Transactions orConditions respecting Well-Being of a FinancialInstitution Reportable by the External Auditor to theBank of Mauritius, effective 24 February 2003,requires external auditors to report to the Bank ofMauritius transactions or conditions that may affectthe well-being of banks.

The Mauritian authorities have committedthemselves to combat money laundering andfinancing of terrorism. Without proper checks, thewide array of services provided by Category 2 banksincreases their exposure to money laundering. InNovember 2003, the Bank of Mauritius issuedGuidance Notes on Anti-Money Laundering and

Combating the Financing of Terrorism, inreplacement of the previous Guidance Notes onAnti-Money Laundering issued in 2001, whichrequire Category 2 banks to have in place 'KnowYour Customer' procedures for proper monitoring ofcustomer activities. The Bank of Mauritius keeps aclose watch on banks’ cash transactions reported ona monthly basis. Transactions other than moneymarket operations are also monitored for anysuspicious fund movement in and out of thecountry. Category 2 banks are also subject to theprovisions of the Financial Intelligence and Anti-Money Laundering Act 2002 and Prevention ofTerrorism Act 2002 and have to report suspicioustransactions to the Financial Intelligence Unit.

Asset protection and asset growth are among themain objectives of many high networth individualswho are in quest of places of business which allowflow of funds free from exchange controlrestrictions and provide tax planning opportunities.Mauritius offers an attractive destination with itsnetwork of double taxation avoidance treatiessigned with 26 countries. Tax planningopportunities supported by modern communicationfacilities and availability of highly professionalservices are the underpinning factors responsiblefor the success of the Global Business sector. Thepromotion of Mauritius as a cyber island with thepotentials of a high standard back-officeadministration centre and business processoutsourcing possibilities paves the way for furtherdevelopment of this sector.

2.7.1 ASSETS

The activities of Category 2 banks show acommendable improvement during the year underreview in spite of a sluggish international market.The overall asset base of these banks grew byUSD369 million or 8.5 per cent from USD4,320million at end-June 2002 to USD4,689 million atend-June 2003 compared to a higher growth rate of14.0 per cent recorded in the previous year.

Placements with banks and loans and advancesto non-bank customers are the main earning assetsof Category 2 banks. At end-June 2003, 94 per centof total resources of Category 2 banks weredeployed in these two assets. The growing demand forcredit by non-bank customers over the past fouryears has resulted in a major change in Category 2 30

banks' asset structure as can be seen in Chart 14.Placements with banks, which made up 60 per centof total assets at end-June 2000, held a proportionof only 43 per cent at end-June 2003.

2.7.1.1 Placements with Banks

Placements with head office, parent bank,subsidiaries, fellow subsidiaries and other banksconstituted 43.1 per cent of their total assets at end-June 2003, compared to 47.9 per cent a year earlierand are banks' second largest assets.

Placements with banks decreased by USD52million or 2.5 per cent from USD2,071 million atend-June 2002 to USD2,019 million at end-June2003.

2.7.1.2 Advances to Non-Bank Customers

At end-June 2003, advances to non-bankcustomers constituted 51.1 per cent of total assets ofCategory 2 banks compared to 47.0 per cent a yearearlier and were the banks' main earning assets.Advances to non-bank customers grew by USD374million, or 18.5 per cent, from USD2,024 million atend-June 2002 to USD2,398 million at end-June2003, compared to a more significant growth ofUSD531 million or 35.6 per cent during thepreceding year.

At end-June 2003, an 81.2 per cent share of totaladvances of Category 2 banks was granted toresidents outside Mauritius compared to 87.0 percent a year earlier. Lending to Global Businesscompanies domiciled in Mauritius doubled duringthe year to USD341 million and accounted for14.2 per cent of Category 2 banks’ total advances atend-June 2003, up from 8.4 per cent a year earlier.Advances to residents in Mauritius grew by 17.1 percent, from USD94 million at end-June 2002 toUSD110 million at end-June 2003, with itsproportion in total advances remaining unchangedat 4.6 per cent. These facilities are mainly extendedto certain public sector enterprises.

2.7.1.3 Investments

During the year under review, Category 2 banks’investments comprising mainly investments inbonds outside Mauritius picked up by USD53million or 29.0 per cent from USD183 million atend-June 2002 to USD236 million at end-June2003. The share of investments in total assets stoodat 5.0 per cent at end-June 2003 as compared to4.2 per cent at end-June 2002.

2.7.2 FUNDING

Category 2 banks continued to raise the bulk oftheir funds by way of deposits from non-bankcustomers and borrowings from banks whichtogether made up 86.7 per cent of their totalresources at end-June 2003. Deposits from non-bank customers accounted for 41.3 per cent of totalresources of Category 2 banks, down from 50.6 percent at end-June 2002 while the proportion ofborrowings from banks in total resources increasedfrom 38.4 per cent to 45.4 per cent. However,during the year ended 30 June 2003, banks reliedmore on deposits from non-bank depositors ratherthan borrowings from banks for financing theiractivities. This is reflected by the higher averagemonthly non-bank deposits of USD2,032 millionreported by banks compared to the averagemonthly borrowing figure of USD1,801 million. Thecorresponding figures for the preceding year stoodat USD1,750 million and USD1,642 million,respectively. 31

2.7.2.1 Non-Bank Deposits

Total deposits from non-bank customers showeda drop of USD250 million or 11.4 per cent fromUSD2,187 million at end-June 2002 to USD1,937million at end-June 2003 as compared to a rise ofUSD552 million or 33.8 per cent in the precedingyear. Fixed deposits constituting 65.2 per cent oftotal deposits at end-June 2003, dropped byUSD212 million and accounted for 84.8 per cent ofthe total decrease in deposits in 2002-03.

2.7.2.2 Borrowings from InternationalMoney Market

Borrowings from the international moneymarket by Category 2 banks recorded a significant28.3 per cent rise from USD1,658 million at end-June 2002 to USD2,127 million at end-June 2003compared to a lesser growth of USD8 million in thepreceding year.

Funds borrowed from outside Mauritiusaccounted for 98.6 per cent of total borrowings.During the year under review, Category 2 bankscontinued to rely mainly on their head office,parent bank, subsidiaries and fellow subsidiaries fortheir borrowings and at end-June 2003, 87.4 percent of their total borrowings emanated from thesesources. However, a marked increase of USD126million to USD239 million, was registered inborrowings from other banks outside Mauritiuswhile borrowings from banks in Mauritius droppedfrom USD48 million to USD28 million.

2.7.3 LIQUIDITY

Liquidity risk arises when banks cannot raiseadequate funds at a reasonable cost to meet theirforeseeable and unforeseeable commitments. Thisrisk by itself can have immediate consequences onthe financial health of banks. Banks' inability tomeet their commitments may cause reputationaldamage which may result into massive erosion andeventual failure.

Since Category 2 banks do not impact directlyon the domestic money supply and are not subjectto maintenance of a minimum cash reserve ratio in

relation to their deposit base, the Bank of Mauritiusexercises close scrutiny on banks' maturity patterntransformation on a monthly basis. The fact thatCategory 2 banks undertake the bulk of theiractivities on short-term rollover basis except forsome specific long-term borrowings toward lendingof equal maturities reduces the risk of majormaturity mismatch and potential liquidity crisis.

The Guideline on Liquidity requires Category 2banks to establish and implement prudent liquiditymanagement policies providing for measures andcontrols for their funding requirements. Banks arealso required to submit, every six months, a reporton the status on their liquidity policy and theimplementation thereof.

2.7.4 PROFITABILITY

Nine Category 2 banks close their accountson 31 December and the remaining three on31 March. The consolidated position of profit andloss accounts of the twelve Category 2 banks basedon the combined data at these different financialyear-ends is referred to as 2002/03. Eleven Category2 banks recorded net profits while one bank whichhas virtually ceased operation and was yet tosurrender its banking licence as at 30 June 2003,incurred a loss.

Aggregate net pre-tax profits of Category 2banks dropped substantially from USD98.0 millionin 2001/02 to USD55.0 million in 2002/03. Thisdecline was mainly attributable to a significantreduction registered by one major bank in the profitfrom translation of foreign currencies andsubstantial additional provision for bad anddoubtful debts made by banks in 2002/03.Individually, the banks' profits ranged fromUSD0.03 million to USD29.7 million in 2002/03compared to a range of USD0.2 million toUSD61.8 million in 2001/02.

Table 12 gives the profit performance ofCategory 2 banks from 2000/01 to 2002/03.

Chart 15 shows net profits of Category 2 banksin relation to their total funds for the years endedDecember 1995 through 2001/02.


32

2.7.4.1 Net Interest Income

Despite a rise in total assets, net interest incomecontinued to decline for the second consecutiveyear and registered a drop of USD4.6 million or7.1 per cent, from USD64.8 million in 2001/02 toUSD60.2 million in 2002/03 as compared to a fallof USD14.8 million in the previous year. Category 2banks operate in an environment of globalcompetition and are faced with a narrowingoperating margin.

Total interest earnings maintained a downwardpath reflecting the general trend of falling interestrates on the international market. During the year2002/03, interest income decreased by a lesseramount of USD24.1 million or 11.1 per centcompared to USD68.1 million or 23.9 per cent inthe preceding year. However, the proportion ofinterest income in total income picked up from82.5 per cent in 2001/02 to 91.5 per cent in2002/03 on account of a higher percentage fall innon-interest income.

Table 12: Category 2 Banks - Profit Performance

2000/01 2001/02 2002/03

(USD million)

Interest Income 284.7 216.6 192.5

Less Interest Expense on Deposits & Borrowings 205.1 151.8 132.3

Net Interest Income 79.6 64.8 60.2

Add Non-interest Income 34.4 46.0 17.8

Operating Income 114.0 110.8 78.0

Less Total Operating Costs 8.9 10.0 10.5

Staff Expenses 3.1 3.7 3.8

Provision for Depreciation 0.4 - -

Other Expenses 5.4 6.3 6.7

Operating Profit 105.1 100.8 67.5

Less Charge for Bad and Doubtful Debts 8.5 2.8 12.5

Net Profit 96.6 98.0 55.0

Interest Income as a Percentage of Total Income

(Per cent) 89.2 82.5 91.5

Cost to Income Ratio (Per cent) 8.4 9.3 16.0

Return on Average Assets (Per cent) 2.7 2.6 1.5

Return on Equity (Per cent) 32.2 40.7 21.5

33

Placements with banks and advances to non-bank customers continued to be the main interestearning assets of Category 2 banks and togethercontributed 85.6 per cent of banks' total incomecompared to the lower proportion of 79.5 per centin 2001/02. The share of interest from placementswith banks in total interest earnings fell further by9.9 percentage point to 41.2 per cent in 2002/03after a decline from 58.4 per cent in 2000/01 to51.1 per cent in 2001/02. Earnings fromplacements dropped substantially from USD110.7million in 2001/02 to USD79.4 million in 2002/03while earnings from loans and advances to non-bank customers edged up from USD98.1 million toUSD100.6 million.

Total interest expenses went down by USD19.5million or 12.8 per cent, from USD151.8 million in2001/02 to USD132.3 million in 2002/03 as againsta fall of USD53.3 million or 26.0 per cent a yearearlier. During the year 2002/03, interest paid onborrowings from the international money marketrose by USD12.1 million or 14.4 per cent, fromUSD83.8 million to USD95.9 million, in contrast tothe preceding year when the cost of borrowings fellsharply by USD42.6 million or 33.7 per cent.Interest paid on deposits from non-bank customerswhich went down by USD10.7 million in 2001/02,dipped further by USD31.6 million to USD36.4million in 2002/03.

2.7.4.2 Non-Interest Income

Non-interest income comprises mainly profitfrom translation of currencies and fees andcommissions. After having recorded a steady risefrom USD8.6 million in 1998/99 to USD46.1million in 2001/02, Category 2 banks suffered asetback in terms of their non-interest income whichfell sharply from USD46.0 million in 2001/02 toUSD17.8 million in 2002/03. This was mainlyattributable to adverse effects of exchange rates onthe profit on translation of currencies of one majorbank which maintains its books in a currency otherthan US Dollar, the reporting currency.

Non-interest income accounted for only 8.5 percent of total income in 2002/03 as compared to17.5 per cent in 2001/02.

2.7.4.3 Non-Interest Expenses

Non-interest expenses consisting of staffexpenses and other operating expenses were wellcontained in 2002/03 and edged up by onlyUSD0.5 million to USD10.5 million compared toan increase of USD1.1 million in 2001/02. Staffexpenses went up by USD0.1 million to USD3.8million while other operating expenses which madeup 63.8 per cent of non-interest expenses, rose byUSD0.4 million to USD6.7 million.

Cost to income ratio is an indicator of banks'efficiency at operational level. After a moderateincrease of 0.9 percentage point in 2001/02, cost toincome ratio recorded a significant rise from 9.3 percent in 2001/02 to 16.0 per cent in 2002/03 onaccount of the low operating income realised bybanks coupled with a higher charge for bad anddoubtful debts.

2.7.4.4 Return On Average Assets And Equity

Table 12 outlines the financial performance ofCategory 2 banks in terms of their returns onaverage assets and equity in 2000/01, 2001/02 and2002/03. It can be seen from the table thatprofitability indicators were dragged lower in2002/03 by the declining profits realised by thebanks.

The overall return on average assets ofCategory 2 banks lost 110 basis points from 2.6 percent in 2001/02 to a low of 1.5 per cent in 2002/03.Individual banks' returns on average assets rangedbetween negative 0.2 per cent and 2.6 per cent in2002/03 compared to negative 1.0 per cent and5.8 per cent a year earlier. Return on average assetsof four Category 2 banks stood above 1.5 per centin 2002/03 compared to similar performanceachieved by five Category 2 banks in 2001/02.

The overall return on equity of Category 2 banksrose from 32.2 per cent in 2000/01 to 40.7 per centin 2001/02 but dropped substantially to 21.5 percent in 2002/03. In 2002/03, individual banks'returns on equity ranged from negative 1.0 per centto 66.4 per cent compared to a range of negative


34

4.0 per cent to 82.8 per cent in the previous year.Only three banks achieved a return on equity ofover 20 per cent in 2002/03 compared to fourbanks in 2001/02.

2.7.5 Provision for Bad and Doubtful Debts

The Guideline on Credit Classification forProvisioning Purposes and Income Recognitionrequires Category 2 banks to hold a generalprovision equivalent to at least one per cent of theirstandard advances (net of advances collateralisedby cash deposits) and specific provisions for lossesin respect of individual impaired credits.

Table 13 shows the trend of the provisions forbad and doubtful debts with respect to non-performing advances and total advances of banksfrom 2000/01 through 2002/03. Non-performingadvances increased significantly from USD6.9million in 2001/02 to USD52.2 million in 2002/03and likewise, the ratio of non-performing advancesto total advances went up from 0.5 per cent in2001/02 to 3.4 per cent in 2002/03. Specificprovisions for bad and doubtful debts, on the otherhand, rose by only USD9.2 million to USD15.5million in 2002/03. As a result, the ratio of specificprovisions to non-performing advances fellsubstantially from 91.3 per cent to 29.7 per cent. �

Table 13: Category 2 Banks - Total Advances, Non-performing Advances andProvision for Bad and Doubtful Debts*

2000/01 2001/02 2002/03

(USD million)

General Provision 13.3 13.4 20.1

Specific Provision 5.9 6.3 15.5

Total Provision for Bad and Doubtful Debts 19.2 19.7 35.6

Total Advances 1,430.9 1,532.6 1,522.3

Non-performing Advances 9.0 6.9 52.2

Ratio of Non-performing Advances to totalAdvances (Per cent) 0.6 0.5 3.4

Ratio of Specific Provision for Bad and DoubtfulDebts to Non-performing Advances (Per cent) 65.6 91.3 29.7

* based on audited accounts

35

Capital is one of the key factors to assess thesafety and soundness of a bank and provides abenchmark against which its financial conditioncan be measured. Capital also serves as animportant internal insurance fund to cover on-balance sheet and off-balance sheet risks. A bank’sattitude towards risks will therefore determine theamount of capital it needs to support those risks.

In 1988, the Basel Committee on BankingSupervision (BCBS) made a major step in capitalregulation by introducing the concept of a risk-based capital adequacy standard. The proposalswhich were made in a document known as the1988 Capital Adequacy Framework (hereafterreferred to as Basel 1) brought a dramatic change inbanking capital requirement rules. Basel 1 aimed atestablishing a level playing field among the bankingsystems of the major industrialized countries and atimproving the safety and soundness of banksworldwide.

The business of banking has undergonetremendous changes over the past decade and theintegration of the global financial markets has led toincreased risk taking by large banks. Withincreasing concentration of the banking system andthe evolution of risk management techniques in thelargest banks, Basel 1 started presenting seriousshortcomings, which are becoming more evidentover time. The limited number of risk categories inBasel 1 creates incentives for banks to game thesystem through capital arbitrage. The developmentof a new framework thus became imperative for thesmall number of large internationally activebanking organisations.

In 1999, the BCBS issued a Proposed NewCapital Adequacy Framework (hereafter referred toas Basel II). Basel II is founded on three pillars,namely,

� Pillar 1: Minimum Capital Requirements,

� Pillar 2: Supervisory Review Process, and

� Pillar 3: Market Discipline.

The first pillar proposes three options to dealwith credit risk. They are

(i) The Standardized Approach

(ii) The Foundation Internal Ratings Based (IRB)Approach

(iii) The Advanced Internal Ratings BasedApproach.

Pillar 2 deals with supervisory reviews that aimat ensuring that a bank's capital level is adequate tocover its overall risk.

Pillar 3 relates to market discipline and detailsthe minimum levels of public disclosure that areexpected from banks.

The main objectives of Basel II are

• to continue promoting the safety and soundnessof the financial system,

• to improve risk measurement and managementboth domestically and internationally,

• to align the amount of required capital to theamount of risk taken,

• to further focus the supervisory bank dialogue onthe measurement and management of risk andthe risk-capital nexus,

• to make all of the above transparent to thecounterparties that ultimately fund and sharethose risk positions.

The BCBS has issued three consultativedocuments since 1999 and conducted threeQuantitative Impact Studies (QIS). During eachconsultative round, the views of the bankingcommunity around the world were sought. Thesuggestions received were, as far as possible, takeninto account by the BCBS, in improving andrefining the proposals. The last Consultative Paper(CP3) on the Proposed New Capital AdequacyFramework was issued in April 2003 and commentsand suggestions were received by the BIS by31 July 2003. The BCBS envisages the finalpublication of the new proposals by end 2003 andmember countries of the BCBS intend a commonimplementation of Basel II for their internationallyactive banks by year-end 2006.

3. The Proposed New Capital AdequacyFramework

The Proposed New Capital Adequacy Framework

36

• CHANGES BROUGHT ABOUT IN CP3

One major innovation of CP3 is thedevelopment of a Simplified Standardised Approach(SSA) for computing credit risk. This newmethodology assigns a flat risk weight of 100% toall corporate exposures instead of relying on ratingsgenerated by External Credit Assessment Institutions(ECAIs). National supervisors are thus relieved ofthe burden of setting up processes to select eligibleECAIs. Concerns raised by banks regarding the costof rating their corporate customers by ECAIs havealso been addressed.

An important improvement in CP3 relates to thepreferential treatment defined for fullycollateralized mortgage loans. The SSA nowproposes a lower capital requirement of 35% onlending which is fully collateralized by mortgageson residential property that is or will be occupiedby the borrower. However, supervisors may imposehigher risk weights if they believe that thepreferential risk weight is not adequatelyprudential.

Under the Internal Ratings Based Approach,CP3 brings greater risk sensitivity by introducingthree subclasses under retail exposures and fivesubclasses under corporate exposures. Each of thesubclasses has been tied to distinct risk weightfunctions with a view to reflecting its different riskcharacteristics and eventually to varying levels ofminimum capital requirements. Retail exposureshave been subdivided into exposures secured byresidential properties, qualifying revolving retailexposures and other retail exposures whilecommercial exposures have been categorized intoproject finance, object finance, commoditiesfinance, income producing real estate and highvolatility commercial real estate. Additionalrefinement has been introduced to allow banksusing the IRB Approach to distinguish betweenloans to Small and Medium-sized Entity ( SME)borrowers and those to larger firms. Small business-related exposures will be treated as a “retailexposure”. In addition, CP3 categorizes purchasedreceivables into retail and corporate receivablesand prescribes distinct capital requirement to eachclass.

CP3 has also introduced two specificapproaches for computing capital requirement forequity exposures. The first one builds on the IRB

treatment for corporate exposures while the secondone allows banks to model the potential decrease inthe market value of their holdings. Guarantees andcredit derivatives in the IRB risk inputs are nowrecognised as credit risk mitigation instruments.

Under the IRB treatment for securitization,banks may base the capital requirement on theexternal rating of a securitization exposure or thecapital requirement for the pool of assets underlyinga given securitization.

Further, the computation of a minimum capitalfor operational risk no longer requires a separatefloor on the capital charges. Greater flexibility hasbeen introduced through the setting up of anAdvanced Measurement Approach (AMA) forcomputing operational risk capital. This methodallows banks to use their own methods for assessingtheir exposure to operational risk as long as theysatisfy a set of qualifying criteria. Risk mitigation isalso recognized under the AMA.

Stress testing has also been introduced withrespect to credit risk capital. Banks adopting an IRBapproach to credit risk will be required to set upconservative stress testing processes to estimate theextent to which their IRB capital requirements couldincrease during a stress scenario. The outcome ofthe stress test would enable both banks andsupervisors to assess whether capital buffer issufficient.

Under CP2, banks were required to hold five-year data on the loss characteristics defined underthe IRB approaches. CP3 has now defined a three-year transitional period starting from theimplementation date at year end 2006. Banks arethus eligible for the IRB approach provided theyhave at least two years of historical data at theimplementation date. The historical data isexpected to increase by one year for each transitionyear.

MAJOR CHALLENGES OF THE NEW BASELCAPITAL ACCORD

Complexity

One of the major concerns that have been raisedregarding Basel II is that it is extremely complex.Unlike the 1988 Accord, which is a one-size-fits-allapproach, the new proposals provide a wide rangeof options for setting minimum capital requirements 37

based on complex statistical and mathematicalassessment of risks. These techniques have evolvedwith the broader direction that banking and riskmanagement has taken over the past decade.Further, to achieve greater risk sensitivity in themeasurement of capital ratios, Basel II makes anumber of distinctions between exposures andtransactions. The trade off between greater risksensitivity and complexity has been widelydiscussed by industry participants around theworld.

Cost and Transparency

The increased complexity, scope and flexibilityof the new proposals could lead to reducedtransparency and obscure the evaluation of capitaladequacy. The simplicity of Basel 1 has favoured itsworldwide applicability and has over the yearsprovided a consistent and relatively robust systemthat was less open to subjective interpretation byregulators around the world. The wide range ofapproaches open for calculating risk capital underBasel II can thus undermine transparency.

The new proposals also call for the developmentand implementation of new risk managementsystems, the cost of which can be significant. Thebenefit resulting from a lower capital charge isunlikely to be sufficient to warrant the expenditure,especially for emerging economies. However, largeand complex financial institutions with existingcomprehensive risk management systems are likelyto utilize the most sophisticated approaches whilemost of the other banks are likely to opt for cost-effective simplicity. The twin factors of complexityand cost will limit, at least in the short term, theapplication of all the basic aspects of the proposedAccord to large and sophisticated financialinstitutions with well developed risk managementsystems.

Competitive inequality

According to the third quantitative impact studycarried by the BCBS, which saw the participation of365 banks from 43 countries, it was found that thecapital requirement of banks using the standardizedapproach would increase while risk capitalcalculated under IRB would fall considerably. Theresults also showed that the new operationalcharges would outweigh capital reduction in credit

risk under the standardized approach. Banks usingthe advanced approach would thus, experience asignificant fall in capital requirement as thereduction in capital requirement for credit risk willoutweigh the charge for operational risk. Smallerbanks, which are managing their credit risks andcapital prudently, may be unfairly imposed with ahigher capital charge.

Basel II also creates a higher barrier to entryespecially in banking industries where banks arefaced with competition from non-bank deposittaking institutions. The new proposals will imposeconstraints on banks that are not imposed on theirnon-bank competitors especially in markets wherenon-banks are allowed to operate with less capital.

In developing countries (DCs), most banks havestraightforward balance sheets, and do not requiresophisticated risk management systems to calculaterisk capital. These banks would therefore use thestandardized approach to measure credit risk whilebranches of foreign banks may, with the approval ofthe local supervisory authority, use the IRBapproach. This will pose serious challenges todomestic and cross border supervisory cooperation.Moreover, foreign entities using the IRB approachcould enjoy capital savings as they can achievelower risk capital while domestic banks using thestandardized approach would suffer from unfaircompetition while operating in the sameenvironment.

Although banks in developing countries haveexpressed their appreciation of the advantages ofthe IRB approach, they believe that its introductionwill be more difficult for developing country banksowing to weaker managerial and supervisorycapacity and the non-availability of historical data.

Unfair disadvantage

The new proposals provide an incentive for banksto increase lending to borrowers that have a ratingabove BBB. The majority of these borrowers, whichare found in developing countries, may be viewedas less desirable customers by internationally activebanks. These banks will favour highly ratedsovereigns, corporates and banks. With the reducedcapital inflows in developing countries, theeconomic performance of such countries will beseriously and unfairly affected.


38

Pro-cyclicality

There are serious concerns that Basel II willexacerbate pro-cyclical tendencies within thebanking system. This aspect will reflect itself in theloss characteristics of the IRB approach whereby,the probability that a borrower will default (definedunder the IRB as PD, Probability of Default) willdecrease during an economic upturn and increaseduring an economic downturn due to stressedeconomic conditions. During deterioratingeconomic conditions, existing loans would”migrate” to higher risk categories, thereby raisingoverall capital requirements. As raising capital isexpensive for banks especially in downturns, thecost of bank funding increases leading to a creditcrunch. This in turn exacerbates the recession andfurther deepens the non-performing loan problem.

Credit Rating Agencies

Under the standardized approach of the newproposals, risk weight would be dependent on theratings provided by the credit rating agencies. Thereare serious reservations as to whether ratingagencies would be able to measure risk associatedwith bank loans as rating agencies do not havemuch experience with regard to risk ratingborrowers. Furthermore, experience shows thatrating agencies are more reactive than proactive.The downgrade of Enron and Worldcom came onlyafter the frauds in those companies were disclosedpublicly. Further, the use of credit rating agenciesfor the purpose of determining required capital mayresult in ”biased” ratings of borrowers. Thefundamental reason is that credit rating agencieswill be ”hired” by companies needing to borrowfrom banks. With the exception of the largecorporations (which may already be rated),corporations selecting the rating agency will standto gain by selecting the one that is willing to providethe desired rating. This problem known as ' the raceto the bottom' would imply credit risk assessmentsthat do not reflect the true credit risk profile of theborrower. In its attempt to improve on creditassessments by introducing external ratingagencies, the proposed accord may actually resultin a more distorted computation of banks'individual risks.

Banks in developing countries will be furtheraffected by ECAIs in that such agencies are almostnon-existent in these countries. In seeking the

services of internationally recognized ratingsagencies which meet the eligibility criteria set outby Basel II, banks in DCs will have to price theirassets based on the additional costs incurred inobtaining the ratings for each group of borrowers.This would exacerbate the already stressedconditions of banks in DCs.

Further, supervisors in DCs do not havesufficient expertise to accredit ECAIs. Both thesupervisors and banks in DCs would face seriousdifficulties with ECAIs. Reliance on credit ratingspresents additional difficulties to DCs, namely, thelimited coverage of most rating agencies, thepossibility that new, less reliable agencies willemerge and the problem of unsolicited ratings.Many DCs have suggested in their responses duringthe consultative rounds that dependence on ratingagencies is so unsatisfactory that a different way ofsetting risk weights needs to be defined.

Risk Weights

To bring regulatory capital more in line witheconomic capital, Basel II proposes to widen therange of risk weights and to introduce weightsgreater than 100%. Banks adopting the IRBapproach would be allowed to develop their ownrisk analysis, management and control systems.Since the range of risk weights is considerablywider in the IRB Approach than in the Standardizedapproach, banks with loan portfolio concentratedon lower risk borrowers may have the strongestincentives to use the IRB Approach as it generates alower capital requirement. Banks with higher riskloans portfolio may opt for the StandardizedApproach. Banks may also design rating systemswhich underestimate credit risk and hence settle fora lower regulatory capital requirement. This couldseriously threaten the stability of the financialsystem.

It is also questionable as to whether the riskweights applied to different categories of assetsunder Basel II reflect the true risk profiles orwhether risk categories are well defined under thenew proposals. The risk weights have also beencriticized as being set on an arbitrary basis and thatthe BCBS would not be in a position to justify therisk weights set. Moreover, certain proposedweights are considered to be too high or notparticularly suited for the local context, resultinginto the initial objective of creating a level playingfield being undermined. 39

• OPERATIONAL RISK

Operational risk is defined as the risk of lossresulting from inadequate or failed internalprocesses, people and systems or from externalevents. Basel II proposes three methods for settingcapital charges for operational risk, namely,

� The Basic Indicator Approach

� The Standardized Approach

� The Advanced Methodology Approach

Although there is a general consensus that banksworldwide are faced with significant operationalrisk due to increased sophistication in theiractivities such as e-commerce, new complexfinancial products, highly automated technology,increased globalisation of their activities, thequantification of operational risk remains difficult.Credit risk capital calculated under Basel 1 is sethigh enough to cover implicitly other types of risksincluding operational risks. Consequently, the needfor an explicit capital charge for operational risk isnot felt by industry participants.

The methodology for calculating operationalrisk capital charge is viewed by some participantsas being set on an arbitrary basis. In the simplestapproach, i.e the Basic Indicator Approach, theoperational risk capital has been set at 15 percent ofgross income. This may not truly reflect theoperational risk faced by a bank. Under theStandardized Approach, which is a moresophisticated approach for calculating capitalcharge, operational risk capital is determined on aBeta Factor supplied by the BCBS. This Beta Factormay differ between countries and therefore theneed has been expressed to adapt the Beta Factor tolocal contexts.

Banks are spending much time and resources toimprove risk management practices as theirfinancial interest lies in better measuring andmanaging risks. The objective of a reasonable,flexible and comparable approach to operationalrisk is achievable and banks believe that they havealready catered for such risks by applying formaltechniques to their measurement and management.But there are some concerns as to whether a bankwhich is already managing its operational risksperfectly should set aside a capital charge for suchrisks. A bank having risk management processes tocalculate its operational risk capital under thesimplest approach would still be unable to

accurately calculate the capital to be set aside asthe operational loss cannot be quantified until theloss actually occurs. The Barings Bank and Allfirstfailures clearly demonstrate that they would havefailed to cope with operational risk even if they hadset aside a capital charge calculated under the BasicIndicator Approach. Banks should therefore focuson robust risk management practices rather thansetting capital charge under the simplestapproaches proposed by Basel II.

Developing countries have serious concernswith regard to the proposed methods for calculatingoperational risk capital. The capital charge thatwould result under the Basic Indicator Approachwould be too high given the less complex nature ofbanking in developing countries. For mostemerging economies, there is a more complex (lessdirect) relationship between gross income and risks.This could create some imbalance in thequantification of operational risks and hencepenalize banks by over-estimating risk and therelevant capital charges.

Standardization of risk management practices

Most sophisticated banks already haveadvanced risk management systems in place, tocater for the calculation of risk capital for theircomplex products. The new proposals may not bedesirable and may result in additional costs forthose banks having to change their systems.Excessive reliance on risk management processesmandated by supervisors may cause banks to followthose processes blindly and reduce theirresponsibility as to the adequacy of those processes.Basel II may thus drive diversity out of the market asholding the same views and using similar modelsmay lead to systemic consequences.

Competitive disadvantage

The implementation of the Basel II proposalsinvolves significant resources in the process of datamanagement and credit modelling. Most banksaround the world are not sophisticated enough toqualify for the advanced methodologies and are stillin the early stages of developing firm wide data.These banks as well as those in the G10 countries,are more likely to adopt the simplest approach forcalculating operational risk capital. Thus banksusing the advanced approach will enjoy unfaircompetitive advantage against other banks with lesssophisticated systems. Further, smaller banks are


40

not necessarily more exposed to operational risk.The increased capital charge would simply betransferred to customers through pricing, puttingbanks at competitive disadvantage.

Under Basel II, banks do not have the incentiveto shift from the less sophisticated approach to theadvanced approach in respect of operational risk.To graduate from the Standardized Approach to theAMA, banks would be required to deploysignificant effort and resources in data collection,scenario development and benchmarking whichwould result in a maximum reduction of 25% incapital charge.

• PILLAR 2 CONCERNS

Basel II imposes a heavy burden on supervisorsin that it would require a substantial upgrade insupervisory resources and supervisory capabilitiesin most countries. Supervisors will have toparticipate in model building as well as assess theiradequacy and validate the advanced approaches.

In developing countries, the unavailability ofsufficiently experienced regulators and trainedpersonnel in commercial banks is likely to be a keyhurdle. On account of this, it is questionablewhether banks will be able to properly implementthe new risk management techniques set out inBasel II. Improper risk management practices, ifimplemented, are less likely to be discovered andresolved in a timely fashion.

Supervisors could also divert their attentionaway from banks with weaker risk analysis andmanagement systems by focussing excessively onthe use of sophisticated models. This could pose aserious threat to systemic stability. Furthermore, thedeep involvement of supervisors in riskmanagement decisions implies that any bank failuremay be viewed as the failure of the supervisors.Consequently, supervisors will be more reluctant toallow banks to fail. As a result, the risk attitude ofbanks will not be in line with the new proposals,which encourages banks to take calculated risk.

• PILLAR 3 CONCERNS

Industry participants have expressed theirconcern that disclosure of proprietary informationcould undermine their competitive position if thatinformation is shared with competitors namelybanks and non-banks. They also pointed out thatPillar 3 disclosure standards for IRB approach areonerous and counter-productive.

Developing countries also believe that, theinitial objectives of improving market transparencythrough Pillar 3 may be undermined as excessivedisclosure of information may confuse marketparticipants who cannot interpret such informationproperly. For this reason it will be necessary toeducate analysts and other market participantsconcerning the correct interpretation of Pillar 3disclosures to avoid unexpected and uninformedmarket reactions to this information.

• CONCLUSION

Although capital is not a substitute for badcorporate and risk management processes in abank, additional capital requirements are notalways the right solution to deal with deficiencies inthe risk management processes of banks. It is awidely held view that capital increases should beused as an interim measure while permanentmeasures should be in place to improve the bank'sposition.

The proposed Basel II Accord is definitely morecomplex than its predecessor but it bringsadditional benefits to banks, supervisors and othermarket participants namely in terms of better riskassessment by market, stronger relationshipbetween banks and supervisors and betteralignment of economic capital and regulatorycapital.

As an emerging financial centre, Mauritius hasto gear itself to the challenges represented by BaselII. The Bank of Mauritius has created a task force todraw up an implementation plan, after closeconsultation with other regional supervisors and thehome country supervisors of international banks. InMauritius, a tentative target for the implementationof Basel II has been set at December 2006.

Notwithstanding the merits of Basel II, the Bankof Mauritius is committed to ensuring that banksmeasure, manage and mitigate risks properly.

As rightly pointed out by Roger W Ferguson,Vice Chairman of the Board of Governors of the USFederal Reserve System, ‘Banks exist for the purposeof risk-taking and the objective of supervision iscertainly not to eliminate, and perhaps not even tolower risk taking. Rather, the objective ofsupervision is to assist in the management of risk'. � 41

IAS 39 - The implication of its implementation

INTRODUCTION

The promulgation of Companies Act 2001 (CA2001) in December 2001, has brought significantchanges in the local financial reportingenvironment. Section 211 of CA 2001 requires allcompanies to prepare their accounts in fullcompliance with the International AccountingStandards (IAS). Such a requirement came at theright time when Mauritius was seeking toconsolidate its financial sector. Compliance withIASs will help in further increasing transparency andcomparability of accounts.

However, the full adoption of IASs also poses asignificant challenge to most companies, especiallyas far as compliance with IAS 39, FinancialInstruments – Recognition and Measurement, isconcerned. Banks and financial institutions are theones most concerned as they deal primarily infinancial instruments.

IAS 39 is believed to be one of the mostcomplex accounting standards issued by the IASBso far, and a 350-page IAS 39 ImplementationGuidance has had to be issued as a complement tothe standard. IAS 39 transforms the whole way inwhich companies report their financial assets andliabilities and introduces the concept of partial fairvalue1 reporting.

HISTORICAL DEVELOPMENT OF THE STANDARD

The International Accounting StandardCommittee, now International Accounting StandardBoard (IASB), began its project to develop acomprehensive set of accounting standardsaddressing financial instruments in 1989. It was feltthat historical cost accounting may not alwaysreflect a realistic picture and that changes in fairvalue1 may not always be apparent to users ofaccounts until impairment or write-down. Also, thesophistication of the financial market and theincreasing need for risk control measures haveresulted in loads of innovative and complex

financial products, which ought to be captured inthe accounts, but which were often not the case asthere were no specific requirements to that effect.The IASB, through a standard on financialinstruments, aimed at addressing these two lacunas.

In 1994, the IASB divided the project into twophases. The first phase addressed disclosure andfinancial statement presentation, and resulted in theissuance of IAS 32 in 1995. The second phase of theproject addressed recognition and measurementand resulted in the issuance of IAS 39 in December1998, with 1 January 2001 as the effective date.

The standard itself has been issued amidstwidespread criticism. Detractors of IAS 39 claimthat there has not been adequate consultation priorto its issue and that the standard is basically apolitical product. Consequently, it lacks theconsensus and practicability which a goodaccounting standard should have.

The IASB is currently working on revising IAS 32and IAS 39 and a voluminous Exposure Draft onProposed Amendments to the standards was issuedin June 2002 and closed for comments on 14October 2002. It is reported that significantcomments have been received on the ExposureDraft, especially emanating from the bankingindustry. These are being studied and a new revisedstandard or an Exposure Draft is expected in the lastquarter of 2003 or first quarter of 2004.

Although significant changes to accounting forfinancial instruments are in the pipeline, it isexpected that IAS 32 and IAS 39, in their presentform, will remain applicable for several years.

In Europe and most other countries, companiesare expected to be compliant with IASs as from1 January 2005. However, in Mauritius, compliancewith IASs, is already mandatory for all accountingperiods commencing on or after 1 December 2001.While most IASs already had a MauritiusAccounting Standard (MAS) equivalent, IAS 32 and

4. IAS 39 - The implication of itsimplementation

1 Fair value is the amount at which an asset can be exchanged, or a liability settled, between knowledgeable and willing partiesin an arm’s length transaction.42

IAS 39 were relatively new standards and theirapplicability took most companies by surprise. It isargued that MAS equivalent of these two standardswere already in issue well before 1 December2001, but with the development in the financialsector at that time, the issue had taken thebackstage. Besides, it is only in late 2001, whenEuropean companies started the process ofimplementing IAS 32 and IAS 39 that the practicalissues and constraint of implementing IAS 32 andIAS 39 came to the limelight.

By that time it was already too late. Studies haverevealed that at least two to three years preparationis required for an effective and smoothimplementation of IAS 39 – enough time has to beallowed for changes in systems requirements,training, documentation and in parallel run.However, given that the local financial sector is notvery sophisticated and that financial products arerather simple, implementation of IAS 39 should notbe a major problem for most companies.

Nevertheless, the situation is different for banksand similar financial institutions as they basicallydeal in financial products.

Given that it would be unworkable for banks tocomply with IAS 32 and IAS 39 at such short notice,an application was made to the Registrar ofCompanies for a deferment of the standards. TheBank of Mauritius resolutely supported thisendeavour and on 20 June 2003, the Registrar ofCompanies granted all companies holding Category1 and Category 2 banking licences under theBanking Act 1988 the desired deferment. However,this moratorium period is applicable only foraccounting periods commencing on or prior to1 January 2003 and has not been extended to non-bank financial institutions.

REQUIREMENTS OF THE STANDARD

IAS 39 identifies four categories of financialassets2 and two categories of financial liabilities3.The prescribed accounting treatment will bedetermined based on the categorisation of thefinancial asset or liability. Table 1 below provides abrief summary of the categories of financial assetsand of their respective accounting treatment.Table 2 provides the same information in respect offinancial liabilities.

2 A financial asset is defined in IAS 39 as: cash, a contractual right to receive cash, a contractual right to exchange financial instruments under potentially favourable conditions or an equity instrument of the enterprise.

3 A financial liability is defined by IAS 39 as a contractual obligation to: deliver cash, deliver financial assets, or exchange financialinstruments under potentially unfavourable conditions.

Table 1 : Financial Assets

Category Defining Characteristics Prescribed Accounting Treatment

Held-to-maturity Fixed or determinable payments; Amortised cost.Fixed maturity with positive intent and (at the effective interest rate)ability to hold to maturity.

Held-for-trading Purchased with the intention of Fair value.making a profit from short-term market Gains and losses on revaluationfluctuations (including all non-hedging recognised in income statement.derivative assets).

Originated by the Loans and receivables originated by Amortised cost.enterprise the enterprise by providing money, (at the effective interest rate)

goods or services directly to a debtorand not for trading.

Available-for-sale All other financial assets. Fair value.Gains recognised in income ordeferred in equity, depending onone-off enterprise-wide decision.

43

Table 2 : Financial Liabilities

Category Defining Characteristics Prescribed accounting treatment

Trading Incurred to make a margin, or a gain Fair value.from short-term market fluctuations Adjustment recognised in income.(including all non-hedging derivativeliabilities).

Other liabilities All Other Liabilities. Cost or amortised cost.

HEDGE ACCOUNTING

IAS 39 also introduces the concept of hedgeaccounting. On its own, IAS 39 may bringsignificant volatility in the income statement as fairvalue movements are caught on the incomestatement. Hedge accounting can reduce thisvolatility.

Hedging involves entering into transactions thatgive an offsetting profile to a risk. Ideally theincrease or decrease in an underlying hedged itemshould be matched with the effect of the increase ordecrease in the hedging instrument. However,applying normal accounting procedures may notalways allow this. At times the underlying hedgeditem may not be recognised in the accounts (e.g. aforecasted future cash flow), while thecorresponding hedging instrument is classified asHeld-For-Trading and is recognised on the balancesheet. At other times, there may be measurementmismatches, where the hedged item is recognised atamortised cost and the hedged instrument isrecognised at fair value. This invariably results inunwarranted variability in profits. Hedgeaccounting provides a leeway to avoid suchvolatility by explicitly requiring that the effect of thehedged item and the hedging instrument bematched in the income statement in those situationswhere they would not be achieved by applying thenormal accounting procedures.

There are strict and onerous conditions thatmust be fulfilled before hedge accounting can beused. These are:

� Formal documentation identifying the hedgeditem, the hedge, the nature of the risk, and howhedge effectiveness will be measured;

� Realistic expectation of the hedge effectiveness;

� Hedge to actually be effective;

� For cash flow hedges of an anticipatedtransaction, such transaction must be probableand must ultimately have a profit or loss effect.

PROBLEMS TO APPLY THE STANDARD

At first sight, the requirements of IAS 39 do notappear overwhelming. However an in-depthanalysis will reveal how complex the standardactually is. Banks may have particular problems inthe following areas:

� Computing effective interest rates;

� Fair value measurement of financial instruments;

� Debt securities as originated loans and receivables;

� Embedded derivatives;

� Macro hedging.

COMPUTING EFFECTIVE INTEREST RATE

The effective interest rate is the rate that exactlydiscounts an expected stream of future cashpayments through maturity or the next market-based repricing date to the current net carryingamount of a financial asset or financial liability. Insimple terms it is the internal rate of return of a cashflow stream.

It is common for banks to provide loans with afixed interest rate for an initial period of two to threeyears followed by a variable or a different fixed ratefor the remaining period of the loan. In such cases,IAS 39 requires that the effective interest rate beused to accrue interest income. In order to complywith this requirement, banks will have to beef uptheir system to allow them to compute the effectiveinterest rate and to accrue interest at that rate.

At other times, the bank may allow the borrowerto repay the loan earlier. In such a case, computingthe effective interest rate means that the bankshould not base itself on the contractual stream ofcash flows but should also take into account thelikely timing of payments.


44

FAIR VALUE MEASUREMENT OFFINANCIAL INSTRUMENTS

As already mentioned, there are four categoriesof financial assets. Based on its underlyingcharacteristic, a financial asset should be classifiedas either Originated Loans and Receivables, Held-to-Maturity, Held-for-Trading or Available-for-Sale.

Financial assets Held-for-Trading should be fairvalued with any resulting gain or loss chargeddirectly to the Income Statement. Available-for-Salefinancial asset should also be fair valued, but herethe company should make a one-time election as towhether the resulting gains or losses are to becharged to the income statement or whether theyshould go directly to equity. Originated Loans andReceivables and Held-to-Maturity should bereported at amortised cost, subject to impairmenttests.

Banks will find themselves having to fair valuemany types of financial assets, which were up tonow stated at cost. In small countries like Mauritius,fair value information may not be readily availableand banks will have to devise estimationtechniques, such as the discounted cash flowmodel, to produce the required fair values.

In the case of Available-for-Sale financial assets,where the bank has opted to account gains or lossesin equity, IAS 39 requires that such gains and lossesshould be transferred to the revenue reserve whenthe asset is impaired, sold, collected or otherwisedisposed of. In such a case, the accounting systemshould be capable of recognising separately eachrevaluation gain or loss on each financial asset, sothat in case of derecognition or impairment, therespective amount can be included in the revenuereserve. This is likely to be a very cumbersome andpainstaking exercise.

The audit of fair value is also likely to present asignificant challenge to auditors. Auditing fair valueis much different from auditing historical costfigures. In the latter case it is relatively easier ashistorical cost data can be substantiated and areverifiable. However, fair value may not be readily

available and management will have to makedifferent assumptions and use various valuationmodels to compute the fair value. Consequently, toaudit the fair values, auditors will have to audit theappropriateness of the assumptions and valuationmodels utilised. The risk of oversight is higherthereby resulting in higher audit risk. Auditors willhave to allocate more time to their audit and to seekmore expert advice. As a consequence, they willend up passing the cost to their customers bycharging higher audit fees.

DEBT SECURITIES AS ORIGINATEDLOANS AND RECEIVABLES

IAS 39 defines loans and receivables as financialassets created by an enterprise by providing money,goods or services directly to a debtor, provided thatthere is no intent to immediately sell those assets.

Banks that are primarily dealers in Treasury Billsare likely to hold Treasury Bills for investmentpurposes, for trading or for meeting liquidityrequirements. Investment in Treasury Bills, if there isintent and ability to hold to maturity can beclassified as Held-to-Maturity. However, there aresevere restrictions when classifying an asset asHeld-to-Maturity and it is unlikely that banks willopt for such classification.

Most banks will prefer to classify their TreasuryBills, held as investment or for liquidity purposes, asAvailable-for-Sale and account for the change in fairvalue through equity. However, under IAS 39, anydebt security purchased directly from the issuershould be classified as either Originated Loans andReceivables or Held-for-Trading.

EMBEDDED DERIVATIVES

An embedded derivative4 is a financialderivative built into a plain financial instrumentknown as a host contract. Where the economicbenefit and risk profile of the embedded derivativeis different from the host instrument, the formershould be separated from the latter (known asdebundling) and accounted for separately as if theyare stand-alone instruments.

4 A derivative is a financial instrument:

* whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate,index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the ‘underlying’);

* that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar responseto changes in market conditions; and

* that is settled at a future date. 45

It is generally believed that embeddedderivatives exist only in complex financial products.However, a simple product such as loan with anearly repayment option may contain an embeddedderivative (the option to repay the loan earlier),which has to be separately fair valued andaccounted for. This is a major issue for mostfinancial institutions.

MACRO HEDGING

It is common practice for banks to hedge theirrisks. However, they are more concerned with theirnet position. As such, up to now they have not beenhedging each of their individual risk on a one-to-one basis. Rather they hedge their net position. Thisis known as macro hedging. As per IAS 39, macrohedging is not eligible for hedge accounting. Such arestriction may result in variability in profits.

To avoid such variability and to enable theirhedging to be qualified for hedge accounting, banksmay designate their hedged instrument to specifichedged item on a one-to-one basis. But such anexercise is likely to be challenging, painstaking andmay require extensive changes in banks’ processesand systems.

CONCERN OF REGULATORS

IAS 39 is a major cause of concern to bankingsupervisors around the world. The main worries are:� Accounting for credit losses;� Volatility in profits;� Capital adequacy.

ACCOUNTING FOR CREDIT LOSSES AND GUIDELINE ON CREDIT IMPAIRMENTMEASUREMENT AND INCOME RECOGNITION

It is imperative that the assets of banks are notoverstated and that credit losses are recognised ona timely basis. Under the present system, banks arerequired to use matrix provisioning to determineallowance for credit losses.

The Bank of Mauritius, through its Guideline onCredit Classification for Provisioning and IncomeRecognition, prescribed minimum provision based

on the number of days the facility is overdue. Thecalculation was rather simple and there is theshared view that this particular system is yieldingacceptable results, with little chances ofoverstatement of assets.

However, IAS 39 strictly disallows matrixprovisioning – it requires companies to calculateloan impairment by comparing the recoverableamount of a loan to the carrying value of the loan.In case the former is lower than the latter, the loanis considered impaired and should be written downto its recoverable amount. The calculation of therecoverable amount is a highly subjective exerciseas banks have to make their own estimates of thefuture expected cash flows on the loan and discountit to the present. It was possible for institutions toabuse of this loophole to overstate their loan assetswhile understating their loan loss provisions.

To cope with this problem, the Bank ofMauritius has come forward with a Draft Guidelineon Credit Impairment Measurement and IncomeRecognition, which will supersede the previousGuideline on Credit Classification for Provisioningand Income Recognition. Comments received onthe Draft Guideline were mostly unfavourable asbanks view it as being overly prudent and are of theopinion that it will increase their administrativeburden. However, there is a need for a stringentGuideline so as to put accrued objectivity in thedetermination of impairment losses.

VOLATILITY IN PROFITS

IAS 39 requires some types of financialinstruments to be fair valued and the resulting gainsand losses be reported directly in the incomestatement. Market prices are rarely stable. Ratherthey tend to fluctuate rapidly depending on currentmarket situation and perception. Accordingly, thereported figures will change as price varies on themarket.

The IASB is of the view that volatility is a fact oflife and that it should be captured in the accountsof companies. However, high volatility may causeerosion of market confidence and thereby weakenthe financial sector.


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CAPITAL ADEQUACY RATIO

The capital adequacy ratio is a major prudentialratio used by bank regulators around the world. Itrepresents the ratio of a bank's capital base to itstotal risk weighted assets and it basically defines theminimum capital a bank should have as a bufferagainst credit and market risks.

The capital base for capital adequacy purposesincludes paid up capital and other undistributedreserves. Revaluation reserve is also included in thecapital base but is discounted by 25% and shouldbe supported by a valuation prepared by anapproved appraiser.

With IAS 39, fair value changes will be bookedon the balance sheet with changes in value beingrecorded in the income statement or directly inequity. Given the nature of a bank's balance sheet,there is likely to be significant unrealised fair valuechanges being recorded as gain.

In the absence of any specific guidance theresulting gains or losses on fair value changes willaffect the capital base of a bank and accordingly

will affect its capital adequacy ratio. Given thescope for manipulation of fair value changes, itwould be relatively easy for unscrupulous banks toplay around with their capital adequacy ratios.

Besides, fair value figures are likely to changerapidly with changes in market confidence andperception. The capital adequacy ratio is likely tofluctuate with changes in the fair values of financialassets and liabilities. This may be wronglyinterpreted by the market and may result in erosionof market confidence.

CONCLUSION

The IASB is working on a project to furtherconsolidate the standard and may in some yearscome forward with fair value requirements for allfinancial instruments.

In the meantime, banks in Mauritius and abroadwill have to modify their systems and procedures tobe compliant with IAS 39 by 1 January 2004. Thisconversion process is a major project and willrequire much effort, both financial andpsychological, from banks. �

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The financial crises of the last decade haveaffected many countries in varying degrees mainlythrough their high cost, in particular, by way of lossin output and the fiscal outlay to shore up theeconomies. They have provoked much reflectionon the ways to strengthen the global financialsystem. It is becoming increasingly important toacquire a better understanding of what determinesfinancial system soundness and identify thosesignals, which might help policymakers preventfinancial crises. In this context, the InternationalMonetary Fund (IMF) has identified a number ofFinancial Soundness Indicators (FSIs).

The FSIs include a core set of aggregatedprudential indicators of the banking sector and abroader set of indicators that covers the financialhealth of the non-bank financial, corporate, andhousehold sectors and real estate market. TheseFSIs, also known as macroprudential indicators,will help countries assess their banking systems’vulnerability to crisis and take preventive measures.

In order to place reliance on the FSIs, there is aneed for a supportive framework. Countries shouldadhere to internationally agreed prudential,accounting and statistical standards. As a membercountry of IMF, Mauritius has already adhered tosome of the Standards.

The following paragraphs give some insights ofFSIs and the work undertaken by the Bank ofMauritius to come up with a supportive frameworkfor the implementation of FSIs in Mauritius.

WHAT ARE FSIs?

The origin of FSIs can be traced back to 1999when the IMF held a consultative meeting on FSIs.Subsequently, in the year 2000, the Executive Boardof IMF endorsed a list of macro-prudentialindicators. The list was eventually renamed FSIs inJune 2001 and recently in March 2003, the IMF haspublished a draft Compilation Guide (the Guide) onFSIs.

The FSIs are categorised into a Core Set of 15indicators and an Encouraged Set of 26 indicatorswhich are listed in Table A. The Core Set ofindicators consists of ratios, which have beendetermined on the basis of their relevance in a widerange of countries, the availability of the underlying

data and the understanding of how the ratios shouldbe used. On the other hand, the Encouraged Setcontains those indicators which are likely to berelevant in many countries but with a need offurther analytical work to clarify their usefulness.

In line with the strategic role played by bankswithin most financial systems, all indicators withinthe Core Set and the first 14 indicators in theEncouraged Set are calculated using data gatheredfrom banks. The risks leading to financial systeminstability caused by certain developments in NonBank Financial Intermediaries (NBFIs), thecorporate sector, households and the real estatemarket are also incorporated. In this context, thereare two indicators that reflect the state of health ofNBFIs, five for the corporate sector, two for thehousehold sector and three for the real estatemarket.

The Core Set of indicators is based on theCAMELs framework which analyses the health of anindividual institution by looking at its six majoraspects, where “C” stands for capital adequacy, “A”for asset quality, “M” for management, “E” forearnings, “L” for liquidity and “s” for sensitivity tomarket risk. However, for the purpose ofcomputing the FSIs, the “M” component isexcluded from the Core Set of indicators. The othercomponents are defined as follows:

(i) the capital adequacy ratios indicate the abilityof banks to cope with shocks to their balancesheets;

(ii) the asset quality ratios reflect the quality ofbanks’ assets in terms of overexposure tospecific risks, trends in non-performing loansand the health and profitability of bankborrowers;

(iii) earnings and profitability ratios also indicatethe quality of assets of banks as well as theirsustainability of earnings;

(iv) liquidity ratios capture the ability of banks tomeet deposits withdrawals or large maturitymismatches; and

(v) the ratios regarding sensitivity to market riskcapture the impact of adverse movements ininterest rates and exchange rates on banks’profitability.

5. Financial Soundness Indicators

Financial Soundness Indicators

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Core Set of FSIsDeposit-taking institutions

Capital adequacy

1. Regulatory capital to risk-weighted assets

2. Regulatory Tier I capital to risk-weighted assets

Asset quality

3. Nonperforming loans to total gross loans

4. Nonperforming loans net of provisions tocapital

5. Sectoral distribution of loans to total loans

6. Large exposures to capital

Earnings and profitability

7. Return on assets (net income to average totalassets)

8. Return on equity (net income to averageequity)

9. Interest margin to gross income

10. Noninterest expenses to gross income

Liquidity

11. Liquid assets to total assets (liquid asset ratio)

12. Liquid assets to short-term liabilities

Sensitivity to market risk

13. Duration of assets

14. Duration of liabilities

15. Net open position in foreign exchange tocapital

Encouraged Set of FSIs

Deposit-taking institutions

1. Capital to assets

2. Geographical distribution of loans to totalloans

3. Gross asset position in financial derivatives tocapital

4. Gross liability position in financial derivativesto capital

5. Trading and foreign exchange gains (losses) tototal income

6. Personnel expenses to noninterest expenses

7. Spread between reference lending anddeposit rates

8. Spread between highest and lowest interbankrate

9. Customer deposits to total (non-interbank)loans

10. Foreign currency-denominated loans to totalloans

11. Foreign currency-denominated liabilities to total liabilities

12. Net open position in equities to capital

Market liquidity

13. Average bid-ask spread in the securities market

14. Average daily turnover ratio in the securitiesmarket

Non-bank financial institutions

15. Assets to total financial system assets

16. Assets to GDP

Corporate sector

17. Total debt to equity

18. Return on equity (earnings before interest andtaxes to average equity)

19. Earnings before interest and taxes to interest and principal expenses

20. Corporate net foreign exchange exposure toequity

21. Number of applications for protection from creditors

Households

22. Household debt to GDP

23. Household debt service and principalpayments to income

Real estate markets

24. Real estate prices

25. Residential real estate loans to total loans

26. Commercial real estate loans to total loans

Table A

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The two indicators regarding NBFIs reflect theirsystemic importance on account of their size andimportance in the economy. Moreover, NBFIs andbanks are often related via ownership or investmentlinkages and any adverse impact on the NBFIs willaffect banks’ performance.

The corporate sector of an economy plays animportant role in maintaining financial stability. Asignificant proportion of banks’ assets, whichcomprises mainly of loans and advances, is investedin corporates. In this respect, five indicators relateto the corporate sector, thus, enabling a propermonitoring of corporate borrowers. The proposedratios for the corporate sector may act as earlywarning signals for financial distress. Banks maythus take timely actions, for instance, bystrengthening their capital base or reducing theirexposures to high-risk corporate customers.

The two indicators regarding the householdsector reflect its repayment capacity, which may beused by banks to assess the quality of creditextended to this sector.

The remaining two indicators that relate to thereal estate market provide additional signals forfinancial sector stresses, which normally result fromrapid increase in real estate prices followed by asharp economic downturn. Such cycles can have anegative impact on the profitability of banksnotably through a decline in credit quality causedby deterioration in the value of collaterals.

FRAMEWORK FOR AN EFFECTIVEIMPLEMENTATION OF FSIs

FSIs are calculated and disseminated for thepurpose of assisting in the assessment andmonitoring of the strengths and vulnerabilities offinancial systems. However, the FSIs can effectivelybe implemented if there is a proper framework, inparticular, an institutional, legal and conceptualframework.

Institutional Framework

The collection of data for the computation ofFSIs is a complex task mainly because of the widerange of data sources. Some countries already havean established system for compiling anddisseminating FSIs data. However for manycountries, such compilation is a new endeavour.

The Guide on FSIs recommends that one agencyshould be given the primary responsibility forcalculating and disseminating FSIs so as to ensurethat there are clear lines of responsibility andaccountability. It also emphasizes certain issuessuch as the periodicity, the range of data to bedisseminated, the timeliness of release and theformat in which the FSIs should be released. Itencourages the dissemination of FSIs data on aquarterly basis but also suggests the release of somekey data on a monthly periodicity. Regarding theformat, the Guide recommends that thedissemination be centralized on a single website,allowing simultaneous release to all users, generalaccessibility of the data and transparency.

Legal Framework

A proper legal framework will enhance the datacollection mechanism. In this respect, countriesneed to assess their legal system already in place.The architecture in place may require someadjustments with the following characteristics:

� the types of entities that can be approached fordata;

� the boundaries in which compilers will operateand their responsibilities;

� the compliance and power to impose penaltieson entities that fail to report;

� the confidentiality aspect and prohibition to useinformation from individual entities for otherthan statistical compilation purposes;

� the establishment of independence of thestatistical compilation function from othergovernment activity, for instance, the taxationauthorities;

� the integrity of statistical releases; and

� the confidence in the compiling agency.

Conceptual Framework

(a) Accounting Framework

The guiding principle in preparing FSIs requiresthe application of an accounting standard at thenational level. One such accounting standard isthe International Accounting Standards (IASs).IASs are standards that provide concepts, whichunderlie the preparation and presentation offinancial statements of commercial, industrialand business reporting enterprises, whether inthe public or the private sector.


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The Guide on FSIs recommends that the accrualconcept of accounting be applied, which meansrevenues and gains should be recognised in theperiod in which they are earned while expenses andlosses should be recognised when they areincurred, rather than when cash is received ordisbursed.

(b) Valuation Method

Institutions should value their financialinstruments on a basis that gives the most realisticassessment. A market for these instruments or amarket for instruments having similar characteristicswould help in establishing a proper valuationapproach. For instance, an instrument, which istradable, is expected to be valued at fair value(approximation of market value) whereas for non-tradable instruments, nominal values would bemore appropriate.

(c) Residence

There should be a clear distinction between aresident and a non-resident so that the datacollected do not distort the FSIs. An institution issaid to be resident in the country where it has acentre of economic interest, a place of production,a dwelling or other premises from which it intendsto engage in economic activities on a significantscale for at least a year. Corporations, branches andsubsidiaries are residents of a country in which theyare ordinarily located given that they are engaged ineconomic activity and transactions from thatlocation rather than the economy in which theirparents are located. The residence of offshore unitsis attributed to the economies in which they arelocated. Other entities, such as shell companies,are resident in the economy in which they arelegally incorporated, or in the absence of legalincorporation, are legally domiciled.

(d) Currency and Exchange Rates

With the increasing trend in international trade,countries transact in various currencies. For thepurpose of aggregation and consolidation of data,all transactions in foreign currencies should beconverted into the domestic currency. The Guiderecommends that the applicable exchange rate bethe mid-point rate between the buying and sellingexchange rate.

(e) Maturity

The maturity of financial instruments is anotherimportant concept that should be viewed from bothliquidity and asset/liability mismatch perspectives.Liquidity measurement determines the value ofliabilities falling due in the short-term (maturity ofone year or less) while the asset/liability mismatchperspective relates to the effect of changes ininterest rates on profitability.

The Guide specifies three approaches that canbe used to determine the maturity classification offinancial instruments as follows:

(i) the first approach is on the basis of the timeuntil repayments of principal (and interest) aredue, known as remaining/residual maturity;

(ii) the second approach is on the basis of thematurity at issuance known as originalmaturity; and

(iii) finally, the duration method is based on theweighted average term to maturity of afinancial instrument. The more the cash flowsare concentrated towards the early part of aninstrument’s life, the shorter the durationrelative to maturity.

(f) Sectoral Financial Statements

The computation of FSIs requires a sectoralanalysis of the economy. Data reported byindividual institutions need to be adjusted at thesector-level primarily to eliminate transactions andpositions among institutions within the same sector.The sectoral financial statements present thespecific sectors within the context of the overalleconomy and can be used to analyse financialsector dynamics and the transmission of financialstress across sectors.

(g) Quality of Data

In practice, data collection should pass throughvarious stages notably, processing, compilation andanalysis before reaching the dissemination stage.The data should be collected and compiled on animpartial basis. The principle of objectivity has tobe firmly adhered to while manipulating datathrough the various stages. There should also be afrequent data revision policy to assess the reliabilityof preliminary data and to have regular consistencychecks carried out by the lead agency. 51

USEFULNESS OF FSIs

Assessment of the Soundnessof the Financial System

FSIs are considered as a key tool for assessingfinancial sector soundness by national authorities.Moreover, they enhance the overall effectiveness ofsurveillance by IMF, increase the transparency andstability of the international financial system andstrengthen market discipline.

The levels and trends in FSIs give an indicationof the health of the financial system. For instance,the health of the banking sector is assessed bylooking at the capital adequacy, asset quality,profitability, liquidity and exposure to market risksand the linkage between these indicators andchanges in the macroeconomic environment.

Data from the rest of the financial system, suchas the bank borrowers (also referred to as thecorporate sector), price trends and exposures to realestate markets, also serve as the basis forquantifying the vulnerability of the financial system.The combination of data analysis and qualitativeinformation will produce an overall assessment ofthe stability of the financial system.

Tool for Regulators

FSIs will be an effective early warning system forfinancial distress, through which certain symptomsmay appear. Monitoring the behavior of a numberof indicators as they exceed certain thresholdvalues or critical levels may be a good prescription.The ratios from the set of FSIs that will issue signalsof a forthcoming crisis will be identified and help todetermine the source and depth of themacroeconomic problem and subsequently timelyremedial actions may be taken.

Comparability

FSIs will promote analysis and potentially fosterbetter data collection and quality in the futurewhich will assist comparison across countries. Infact indicators would be comparable provided thatcountries adhere to internationally agreedprudential, accounting and statistical standards.The adherence to these standards is important giventhe magnitude and mobility of international capitaland the risk of contagion of financial crises fromone country to another.

According to the Guide, advancing internationalcomparability of FSIs and convergence towards abest practice remain a medium-term goal. In thenear term, most of these FSIs can be compiled fromunharmonized national data that reflect differentsupervisory and accounting practices. Over thelonger term, if FSIs are to be comparable acrosscountries, it will be important to addressharmonization of underlying accounting standards,aggregation and consolidation issues and assetvaluation, classification and provisioning rules. Inthe absence of harmonization and resolution ofthese issues, the usefulness of the core set of FSIscan be enhanced if national authorities disseminate,along with the FSIs, descriptions of the conceptsand compilation practices used in their construction.

Complement for Stress Testing

Stress testing is a key element ofmacroprudential analysis that helps to monitor andanticipate potential vulnerabilities in the financialsystem. When the set of FSIs is used as acomplement to the stress testing, it enhances themacroprudential analysis. It also adds a dynamicelement to the analysis of stress testing, that is, thesensitivity of FSIs’ outcomes in response to a varietyof macroeconomic shocks and scenarios.

APPLICATION TO MAURITIUS

The framework for an effective implementationof the FSIs in Mauritius is already in place. TheMauritian financial system is mainly governed by,inter-alia, the Banking Act 1988, Financial ServicesDevelopment Act 2001 and Companies Act 2001.The legal framework for banking and non-bankdeposit taking business is embodied in the BankingAct, which governs the licensing, regulation andsupervision of Category 1 banks, Category 2 banksand non-bank deposit taking businesses.

The Financial Services Development Act 2001provides the structure for licensing, regulation andsupervision of non-bank financial services whichmainly consists of global business companies,companies listed on the Stock Exchange ofMauritius, insurance companies and pension funds,asset and pension management companies. TheCompanies Act 2001 provides for theincorporation, internal management and windingup of companies. It also incorporates internationalbest practices.


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Presently, three main institutions gather primarydata and process them for dissemination, namely,Bank of Mauritius, Financial Services Commissionand Central Statistical Office.

The Bank of Mauritius publishes monthlystatistical bulletins and annual reports of the Bankand its Supervision Department. In addition, it hasalready embarked on the implementation of theIMF Monetary and Financial Statistics Manual for itscollection of data from deposit-taking institutions.The adoption of this Manual will further promoteharmonization in presenting comparable financialstatistics among countries. The Bank hasstandardized the balance sheet formats of Category1 banks, Category 2 banks and non-bank deposit-taking institutions. This format has improvedcomparability, sectorisation and classification ofaccounts.

Regarding the conceptual framework, theprovisions of the Companies Act incorporate theapplication of international best practices, forinstance, companies have to comply withInternational Accounting Standards. In this respect,the Bank of Mauritius has issued a draft Guidelineon Credit Impairment Measurement and IncomeRecognition with the prime focus on the

International Accounting Standard 39 (IAS 39),entitled ‘Financial Instruments: Recognition andMeasurement’. This Standard deals, among otherthings, with the valuation of financial instruments,impairment and uncollectability of financial assets.

At the regional level, the East and SouthernAfrica Banking Supervisors Group (ESAF) hasinitiated actions to harmonise, among others, theaccounting and auditing standards for banks. In thisrespect, ESAF members have been encouraged toadopt International Accounting Standards, whichwill promote better integration of the region andalso aim at a better comparability of regionalfinancial statements of key financial stakeholders.

CONCLUSION

The compilation of FSIs is a challenging task forMauritius. Its successful implementation willfacilitate the periodic monitoring of financialinstitutions and help to assess the health of thebanking sector vulnerability to a crisis and act inanticipation of any such crisis. However, certainissues such as consolidation of data forconglomerates, poor data on asset quality and lackof reporting of derivatives positions, will need to beaddressed in the near term. �

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Realisation and Securitisation of Assets

By its very nature banking involves taking risks.In most countries and in Mauritius, in particular,banks have deployed their funds into loans whichform the bulk of their assets. Consequently, one ofthe most significant risks faced by banks has beenand will continue to be credit risk, that is the riskthat the counterparty will default on his obligationsas agreed. Banks are now coming up with newtechniques to measure, manage and mitigate therisks to which they are exposed.

Traditionally, banks have placed undue relianceon the collaterals when extending credit facilities.When borrowers default and all means areexhausted to recover their dues, banks finally haveto foreclose the assets held as security. Theforeclosing and disposal of the assets do not alwaysproduce the desired results.

Banks in Mauritius have always favouredcollaterals in the form of freehold property, the priceof which has so far not experienced a sharp downtrend in cyclical patterns. In general, the maximumamount of collateralised loans granted by a bank isstated to be equivalent to two thirds of the totalestimated market value of the collateral. Therefore,when a borrower defaults, the bank will beexpected to recover its dues by disposing of theforeclosed assets. This is unfortunately not alwaysthe case.

Although banks do foreclose assets, they are notpresently empowered by law to directly sell them.The properties have to be disposed of at the sale bylevy. The legal process is overly cumbersome andinvolves time-consuming procedures. It is commonpractice for borrowers acting in bad faith todeliberately seek and obtain postponements, thusdelaying the liquidation procedures. The sales takeplace once every Thursday at the Supreme Court’sSalle des Ventes. The Salle des Ventes can barelyaccommodate 20 persons and sales are made on acash basis, hence the number of potential bidders islimited. Sales are made on a cash basis, with onequarter of the price being payable immediately. Tocompound matters, if after the sale, a buyerproposes to acquire the property for a price higherthan the adjudicated price by one sixteenth, all the

procedures have to be restarted. Even when thesale is effected without any request for outbidding,the proceeds are attributed to the various creditorsonly after a long time which may extend up to 10years. Due to these constraining factors, the pricesthat the properties fetch at the sale do not as a rulereflect their market values. The properties aregenerally adjudicated at less than half their marketvalues. As a result, banks have recourse to thismethod of recovering their dues only after they haveexhausted all the other means available.

In the event, many banks feel that the sale bylevy is not an attractive proposition. They evenhave to make a provision in respect of loans whoseattached collateral fetches much less than theexpected proceeds. This cuts into their profitability.Banks have been quite desperate in exploringavenues to simplify their recovery process and atthe same time realise their securities at valueswhich are more in line with reality.

The solution would lie in the direction of settingup some special purpose or asset managementcompanies which would facilitate the transfer ofproblem assets from financial institutions inexchange for consideration or financing.

EXPERIENCE OF DIFFERENT COUNTRIES

We could draw from the experience of othercountries which have successfully dealt with theproblem. During the South East Asian financialcrisis in 1997-99, banks were confronted with anunprecedented rise in non-performing loans. Thisled the authorities to think out a strategy to addressthe problem. The countries that were hit the hardestby the Asian crisis, viz. Indonesia, Korea, Malaysiaand Thailand, created Asset ManagementCompanies (AMCs). India also passed a legislationto come to grips with the problem of non-performing loans. To this end, the Government ofIndia passed The Securitisation and Reconstructionof Financial Assets and Enforcement of SecurityInterest Act 2002. The Act came into effect on21 June 2002. These measures are reported to beyielding encouraging results and merit our attentiontowards the satisfactory resolution of problemloans.

6. Realisation and Securitisation of Assets

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Asset reconstruction is concerned mainly withthe resolution of non-performing loans. The wholeprocess should be provided with safeguards thatpreclude abuse on the part of secured lenders.Consequently any policy should be accompaniedby a set of clear instructions which should becomplied with by all the securitisation orreconstruction companies. Transactions shouldtake place in a prudent and transparent manner andshould be executed at arm’s length so that theinterest of none of the parties is prejudiced. AMCsshould be audited regularly to ensure that the pricesat which the companies purchase assets reflectmarket prices. The auditor’s reports should be madeavailable to the regulators. AMCs should also berequired to publish regular reports describing theirperformance in pursuing their objectives. In orderto promote market discipline, the Guidelines issuedby the Reserve Bank of India require banks whichsell their assets to a securitisationcompany/reconstruction company (SC/RC) todisclose in the Notes on Accounts to their balancesheets:

(a) Number of accounts

(b) Aggregate value of accounts sold to SC/RC

(c) Aggregate consideration

(d) Aggregate gain/loss at net book value

NEED FOR EFFECTIVE ASSETMANAGEMENT POLICIES

Non-performing loans represent a major threatto any bank. They carry the potential to bring aboutthe collapse of a bank. In times of economicslowdown, a surge in non-performing loans can beexpected which could threaten the whole financialsystem and, ultimately, the whole economy. Themain South Asian countries successfully tackled theproblem by using AMCs which they set up duringtheir economic crisis. An effective assetmanagement policy can help to prevent theproblem of non-performing assets assumingunmanageable proportions.

An AMC helps to stabilise the financialcondition of a distressed bank by the followingmeans:

1. Borrowers get value for money. They are freedfrom the mercy of unscrupulous buyers.

2. Banks recover their dues.

3. It restores liquidity and solvency to financialinstitutions, restores confidence in thevaluation of assets.

4. It frees banks from the worries of perpetuallyhaving to resolve their non-performing loansand helps them to concentrate on banking.The prompt resolution of non-performingassets helps to reallocate resources which isvital to economic recovery.

5. The simultaneous offer of sale of a largenumber of similar assets exerts a downwardpressure on prices. An effective assetmanagement policy will counter that pressureand help to normalise asset prices.

WHAT IS ASSET MANAGEMENT?

Asset management involves in the first instancethe identification of non-performing assets. A non-performing asset means an asset or account ofborrower, which has been classified by a bank as asub-standard, doubtful or loss asset in accordancewith the guidelines issued by the central bank. Thisasset is then categorised into one of four broadcategories of selling, recovery, restructuring andsetting off depending on the characteristics of theasset.

Where any borrower, who is under a liability toa bank under a security agreement, makes anydefault in repayment of secured debt or anyinstalment thereof, and his accounts in respect ofsuch debt is classified by the secured creditor asnon-performing asset, then, the bank may requirethe borrower by notice in writing to discharge in fullhis liabilities to the secured creditor within 60 daysfrom the date of notice failing which the securedcreditor would be entitled to exercise any or all ofthe following rights to recover his secured debt:

(a) take possession of the secured assets;

(b) take over the management of the securedassets of the borrower;

(c) appoint any person to manage the securedassets the possession of which has beentaken over by the secured creditor. 55

Where an AMC exists, it will take over from thebank the above responsibilities until the assets areliquidated. The AMC will acquire the assets at a fairmarket value. Determining a fair value is acomplex exercise. The evaluation can be based onnet cash flows arising from the loan, viz:

• expected interest and principal repayments;

• security value;

• collection, workout and realisation risks;

• transaction costs.

On acquiring the asset from the bank, the AMCwill endeavour to negotiate with the borrower tomaximise the prospects of recovery. Variouscourses of action are open to the AMC:

• Immediate sale of some or all of the loans to athird party;

• Providing borrower additional time to settle hisdues;

• Providing additional finance to enableborrower to become viable;

• Reschedulement of interest and/or principalpayments.

The success of any of the above approaches iscontingent on the borrower’s conditions, type ofloan and macro-economic conditions prevailing inthe country. The ultimate objective of the AMC is tomaximise disposal proceeds and produce a win/winsituation for both the borrower and the bank.

TYPES OF AMCs

The main types of AMCs currently in place invarious countries are:

1. A central disposition agency

2. An entity specific to a particular bank

3. An auction process

The first type would take loans from all financialinstitutions and manage them alone. The secondtype would manage the non-performing loans of allthe banks forming part of a particular bank and/orgroup of banks. The auction process would involveaccumulating assets rapidly and selling them

without considering the other courses of actionopen to AMCs. It will become evident that the typeof an effective AMC will depend primarily on thesize of market.

FRAMEWORK FOR AN EFFECTIVEASSET MANAGEMENT COMPANY

Any effective AMC is highly dependent on twomain prerequisites: (a) Legal Framework and (b)Licensing and Regulation of AMC.

An AMC should be backed by an adequate legalframework in which both creditors and debtorshave confidence. Besides defining the rights ofownership and the legal obligations of debtors andcreditors, the legal framework should provide forthe orderly and expeditious resolution of disputedclaims, including debt recovery and realisation ofcollateral for unpaid debt.

While the AMC does provide financialinstitutions with a powerful weapon to bringdefaulting borrowers to toe the line, it should notabuse the rights of borrowers by foreclosing assetsindiscriminately. Therefore, the law should providefor rights of appeal. Under the Securitisation,Reconstruction of Financial Assets and Enforcementof Security Interest Ordinance 2002 (India) anaggrieved customer may appeal to the DebtsRecovery Tribunal within 45 days. If the borrower isstill aggrieved by an order made by the DebtsRecovery Tribunal he may appeal to an AppellateTribunal within 30 days from the date of receipt ofthe order of the Debts Recovery Tribunal.

A sound regulatory and supervisory frameworkis a basic condition to safeguard the smoothrunning of an AMC. The mainspring of an assetmanagement policy is non-performing loans.Therefore, the regulator needs to define anappropriate loan classification system andprovisioning rules.

Licensing and regulation of AMC is usuallyvested with central banks. Applicants havestatutory conditions to fulfil before being licensed.

The central bank may cancel a certificate ofregistration granted to a securitisation company ifsuch company fails to comply with any conditionssubject to which the certificate was granted.

Realisation and Securitisation of Assets

56

In order to ensure transparency, the companyshould maintain accounts in accordance withrequirements and submit or offer for inspection itsbooks of accounts or other relevant documentswhen so required by the central bank.

CONCLUSION

Loans become non-performing when borrowersfall in arrears in the repayment of principal orinterest payment or both. Some borrowers have themeans to repay but do not have the willingness torepay; i.e. they become wilful defaulters on theloans. On the other hand, there are borrowers whocannot afford to repay on account of hardships of

an economic nature. An economic slowdown canseverely undermine the capacity of borrowers tocontinue servicing and to repay their debts. In suchcircumstances an effective asset managementpolicy in the financial system can help to come togrips with the problem of non-performing assetsand so prevent a crisis that may go out of control.Given the size and specificity of Mauritius, acentralised AMC could be considered to serve theneeds of our financial system. A centralised AMCentails economies of scale and the building up of asound data base. However, this factor should notimpede the pursuit of the main objective which is toresolve non-performing loans by bringing in anasset reconstruction option. �

57

APPENDIX I

Guidelines

Guidelines /Guidance Notes

60

1. List of Guidelines/Guidance Notes1. Guidance Notes on Risk Weighted Capital Adequacy Ratio

2. Guidance Notes on General Principles for Maintenance of Accounting and

Other Records and Internal Control Systems

3. Guideline on Credit Classification for Provisioning Purposes and

Income Recognition

4. Guidelines for Calculation and Reporting of Foreign Exchange Exposures of Banks,

Foreign Exchange Dealers and Money-Changers

5. Guideline on Credit Concentration Limits

6. Guideline on Liquidity

7. Guideline on Internet Banking

8. Guideline on Corporate Governance

9. Guideline on Related Party Transactions

10. Guideline on Public Disclosure of Information

11. Guideline on Transactions or Conditions Respecting Well-Being of a Financial Institution

Reportable by the External Auditor to the Bank of Mauritius

12. Guidance Notes on Fit and Proper Person Criteria

13. Guideline on Credit Risk Management

14. Guidance Notes on Anti-Money Laundering and Combating the Financing of Terrorism

15. Draft Guideline on Credit Impairment Measurement and Income Recognition

2. Guidance Notes on Fit andProper Person Criteria

1.0 INTRODUCTION

The probity and competence of senior officers,directors and shareholders who exercise significantinfluence on financial institutions regulated by theBank of Mauritius are not only of strong interest tothe Bank of Mauritius but also to the institutionsthemselves. Market participants and the public atlarge need to be confident that persons managingthe affairs of the institutions are competent, honest,financially sound and will treat them fairly.Financial institutions must, therefore, ensure thatsuch persons are and are seen to be fit and proper.

1.1 Objective

The objective of the Guidance Notes is to set outa framework for assessing a person’s capacity to actas a fit and proper person and to provide for a basisfor decision in the matter.

1.2 Applicability

The Guidance Notes apply to banks, non-bankdeposit taking institutions, foreign exchange dealersand money changers, collectively referred to asfinancial institutions or institutions. They are issuedunder the authority of the Bank of Mauritius Act,particularly section 20, which empowers theCentral Bank to require, whenever necessary, thecooperation of authorized banks and other creditinstitutions “to ensure high standards of conductand management throughout the banking andcredit system” and section 12(v) of the Act whichempowers the Bank to do all such things as areincidental to or consequent upon the exercise of itspowers or the discharge of its duties under the Act.

The criteria outlined in the Guidance Notes areto be applied individually but it is their cumulativeeffect, which will determine whether a personmeets the test. A failure to meet one criterion willnot, of its own, necessarily mean failure to meet thetest of fit and proper person. The process willinvolve a good measure of judgment, which mustbe exercised in a fair and judicious manner, alwaysin the best interests of the institution and the soundconduct of its business.

2.0 Interpretation

In the Guidance Notes:

“fit and proper person” means a person whowhen subjected to the criteria of the GuidanceNotes together with any other criteria prescribed bythe board of directors, presents the likelihood of hisbeing in a position to discharge his responsibilitiesin a competent, honest and correct manner in thebest interests of the institution;

“senior officer” means:

(a) the chief executive officer, deputy chiefexecutive officer, chief operating officer,chief financial officer, secretary to the boardof directors, treasurer, chief internal auditor,or manager of a significant unit of thefinancial institution; or

(b) a person with a similar level of position orresponsibilities as a person in paragraph (a);

“significant influence” means the capacity of ashareholder to influence persuasively, because ofhis shareholdings, the composition of the board ofdirectors of the financial institution and/or itsfinancial and operating policy decisions.

3.0 Responsibilities of Senior Officers,Directors and Shareholders

Shareholders with significant influence,directors and senior officers of financial institutionsshall at all times be and be seen as fit and proper. Itis incumbent on the board of directors of theinstitution to ensure that this is actually the case.

3.1 Role of the Board of Directors

To effectively discharge its responsibilities, theboard of directors of a financial institution shall:

� establish fit and proper person policy, taking fullyinto account the criteria stated in the GuidanceNotes (the board may need to expand the criteriato provide for the requirements of any specialsituation); 61

� apply the policy to directors, senior officers, andshareholders that are in a position to exercisesignificant influence on the institution;

� ensure creation of appropriate documentation onthe process implemented and decisions made;and

� make the documentation available for inspectionby the Bank of Mauritius, as required.

The board’s further responsibilities are to ensurethat:

� nominations, initiated by the Board, of personsfor election to the board of directors meet the testof fit and proper person set out in theseGuidance Notes before such nominations areplaced before the shareholders’ meeting;

� candidates for appointment to the senior officerlevel, meet the test of fit and proper personbefore the appointments are made;

� acquisition of shares by persons who are likely tobe in a position to exercise significant influenceon the financial institution meet the test of fit andproper person before their shares are registeredin the register of shareholders, and to advise theBank of Mauritius if events have occurred thatput into question their ability to meet the test;

� processes are implemented to keep underconstant review the continuing capacity ofdirectors, senior officers, and shareholders withsignificant influence to meet the fit and properperson test; and

� the chief executive officer applies the fit andproper person test to other managementpositions below the senior officer level andreports to the board periodically on the resultachieved.

3.2 Responsibility of Persons Subject to Fitand Proper Person Test

In the first instance, the onus is on seniorofficers, directors, and shareholders with significantinfluence to demonstrate that they are fit and properpersons. They must, accordingly, complete the Fitand Proper Person Questionnaire, outlined in

Appendix 1, and provide any additionalinformation that the board of directors may requireto complete its investigation. They are furtherobliged to notify the board forthwith of any eventsor circumstances that have occurred subsequent totheir initial assessment of fit and proper person thatmight change the assessment or at least have amaterial bearing on it. The board shall investigatethe information, on a priority basis, and decide onthe individual’s fit and proper person status.

The board shall, in case an individual fails toobserve the above notification responsibility,nevertheless, remain vigilant about all informationavailable that might throw light on an individual’s fitand proper person status and take action asappropriate. It remains the board’s responsibility tokeep under constant review the fitness andpropriety of all persons covered under theGuidance Notes.

3.3 Role of the External Auditors

If during the course of their statutory audit of afinancial institution, the external auditors becomeaware of information that points to non-complianceor potential non-compliance by a person with the fitand proper person requirements of the GuidanceNotes, they shall forthwith advise the board ofdirectors of the matter and provide all informationnecessary. The board shall, on a priority basis, takea decision in the case and initiate whatever actionis necessary. The board’s proceedings shall beproperly documented. The board shall advise theBank of Mauritius of the matter and its decision.

3.4 Establishment of a New Institution

Any person, group of persons or entity applyingfor a licence or authorisation to establish thebusiness of a bank, non-bank deposit takinginstitution, foreign exchange dealer, or moneychanger, shall be subjected to the fit and properperson criteria specified in these Guidance Notes.Based on the information provided by theapplicant(s), the Bank of Mauritius will assess theirfitness and propriety for the purpose of granting alicence or an authorisation under the Banking Actor other appropriate statutes. The criteria will beapplicable on an on-going basis if the applicant(s) issuccessful in obtaining the licence or authorisation.62


4.0 Assessing fitness and propriety

Criteria for assessing fitness and propriety of aperson are outlined under three captions.

1. Honesty, integrity, fairness and reputation;

2. Competence, and capability; and

3. Financial soundness.

As stated earlier, it is the cumulative effect of theapplication of the criteria that will determine thefitness and propriety of a person. In applying thecriteria, the board may need to discuss the matterwith an informed party, in which a summary of thediscussion should be minuted for future reference.

4.1 Honesty, Integrity, Fairness and Reputation

Honesty, integrity and fairness are qualities thatare demonstrated over time. These attributesdemand a disciplined, on-going commitment tohigh standards of behaviour and honesty.

In determining a person’s honesty, integrity,fairness and reputation, the board of directors shallconsider all appropriate factors, including but notlimited to:

1. whether the person is or has been the subject ofany proceedings of a disciplinary or criminalnature, or has been notified of any impendingproceedings or of any investigation, whichmight lead to such proceedings;

2. whether the person, or any business in whichhe has controlling interest or exercisessignificant influence, has been investigated,disciplined, suspended or criticised by aregulatory or professional body, a court ortribunal, whether publicly or privately;

3. whether the person has been associated, inownership or management capacity, with acompany, partnership or other organisation thathas been refused registration, authorisation,membership or a licence to conduct trade,business or profession, or has had thatregistration, authorisation, membership orlicence revoked, withdrawn or terminated;

4. whether, as a result of the removal of thelicence, registration or other authoritymentioned in criterion 3, the person has beenrefused the right to carry on a trade, business orprofession requiring a licence, registration orother authorisation;

5. whether the person has been the subject of anyjustified complaint relating to regulated activities;

6. whether the person has been charged orconvicted of any criminal offence, particularlyan offence relating to dishonesty, fraud,financial crime or other criminal acts;

7. whether the person has contravened any of therequirements and standards of a regulatorybody, professional body, government or itsagencies, which are of the nature and/orsignificance that may have affected his fitnessand propriety;

8. whether the person has been a director, partner,or otherwise involved in the management, of abusiness that has gone into receivership,insolvency, or liquidation while the person wasconnected with that organisation or within oneyear after the connection;

9. whether the person has been dismissed, askedto resign or resigned from employment or froma position of trust, fiduciary appointment orsimilar position because of questions about hishonesty and integrity;

10. whether the person has ever been disqualified,under the Companies Legislation or any otherlegislation or regulation, from acting as adirector or serving in a managerial capacity;

11. whether the person has at any time shownstrong opposition or lack of willingness tomaintaining effective internal control systems;

12. whether, in the past, the person has been fair,truthful and forthcoming in his dealings with hiscustomers, superiors, auditors and regulatoryauthorities; and

13. whether the person demonstrates a readinessand willingness to comply with the requirementsand standards of the regulatory system andother legal, regulatory or professionalrequirements and standards.

The above matters may have arisen either inMauritius or elsewhere. The board of directorsshould be informed of any of these matters, but willconsider the extent and circumstances of theperson’s involvement in the relevant events, thetime it occurred and its seriousness. The board ofdirectors will gather information from allappropriate sources, on the overall reputation of aperson regardless of whether such informationresults from the above criteria and factor it in itsassessment of the person’s fitness and propriety. 63


4.2 Competence and Capability

A person must demonstrate his competence andability to understand the technical requirements ofthe business, risks inherent and managementprocesses required to conduct its operationseffectively, with due regard to the interests of allstakeholders.

In determining competence, and capability of aperson, the board of directors shall take intoaccount all relevant considerations including, butnot limited to:

1. whether the person has demonstrated, throughhis qualifications and experience, the capacityto successfully undertake the cognateresponsibilities of the position, including theestablishment of effective control regime;

2. whether the person has ever been diagnosed asbeing mentally ill or unstable;

3. whether the person has ever been disciplinedby a professional, trade or regulatory body, ordismissed or requested to resign from anyposition or office for negligence, incompetenceor mismanagement; and

4. whether the person has a sound knowledge ofthe business and responsibilities he will becalled upon to shoulder.

4.3 Financial Soundness

In order to demonstrate his capacity to ensuresafety and soundness of a financial institution,including the balancing of risks and rewards, andprotect the interests of depositors and otherstakeholders, a person must demonstrate, to thesatisfaction of the board of directors, that he hasmanaged his own financial affairs properly andprudently.

In determining a person’s financial soundness,the board of directors must consider all relevantfactors, including but not limited to:

1. whether the person has been the subject of anyjudgment or award in Mauritius or elsewhere,that remains outstanding or was not satisfiedwithin a reasonable period;

2. whether, in Mauritius or elsewhere, the personhas made any arrangements or compositionwith his creditors, filed for bankruptcy, beenadjudged bankrupt, had assets sequestrated, orbeen involved in proceedings relating to any ofthese;

3. whether a person who has been a senior officerof a company or a shareholder in a position toexercise significant influence in the companythat:

a. has been the subject of any judgment oraward, in Mauritius or elsewhere, thatremains outstanding or was not satisfiedwithin a reasonable period; and

b. has, in Mauritius or elsewhere, made anyarrangements or composition with itscreditors, filed for bankruptcy, beenadjudged bankrupt, had assets sequestrated,or been involved in proceedings relating toany of the foregoing.

The fact that a person may be of limitedfinancial means will not, in itself, affect his ability tosatisfy the financial soundness criteria.

5.0 Commencement

This Guidance Notes shall come into effectimmediately.

Bank of MauritiusOctober 2003

64

FOR ASSESSING THE FITNESS AND PROBITY OF PERSONS WITH MATERIAL INFLUENCE ONTHE OPERATION AND AFFAIRS OF BANKS, NON-BANK DEPOSIT TAKING INSTITUTIONS,

MONEY CHANGERS AND CASH DEALERS REGULATED BY THE BANK OF MAURITIUS

PROPOSED POSITION INSTITUTION

PURPOSE OF ASSESSMENT

FAMILY NAME FIRST NAME

DATE OF BIRTH (DD/MM/YYYY) PLACE OF BIRTH (TOWN AND COUNTRY)

NATIONALITY HOW NATIONALITY WAS ACQUIRED?

Birth Naturalisation Marriage

GENDER MARITAL STATUS

Male Female Single Married Divorced

ID NUMBER PASSPORT NUMBER

CURRENT POSTAL ADDRESS CURRENT RESIDENTIAL ADDRESS (if different fromcurrent postal address)

PERMANENT ADDRESS (if different from current TELEPHONE NUMBERresidential address)

Residential Business

FAX NUMBER EMAIL ADDRESS

PERSONAL DETAILS

HAVE YOU EVER BEEN SUBJECT TO A CHANGE OF NAME (if ‘Yes’ providefull details below) YES NO

PREVIOUS FAMILY NAME PREVIOUS NAME DATE OF CHANGE

REASONS FOR CHANGE

HAVE YOU CHANGED YOUR PERMANENT ADDRESS DURING THE LASTTEN YEARS (if ‘Yes’ provide full details below) YES NO

FULL PREVIOUS PERMANENT ADDRESS DATE OF CHANGE

ADDITIONAL DETAILS

Bank of MauritiusFit and Proper Person Questionnaire

65


QUALIFICATION AND YEAR EXAMINING BODY GRADE

ACADEMIC QUALIFICATIONS

PROFESSIONAL BODY STATUS DATE OF ADMISSION

PROFESSIONAL QUALIFICATIONS

PROFESSIONAL BODY STATUS DATE OF ADMISSION

Please provide full details of your proposed duties and responsibilities

PROPOSED RESPONSIBILITIES

66

1 EMPLOYER’S NAME

NATURE OF EMPLOYER’S BUSINESS

EMPLOYER’S ADDRESS

EMPLOYER’S EMPLOYER’S EMPLOYER’SPHONE NUMBER FAX NUMBER EMAIL

YOUR JOB TITLE

BRIEF DESCRIPTION DUTIES AND RESPONSIBILITIES

DATE OF APPOINTMENT DATE OF RESIGNATION

REASONS FOR RESIGNATION

2 EMPLOYER’S NAME




YOUR JOB TITLE




3 EMPLOYER’S NAME




YOUR JOB TITLE




EMPLOYMENT HISTORY COVERING AT LEAST THE TEN PREVIOUS YEARS (start with current and most recent position)

67


DATE INFLUENCE WAS DATE CONTROL WASNAME OF ENTITY

ACQUIRED RELINQUISHED

NAME OF ENTITY DATE OF APPOINTMENT DATE OF RESIGNATION

DIRECTORSHIP HISTORY OVER AT LEAST THE LAST TEN YEARS

SIGNIFICANT SHAREHOLDINGS (INCLUDING INDIRECT HOLDINGS) HISTORY OVER AT LEAST THE LAST

TEN YEARS (include only those holdings which provided you a significant influence over the operations and affairsof the entity)

68

YES NO REF.

1. Have you ever been subject to any proceedings of a disciplinary or criminal nature, orhave been notified of any impending proceedings or of any investigation, which mightlead to such proceedings? – – ……………

2. Have you, or any business in which you have had controlling interest or have exercisedsignificant influence, been investigated, disciplined, suspended or criticised by aregulatory or professional body, a court or tribunal, whether publicly or privately? – – ……………

3. Have you ever been associated, in ownership or management capacity, with acompany, partnership or other organisation that has been refused registration,authorisation, membership or a licence to conduct trade, business or profession, or hashad that registration, authorisation, membership or licence revoked, withdrawn orterminated? – – ……………

4. As a result of the removal of the relevant licence, registration or other authoritymentioned in question 3 above, have you ever been refused the right to carry on atrade, business or profession requiring a licence, registration or other authorisation? – – ……………

5. Have you ever been subject of any justified complaint relating to regulated activities? – – ……………

6. Have you ever been charged or convicted of any criminal offence, particularly anoffence relating to dishonesty, fraud, financial crime or other criminal acts? – – ……………

7. Have you ever contravened any of the requirements and standards of a regulatorybody, professional body, government or its agencies? – – ……………

8. Have you ever been a director, partner, or otherwise involved in the management, ofa business that has gone into receivership, insolvency or liquidation while you havebeen connected with that organisation or within one year after that connection? – – ……………

9. Have you ever been dismissed, asked to resign or resigned, from employment or froma position of trust, fiduciary appointment or similar because of questions about yourhonesty and integrity? – – ……………

10. Have you ever been disqualified, under the Companies legislation or any otherlegislation or regulation from acting as a director or serving in a managerial capacity? – – ……………

11. Have you ever been diagnosed as being mentally ill or unstable? – – ……………

12. Have you ever been disciplined by a professional, trade or regulatory body; ordismissed or requested to resign from any position or office for negligence,incompetence or mismanagement? – – ……………

13. Have you ever been the subject of any judgment or award, in Mauritius or elsewherethat remains outstanding or was not satisfied within a reasonable period? – – ……………

14. Have you ever made any arrangements or composition with your creditors, filed forbankruptcy, been adjudged bankrupt, had your assets sequestrated, or been involvedin proceedings relating to any of these? – – ……………

15. Have you ever been a senior officer of a company or a shareholder in a position toexercise significant influence in the company that:a. has been the subject of any judgment or award, in Mauritius or elsewhere, that

remains outstanding or was not satisfied within a reasonable period;b. has, in Mauritius or elsewhere, made any arrangements or composition with its

creditors, filed for bankruptcy, been adjudged bankrupt, had assets sequestrated,or been involved in proceedings relating to any of the foregoing? – – ……………

16. Do you have reasons to believe that any of your close relatives or business associates, ifsubject to the above tests, would have responded by a ‘Yes’ to any of the above questions? – – ……………

IF THE ANSWER TO ANY OF THESE QUESTIONS IS ‘YES’ PLEASE PROVIDE DETAILS ON SEPARATE PAGES WITH PROPER REFERENCING

SPECIFIC TEST TO ASSESS FITNESS AND PROPRIETY

69


I hereby certify that:

a. to the best of my knowledge and belief the statement made and the information supplied in this

questionnaire and the attachments are correct and that there are no other facts that are relevant to

the board of directors for assessing my fitness and propriety;

b. I understand that the board of directors may seek additional information from any third parties it

deems necessary in view of assessing my fitness and propriety; and

c. I will bring to the attention of the board of directors any matter which may potentially affect my

status as being someone fit and proper as and when it crops up.

SIGNED: DATE:

SIGNATURE AND ACKNOWLEDGEMENT

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1.0 INTRODUCTION

The importance of credit policy has beenhighlighted in several guidelines issued by the Bankof Mauritius.

The Guideline on Related Party Transactionsrequires the board of directors of a financialinstitution to establish a conduct review committee(name subsequently changed to Conduct Reviewand Risk Policy Committee) from its membership tomonitor and review related party transactions (mostof which are likely to be credit related).

The Guideline on Corporate Governance ascribesspecific responsibility to the board of directors toreview the adequacy of risk management policies,systems and procedures, approve them andperiodically review their continuing effectivenessand management’s performance in controlling risks.

Under the Guideline on Credit ConcentrationLimits, the board is mandated to:

� assess and approve the credit concentration riskpolicy;

� review at least once a year the policy and relatedtechniques, procedures and information systems;

� ensure through audit and inspection adherenceto the credit concentration risk policy; and

� review all significant exposures to creditconcentration risk.

The Guideline on Public Disclosure ofInformation requires a financial institution todisclose publicly the role of its board of directors inapproving and periodically reviewing riskmanagement policies, ensuring employment ofcompetent and qualified persons to control andmanage risks, and reviewing reports frommanagement to ensure the adequacy of theinstitution’s risk profile and controls. It furtherenlarges the role of the conduct review committeeto review and approve risk policies and ensure theireffective implementation. This new committee,called Conduct Review and Risk Policy Committee,shall consist of only independent directors.

The proposed Guideline on Credit ImpairmentMeasurement and Income Recognition requires theboard of directors to establish credit risk

management policy and credit impairmentrecognition and measurement policy.

The guideline at hand does not replace, butrather supplements the existing regulations andguidelines. Where it imposes more stringentrequirements than those in the existing regulationsand guidelines, such requirements shall apply. Theguideline will become a focal point of reference forall requirements of the Bank of Mauritius for creditrisk policy formulation and management. For thespecific subject of credit impairment recognitionand measurement, reliance will be placed on theproposed Guideline on Credit ImpairmentMeasurement and Income Recognition.

The guideline underlines, in no uncertainterms, that the role of the board of directors and,through it, the chief executive officer, is to managethe credit activity of the financial institution withintegrity, using strictly and exclusively prudentialcredit criteria. They shall remain accountable andliable for actions taken, or not taken when suchactions were called for using normal prudence, notonly during the time they were in office but alsoafterwards.

The guideline draws its authority from the Bankof Mauritius Act and the Banking Act, withparticular reference to Section 20 of the former andSection 33 of the latter. The applicable provisionsof the Companies Act are Section 143, specifyingduties of directors to act in good faith and in thebest interest of the company, Section 160, settingout standards of care and civil liability of officersand directors, and Section 139, providing forcontinuing liability of directors even after theycease to hold office. Section 174 of the same Actpermits personal actions by shareholders againstdirectors.

The guideline applies to all deposit takingfinancial institutions regulated by the Bank ofMauritius. It is not intended to be socomprehensive that it covers each and every aspectof credit risk management activity. A financialinstitution may want to establish a morecomprehensive and sophisticated framework thanthat outlined in the guideline. This is entirelyacceptable as long as all essential elements of theguideline are fully taken into account.

3. Guideline on Credit Risk Management

71


2.0 Purposes

The Guideline has two purposes. First, it sets outthe responsibilities and accountabilities of theboard of directors and management (chief executiveofficer) in credit risk management and second, itoutlines the processes to be used in managing thecredit activity in a financial institution. Theguideline recognizes that the design of processeswill take into account the specific nature of aninstitution’s business, its constraints, risks,opportunities and strategies.

The guideline further recognizes that creditconstitutes by far the largest part of a financialinstitution’s business in Mauritius and itsmismanagement can pose a serious threat to theinstitution’s continued existence, with resultingimpacts on the interests of depositors and otherstakeholders. Prudential credit risk managementis, therefore, of utmost importance.

When a banking operation is conducted by wayof a branch of a foreign bank, the role of the boardof directors shall be assumed by the head office. Thehead office shall ensure that its branch is complyingwith applicable laws, regulations, guidelines andother prudential directives.

3.0 Interpretation

“credit” means a provision of, or commitment toprovide, funds or substitutes for funds, to aborrower, including off-balance sheet transactions,customers’ lines of credit, overdrafts, billspurchased and discounted, and finance leases.

“credit risk” means the risk of credit loss thatresults from the failure of a borrower to honour theborrower’s credit obligation to the financialinstitution.

“financial institution” means any deposit-takingbody or person regulated by the Bank of Mauritius.

“prudent”, in respect of a financial institution,means the exercise of careful and practicaljudgment that would be exercised by aknowledgeable person in the financial institutionsindustry, having regard to

� the objectives of the financial institution,

� all risks to which the financial institution isexposed, including credit risk, and

� the amount and nature of the financialinstitution’s capital.

4.0 Establishment of Credit Risk Policy

A financial institution must establish a written creditrisk policy that

� includes a statement of principles and objectivesgoverning the extent to which the institution iswilling to accept credit risk;

� establishes the areas of credit (types of credit,target industry sectors, geographical areas,countries) in which the financial institution iswilling to engage and those in which it is notwilling to engage;

� clearly defines the levels of authority to approvecredits;

� establishes prudent limits on the financialinstitution’s exposure to credit risk and on theconcentration of credit risk in different areas ofthe institution’s credit portfolio; and

� clearly defines the accountabilities of the chiefexecutive officer to the board of directors in thelight of this guideline.

5.0 Responsibilities and Accountabilitiesof the Board of Directors

The board of directors shall, as a minimum,

� approve, if acceptable, the credit risk policy;

� review, at least once a year, the policy andrelated techniques, controls, procedures, andinformation systems to implement the policy toensure their continued adequacy andeffectiveness;

� ensure through independent inspection/auditfunction adherence to the policy, techniques,controls, procedures, and information systems;

� ensure the selection and appointment ofqualified and competent management toadminister the credit risk management function;

� ensure the establishment and proper functioningof the Conduct Review and Risk PolicyCommittee of the board, as called for in theGuideline on Public Disclosure of Information, itbeing understood that credit risk managementwill be a prime function of this committee;72

� direct the Conduct Review and Risk PolicyCommittee to report to the board on its activitiesand decisions taken, at such frequency as theboard may decide;

� direct the chief executive officer to submit acomprehensive written report to the board onthe management of exposures to credit risk atleast once every six months (format andcomponents of the report to be decided betweenthe two beforehand), and submit such otherreports at such intervals as the board mayspecify;

� review credits granted to, or guaranteed by,directors or management personnel or to entitiesin which directors or management personnel arepartners, directors or officers, and review theinstitution’s policy related to such credits;

� review credits granted to, or guaranteed by,entities controlled by the financial institution, orofficers or directors of such entities, and reviewthe institution’s policy related to such credits;

� establish country risk limits and ensure that incase of international credit transactions, inaddition to standard risks, any risks associatedwith economic, political and social environmentin the country as well as transfer risk are takeninto account;

� review all significant credit exposures of thefinancial institution, the term significant to bedefined by the board in relation to theinstitution’s capital base;

� review all significant delinquent credits andmanagement’s actions taken or contemplated fortheir recovery;

� review any credits granted in conflict of thewritten credit risk policy, and take action toensure future compliance with the policy;

� review trends in the quality of, and concentrationin, the financial institution’s credit portfolio, toidentify emerging problems and take action todeal with the problems; and

� ensure that the financial institution’sremuneration policy is in line with the credit riskstrategy and does not reward imprudent activitiesof credit staff.

6.0 Responsibilities and Accountabilities ofChief Executive Officer

The chief executive officer shall, as a minimum,

� develop a soundly based credit risk managementpolicy for approval by the board of directors,which deals with, among other things,

- the extent to which the financial institutionshould assume credit risk, taking into accountthe capital base of the institution, a prudentialassessment of the institution’s ability to absorblosses, the financial health of its existing creditportfolio, the diversification of the portfolio,and the institution’s business plan;

- the targeted portfolio concentration limits interms of counterparties, industry sectors,geographic regions, foreign country or class ofcountries, and classes of security;

- the areas of credit in which the institutionshould engage or restrict itself from engaging;

- an in-depth analysis of risks associated withthe introduction of new products or newinitiatives and development of adequatesystems to control the risks, and seek approvalof the board of directors before launchingthem;

- clearly documented delegation of creditapproval authority of management personneland committees, taking into account the typeand size of credit, the types of risks to beassessed, and the experience and competenceof individuals; and

- consistency and tie in with the institution’sbusiness plan and other asset/liabilitymanagement considerations;

� ensure that the board approved credit riskmanagement policy is implemented in its truespirit, using strictly and exclusively prudentialcredit appraisal criteria and considerations andnot influenced by any extraneous factors;

� establish and ensure proper functioning of RiskManagement Committee of management, ascalled for in the Guideline on Public Disclosureof Information, it being understood that creditrisk management will be a prime function of thiscommittee, which shall report on its work to thechief executive officer for ratification of decisionstaken; 73

� ensure that the credit approval process is notunduly influenced by market share or growthtargets;

� establish and utilize effectively a system tomonitor and control the nature, composition,and quality of the credit portfolio and to ensurethat the portfolio is conservatively valued and theguideline of the Bank of Mauritius on creditimpairment measurement and incomerecognition is fully complied with;

� ensure implementation of a credit managementinformation system that

- tracks the evolving circumstances of a credit,repayments regularity, borrower’s financialcondition, continuing value of the security, andother attributes of the credit;

- tracks credits by portfolio characteristics,including single and associated groups ofborrowers, types of credit facilities, industrysectors and geographical regions;

� ensure implementation of an appropriatemanagement reporting system covering thecontent, format and frequency of information tomanagement concerning the institution’s creditrisk position, to permit sound and prudentanalysis and control of existing and potentialcredit risk exposures;

� install adequate internal controls, covering theentire credit spectrum, including segregation ofactivities between the persons responsible foranalysis, authorization, and execution of credittransactions and those responsible for theirmonitoring and in the case of impaired credits,their follow-up, and the establishment of anappropriate internal rating system for individualcredits;

� ensure implementation of an effective internalinspection/audit function to review and assessthe credit risk management activities, which willprovide assurance to management and the boardthat

- credit activities are in compliance with thecredit risk management policy and with thelaws and guidelines;

- credits are duly authorized, accuratelyrecorded, and appropriately valued;

- credits are appropriately rated according to theinternal rating system in place;

- credit files are properly maintained andcomplete;

- potential problem accounts are beingidentified on a timely basis and adetermination can be made whether provisionfor credit losses is adequate in accordancewith the guideline on the subject; and

- credit risk management information reports areadequate and accurate;

� establish a communication system for effectivedissemination of credit risk management policiesand procedures to employees engaged in thecredit risk management process;

� submit comprehensive written reports to theboard of directors at a frequency to be decidedby the board but no less than once every sixmonths, dealing with

- significant credit activities of the financialinstitution and composition and quality of thecredit portfolio;

- significant credit exposures outstanding;

- significant impaired credits, their current statusand collection prospects;

- credit transactions undertaken that are not inaccordance with the credit risk managementpolicy, including delegated approvalauthorities, giving reasons for departure andoutlining initiatives planned by management tocurtail repetition of such transactions;

- credits granted to, or guaranteed by, directorsor management personnel or to entities inwhich directors or management personnel arepartners, directors or officers, including theinstitution’s policy related to such credits;

- credits granted to, or guaranteed by, entitiescontrolled by the financial institution, orofficers or directors of such entities, includingthe institution’s policy related to such credits;and

- trends in portfolio quality and the level ofdiversification, and an analysis of emergingproblems and remedial actions contemplated.

� submit such other reports to the board of directorsand at such interval as the board may decide.


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7.0 Conduct Review and Risk Policy Committee

The Guideline on Public Disclosure ofInformation envisages a much larger role of theConduct Review and Risk Policy Committee thanmerely credit risk management. For functionalityreasons, the board may decide to establish aseparate credit risk management committeereporting to it rather than relying on the ConductReview and Risk Policy Committee. Regardless ofthe format chosen, the function of the committeewould be to assist the board in discharging itsresponsibilities in the area.

The board will assign responsibility with respectto related party transactions to the committee andsuch other responsibilities listed in paragraph 5.0 asit may decide. All decisions taken by the committeeshall be submitted to the board for ratification. Theboard will decide on the frequency of reporting bythe committee but in view of the sensitivitiesnormally surrounding credit risk managementissues, reporting at short intervals is advisable.

8.0 Credit Risk Management Process

Credit risk management process should coverthe entire credit cycle starting from the originationof the credit in a financial institution’s books to thepoint the credit is extinguished from the books. Itshould provide for sound practices in:

� credit processing/appraisal;

� credit approval/sanction;

� credit documentation;

� credit administration;

� disbursement;

� monitoring and control of individual credits;

� monitoring the overall credit portfolio (stress

testing);

� credit classification; and

� managing problem credits/recovery.

There is some duplication between the previoussections of the guideline and this section. This isacceptable in the interest of completeness ofprocesses outlined.

8.1 Credit Processing/Appraisal

Credit processing is the stage where all requiredinformation on credit is gathered and applicationsare screened. Credit application forms should besufficiently detailed to permit gathering of allinformation needed for credit assessment at theoutset. In this connection, financial institutionsshould have a checklist to ensure that all requiredinformation is, in fact, collected.

Financial institutions should set out pre-qualification screening criteria, which would act asa guide for their officers to determine the types ofcredit that are acceptable. For instance, the criteriamay include rejecting applications from blacklistedcustomers. These criteria would help institutionsavoid processing and screening applications thatwould be later rejected.

Moreover, all credits should be for legitimatepurposes and adequate processes should beestablished to ensure that financial institutions arenot used for fraudulent activities or activities thatare prohibited by law or are of such nature that ifpermitted would contravene the provisions of law.Institutions must not expose themselves toreputational risk associated with granting credit tocustomers of questionable repute and integrity.

The next stage to credit screening is creditappraisal where the financial institution assesses thecustomer’s ability to meet his obligations.Institutions should establish well designed creditappraisal criteria to ensure that facilities are grantedonly to creditworthy customers who can makerepayments from reasonably determinable sourcesof cash flow on a timely basis.

Financial institutions usually require collateralor guarantees in support of a credit in order tomitigate risk. It must be recognized that collateraland guarantees are merely instruments of riskmitigation. They are, by no means, substitutes for acustomer’s ability to generate sufficient cash flowsto honour his contractual repayment obligations.Collateral and guarantees cannot obviate orminimize the need for a comprehensive assessmentof the customers ability to observe repaymentschedule nor should they be allowed tocompensate for insufficient information from thecustomer. 75

Care should be taken that working capitalfinancing is not based entirely on the existence ofcollateral or guarantees. Such financing must besupported by a proper analysis of projected levels ofsales and cost of sales, prudential working capitalratio, past experience of working capital financing,and contributions to such capital by the borroweritself.

Financial institutions must have a policy forvaluing collateral, taking into account therequirements of the Bank of Mauritius guidelinesdealing with the matter. Such a policy shall, amongother things, provide for acceptability of variousforms of collateral, their periodic valuation, processfor ensuring their continuing legal enforceabilityand realization value. Needless to say that in theevent of credit deterioration, credit enforcement orforeclosure actions may yield proceeds much lessthan initially foreseen and the value of collateralsshould accordingly be very conservativelydetermined as a set-off against default risk.

In the case of loan syndication, a participatingfinancial institution should have a policy to ensurethat it does not place undue reliance on the creditrisk analysis carried out by the lead underwriter.The institution must carry out its own due diligence,including credit risk analysis, and an assessment ofthe terms and conditions of the syndication.

The appraisal criteria will of necessity varybetween corporate credit applicants and personalcredit customers. Corporate credit applicants mustprovide audited financial statements in support oftheir applications. As a general rule, the appraisalcriteria will focus on:

� amount and purpose of facilities and sources ofrepayment;

� integrity and reputation of the applicant as wellas his legal capacity to assume the creditobligation;

� risk profile of the borrower and the sensitivity ofthe applicable industry sector to economicfluctuations;

� performance of the borrower in any creditpreviously granted by the financial institution,and other institutions, in which case a creditreport should be sought from them;

� the borrower’s capacity to repay based on hisbusiness plan, if relevant, and projected cashflows using different scenarios;

� cumulative exposure of the borrower to differentinstitutions;

� physical inspection of the borrower’s businesspremises as well as the facility that is the subjectof the proposed financing;

� borrower’s business expertise;

� adequacy and enforceability of collateral orguarantees, taking into account the existence ofany previous charges of other institutions on thecollateral;

� current and forecast operating environment ofthe borrower;

� background information on shareholders,directors and beneficial owners for corporatecustomers; and

� management capacity of corporate customers.

8.2 Credit-approval/Sanction

A financial institution must have in place writtenguidelines on the credit approval process and theapproval authorities of individuals or committees aswell as the basis of those decisions. Approvalauthorities should be sanctioned by the board ofdirectors. Approval authorities will cover newcredit approvals, renewals of existing credits, andchanges in terms and conditions of previouslyapproved credits, particularly credit restructuring,all of which should be fully documented andrecorded. Prudent credit practice requires thatpersons empowered with the credit approvalauthority should not also have the customerrelationship responsibility.

Approval authorities of individuals should becommensurate to their positions withinmanagement ranks as well as their expertise.Depending on the nature and size of credit, itwould be prudent to require approval of twoofficers on a credit application, in accordance withthe Board’s policy. The approval process should bebased on a system of checks and balances. Someapproval authorities will be reserved for the creditcommittee in view of the size and complexity of thecredit transaction. Local banks operating throughbranches in Mauritius should consider centralizingtheir credit approval process at the head office.


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Depending on the size of the financialinstitution, it should develop a corps of credit riskspecialists who have high level expertise andexperience and demonstrated judgment inassessing, approving and managing credit risk. Anaccountability regime should be established for thedecision-making process, accompanied by a clearaudit trail of decisions taken, with properidentification of individuals/committees involved.All this must be properly documented.

All credit approvals should be at an arm’slength, based on established criteria. Credits torelated parties should be closely analyzed andmonitored so that no senior individual in theinstitution is able to override the established creditgranting process. Related party transactions shouldbe reviewed by the board of directors under dueprocesses of good governance.

8.3 Credit Documentation

Documentation is an essential part of the creditprocess and is required for each phase of the creditcycle, including credit application, credit analysis,credit approval, credit monitoring, collateralvaluation, impairment recognition, foreclosure ofimpaired loan and realization of security. Theformat of credit files must be standardized and filesneatly maintained with an appropriate system ofcross-indexing to facilitate review and follow-up.The Bank of Mauritius will pay particular attentionto the quality of files and the systems in place fortheir maintenance.

Documentation establishes the relationshipbetween the financial institution and the borrowerand forms the basis for any legal action in a court oflaw. Institutions must ensure that contractualagreements with their borrowers are vetted by theirlegal advisers. Credit applications must bedocumented regardless of their approval orrejection. All documentation should be availablefor examination by the Bank of Mauritius.

Financial institutions must establish policies oninformation to be documented at each stage of thecredit cycle. The depth and detail of informationfrom a customer will depend on the nature of thefacility and his prior performance with theinstitution. A separate credit file should bemaintained for each customer. If a subsidiary file iscreated, it should be properly cross-indexed to themain credit file.

For security reasons, financial institutionsshould consider keeping only the copies of criticaldocuments (i.e., those of legal value, facility letters,signed loan agreements) in credit files whileretaining the originals in more secure custody.Credit files should also be stored in fire-proofcabinets and should not be removed from theinstitution's premises.

Financial institutions should maintain achecklist that can show that all their policies andprocedures ranging from receiving the creditapplication to the disbursement of funds have beencomplied with. The checklist should also includethe identity of individual(s) and/or committee(s)involved in the decision-making process.

8.4 Credit Administration

Financial institutions must ensure that theircredit portfolio is properly administered, that is,loan agreements are duly prepared, renewal noticesare sent systematically and credit files are regularlyupdated.

An institution may allocate its creditadministration function to a separate department orto designated individuals in credit operations,depending on the size and complexity of its creditportfolio.

A financial institution’s credit administrationfunction should, as a minimum, ensure that:

� credit files are neatly organized, cross-indexed,and their removal from the premises is notpermitted;

� the borrower has registered the requiredinsurance policy in favour of the bank and isregularly paying the premiums;

� the borrower is making timely repayments oflease rents in respect of charged leaseholdproperties;

� credit facilities are disbursed only after all thecontractual terms and conditions have been metand all the required documents have beenreceived;

� collateral value is regularly monitored;

� the borrower is making timely repayments oninterest, principal and any agreed to fees andcommissions;

� information provided to management is bothaccurate and timely; 77

� responsibilities within the financial institutionare adequately segregated;

� funds disbursed under the credit agreement are,in fact, used for the purpose for which they weregranted;

� “back office” operations are properly controlled;

� the established policies and procedures as wellas relevant laws and regulations are compliedwith; and

� on-site inspection visits of the borrower’sbusiness are regularly conducted andassessments documented.

8.5 Disbursement

Once the credit is approved, the customershould be advised of the terms and conditions of thecredit by way of a letter of offer. The duplicate of thisletter should be duly signed and returned to theinstitution by the customer. The facilitydisbursement process should start only upon receiptof this letter and should involve, inter alia, thecompletion of formalities regarding documentation,the registration of collateral, insurance cover in theinstitution’s favour and the vetting of documents bya legal expert. Under no circumstances shall fundsbe released prior to compliance with pre-disbursement conditions and approval by therelevant authorities in the financial institution.

8.6 Monitoring and Control of Individual Credits

To safeguard financial institutions againstpotential losses, problem facilities need to beidentified early. A proper credit monitoring systemwill provide the basis for taking prompt correctiveactions when warning signs point to a deteriorationin the financial health of the borrower. Examples ofsuch warning signs include unauthorised drawings,arrears in capital and interest and a deterioration inthe borrower’s operating environment. Financialinstitutions must have a system in place to formallyreview the status of the credit and the financialhealth of the borrower at least once a year. Morefrequent reviews (e.g at least quarterly) should becarried out of large credits, problem credits or whenthe operating environment of the customer isundergoing significant changes.

In broad terms, the monitoring activity of theinstitution will ensure that:

� funds advanced are used only for the purposestated in the customer’s credit application;

� financial condition of a borrower is regularlytracked and management advised in a timelyfashion;

� borrowers are complying with contractualcovenants;

� collateral coverage is regularly assessed andrelated to the borrower’s financial health;

� the institution’s internal risk ratings reflect thecurrent condition of the customer;

� contractual payment delinquencies are identifiedand emerging problem credits are classified on atimely basis; and

� problem credits are promptly directed tomanagement for remedial actions.

More specifically, the above monitoring willinclude a review of up-to-date information on theborrower, encompassing:

� opinions from other financial institutions withwhom the customer deals;

� findings of site visits;

� audited financial statements and latestmanagement accounts;

� details of customers' business plans;

� financial budgets and cash flow projections; and

� any relevant board resolutions for corporatecustomers.

The borrower should be asked to explain anymajor variances in projections provided in supportof his credit application and the actualperformance, in particular variances respectingprojected cash flows and sales turnover.

8.7 Monitoring the Overall Credit Portfolio(Stress Testing)

An important element of sound credit riskmanagement is analysing what could potentially gowrong with individual credits and the overall creditportfolio if conditions/environment in whichborrowers operate change significantly. The resultsof this analysis should then be factored into theassessment of the adequacy of provisioning andcapital of the institution. Such stress analysis canreveal previously undetected areas of potentialcredit risk exposure that could arise in times ofcrisis.


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Possible scenarios that financial institutionsshould consider in carrying out stress testinginclude:

� significant economic or industry sectordownturns;

� adverse market-risk events; and

� unfavourable liquidity conditions.

Financial institutions should have industryprofiles in respect of all industries where they havesignificant exposures. Such profiles must bereviewed /updated every year.

Each stress test should be followed by acontingency plan as regards recommendedcorrective actions. Senior management mustregularly review the results of stress tests andcontingency plans. The results must serve as animportant input into a review of credit riskmanagement framework and setting limits andprovisioning levels.

8.8 Classification of credit

The proposed Guideline on Credit ImpairmentMeasurement and Income Recognition that willreplace the existing Guideline on CreditClassification for Provisioning Purposes and IncomeRecognition, requires the board of directors of afinancial institution to

“establish credit risk management policy, andcredit impairment recognition and measurementpolicy, the associated internal controls,documentation processes and informationsystems;”

Credit classification process grades individualcredits in terms of the expected degree ofrecoverability. Financial institutions must have inplace the processes and controls to implement theboard approved policies, which will, in turn, be inaccord with the proposed guideline. They shouldhave appropriate criteria for credit provisioning andwrite off. Up until the time the proposed guidelinecomes into effect, the existing guideline on creditclassification will continue to apply.

International Accounting Standard 39 requiresthat financial institutions shall, in addition to

individual credit provisioning, assess creditimpairment and ensuing provisioning on a creditportfolio basis. Financial institutions must,therefore, establish appropriate systems andprocesses to identify credits with similarcharacteristics in order to assess the degree of theirrecoverability on a portfolio basis.

The proposed Guideline on Credit ImpairmentMeasurement and Income Recognition specifiesrules for consideration of collateral in assessment ofthe recoverable value of credit. Financialinstitutions should establish appropriate systemsand controls to ensure that collateral continues tobe legally valid and enforceable and its netrealizable value is properly determined. This isparticularly important for any delinquent credits,before netting off the collateral’s value against theoutstanding amount of the credit for determiningprovision.

As to any guarantees given in support of credits,financial institutions must establish procedures forverifying periodically the net worth of the guarantor.

8.9 Managing Problem Credits/Recovery

A financial institution’s credit risk policy shouldclearly set out how problem credits are to bemanaged. The positioning of this responsibility inthe credit department of an institution may dependon the size and complexity of credit operations. Itmay form part of the credit monitoring section ofthe credit department or located as an independentunit, called the credit workout unit, within thedepartment. Often it is more prudent and indeedpreferable to segregate the workout activity from thearea that originated the credit in order to achieve amore detached review of problem credits. Theworkout unit will follow all aspects of the problemcredit, including rehabilitation of the borrower,restructuring of credit, monitoring the value ofapplicable collateral, scrutiny of legal documents,and dealing with receiver/manager until therecovery matters are finalized.

Financial institutions will put in place systems toensure that management is kept advised on aregular basis on all developments in the recoveryprocess, may that emanate from the credit workoutunit or other parts of the credit department. 79

There should be clear evidence on file of thesteps that have been taken by the financialinstitution in pursuing its claims against adelinquent customer, including any legal stepsinitiated to realize on the collateral. Where there isa delay in the liquidation of collateral or othercredit recovery processes, the rationale should beproperly documented and anticipated actionsrecorded, taking into account any revised planssubmitted by the borrower.

The accountability of individuals/committeeswho sanctioned the credit as well as those whosubsequently monitored the credit should berevisited and responsibilities ascribed. Lessonslearned from the post mortem should be dulyrecorded on file.

9.0 Management Information Systems

The feasibility and effectiveness of the variousrequirements of the credit risk managementframework, outlined in this guideline, depend, inlarge measure, on the adequacy of managementinformation systems in a financial institution.

The information generated by managementinformation systems enables the board andmanagement to fulfill their respective oversight

roles, including the adequate level of capital thatthe institution should be carrying. The quality,detail and timeliness of information respecting thecomposition and soundness of credit portfolio, arecritical to credit risk management.

A well functioning information system wouldpermit credit exposures approaching risk limits tobe identified and brought to the timely attention ofmanagement and the board. Also, the system’sdesign can throw out information on concentrationof risks within the credit portfolio, includingconcentration in maturity streams, enablingmanagement to take remedial action in a timelymanner.

10.0 Commencement

The Guideline shall come into effect on5 January 2004.

Bank of Mauritius

December 2003


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APPENDIX II

81

Relevant legislative changes effected during theyear under review and regulatory measures taken toenhance the operational efficiency of financialinstitutions are set out below:-

Legislative Changes

The following enactments were amended by theFinance Act 2002.

(i) The Banking Act 1988

The definitions of “class A banking” formerlydomestic banking and “class B banking” formerlyoffshore banking were amended to “category 1banking” and “category 2 banking” respectivelyand accordingly a corresponding change in thedefinitions of “Class A Banking Licence” to“Category 1 Banking Licence”, “Class B BankingLicence” to “Category 2 Banking Licence” and“class B banking transactions” to “category 2banking transactions” was effected.

The definition of “related corporation” in theBanking Act was deleted and, in line with theCompanies Act 2001, replaced by that of “relatedcompany”.

By virtue of the addition of a new subsection (5)after section 22 subsection (4), banks were, for thepurpose of participating in the equity capital ofenterprises, permitted to set up or participate inequity funds approved by the Financial ServicesCommission with the proviso, however, that thecapital adequacy requirements imposed by theBank of Mauritius from time to time are notimpaired by such investments.

(ii) The Companies Act 2001

The definition of “International AccountingStandards” in section 2(1) of the Companies Act2001 was limited to standards issued by theInternational Accounting Standards Committee andany other entity to which responsibility thereof hadbeen assigned by the Committee and suchinterpretations issued in respect of those Standardsby the International Accounting StandardsCommittee. It has, by the Finance Act 2002, beendeleted and replaced by a new larger definition.

The new definition brings within its four corners,the International Accounting Standards issued bythe International Accounting Standards Committee,the International Financial Reporting Standardsissued by the International Accounting StandardsBoard, and and any Standards issued by thesebodies or their successor bodies and includes theInterpretations of the Standing InterpretationsCommittee of the International AccountingStandards Committee, the International FinancialReporting Interpretations Committee of theInternational Accounting Standards Board, and anyInterpretations issued by the InterpretationsCommittees of the above bodies or their successorbodies.

(iii) The Financial Services Development Act 2001

Section 33 of the Financial ServicesDevelopment Act 2001 with respect toconfidentiality has been amended to permit thedisclosure of information in relation to financialinstitutions carrying out activities specified in Part IIof the First Schedule of the Act, to the Bank ofMauritius and to foreign institutions performingfunctions similar to those of the Financial ServicesCommission. The information so disclosed,however, should remain within the precincts ofthose bodies and should not be revealed to anyother party.

Further, the words “Class A Banking Licence” insection 21(2)(a), “Class B Banking Licence” and“class B banking transactions” in section 42(3) ofthe Financial Services Development Act 2001 weredeleted and replaced by the words “Category 1Banking Licence”, “Category 2 Banking Licence”and “category 2 banking transactions”, respectively,in line with the changes brought in that respect, inthe Banking Act.

(iv) The Foreign Exchange Dealers Act 1995

The definitions of “domestic bank” and“offshore bank” were deleted in the ForeignExchange Dealers Act and definitions for “Category1 banking”, “Category 2 banking”, “Category 1Banking Licence” and “Category 2 BankingLicence” inserted and ascribed as having the samemeaning as in the Banking Act. Similarly, the

1. Legislative Changes and Regulatory Measures

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Appendix II

definition of “offshore company” was deleted and adefinition for “Category 1 Global Business Licence”was inserted and ascribed as having the samemeaning as in the Financial Services DevelopmentAct 2001.

(v) The Non-Citizens (Property Restriction) Act

The definition of “share” in the Non-Citizens(Property Restriction) Act which was limited to aninterest in a company, partnership or société or anyother body corporate which holds or purchases orotherwise acquires an immovable property inMauritius has been enlarged to include:

(i) A share in a partnership or société or anyother body corporate which reckons amongst its assets -

(A) any freehold or leasehold immovableproperty in Mauritius; or

(B) any share in a company or in a companyholding shares in a subsidiary or anyshare in a partnership or société or anyother body corporate, which itselfreckons amongst its assets, freehold orleasehold immovable property inMauritius.

(ii) A share in a company which reckonsamongst its assets –

(A) any freehold or leasehold immovableproperty in Mauritius; or

(B) any share in a company holding sharesin a subsidiary or any share in apartnership or société or any other bodycorporate, which itself reckons amongstits assets, freehold or leaseholdimmovable property in Mauritius.

No certificate under the Act was required toenable a non-citizen to hold property in virtue of alease for a term not exceeding in the aggregate, 6months in a year. The no-certificate requirementhas been enlarged to a lease agreement or tenancyagreement for a term not exceeding 20 years.

Further, a new subparagraph (iii) has beenadded in section 3(3) of the Act requiring nocertificate for a non-citizen or a person not residentin Mauritius to purchase or otherwise acquire animmovable property, a flat or apartment under thePermanent Resident Scheme, or under the Schemeto Attract Professionals for Emerging Sectors or from

a company holding an investment certificate inrespect of a project under the Integrated ResortScheme, prescribed under the InvestmentPromotion Act.

The words “Class B Banking Licence” whereverthey appeared in the Non-Citizens (PropertyRestriction) Act were deleted and replaced by thewords “Category 2 Banking Licence” in line with thechanges brought in that respect in the Banking Act.

(vi) The Unified Revenue Act

The definition of “large taxpayer” in section8B(5) of the Act was amended to exclude acorporation holding a Category 1 Global BusinessLicence or a bank holding a Category 2 BankingLicence or a bank holding both a Category 1Banking Licence and a Category 2 Banking Licencein so far as it relates to the business in respect of theCategory 2 Banking Licence.

(vii) The Value Added Tax Act

The Value Added Tax Act was amended to makethe following services subject to VAT:

(A) services provided to merchants acceptinga credit card or debit card as payment forthe supply of goods or services (merchant’sdiscount);

(B) services in respect of safe deposit lockers,issue and renewal of credit cards and debitcards; and

(C) services for keeping and maintainingcustomers’ accounts (other than transactionsinvolving the primary dealer system).

Services provided by the Bank of Mauritius wereexempted from the payment of VAT.

All Category 1 banks, irrespective of theirturnover of taxable supplies, are henceforthrequired to apply to the Commissioner for ValueAdded Tax for compulsory registration as aregistered person under the Act. Category 1 bankshave, however, been dispensed from issuingreceipts or invoices in respect of the servicesrendered by them or to keep legible copies thereof.

Furthermore, no input tax is allowed as a creditunder the Act in respect of goods and services usedby banks, or services provided by banks, holding aCategory 1 Banking Licence under the Banking Act. 83

On 14 February 2003, the Mauritius Commercial Bank Ltd (MCB) made a public

announcement to the effect that a fraud in the hundreds of millions of rupees would have

been committed to the detriment of the bank. The Bank of Mauritius has sent a team of

inspectors to the MCB to conduct an examination, investigate and report thereon. The team

of the Bank of Mauritius inspectors has submitted its preliminary findings and is still carrying

on its work at the MCB.

The Bank of Mauritius considers that it is of utmost importance to fully identify and

address relevant issues comprehensively. In view of the complexity of the nature of the

examination, the Bank will employ as from today, 17 March 2003, the expert assistance of

Mr Nicky Tan Ng Kuang of Singapore, a forensic accountant who investigated, amongst

others, the collapse of the Barings Bank in 1995. The Bank of Mauritius will issue a further

communiqué in the light of its findings.

Bank of Mauritius

17 March 2003

2. COMMUNIQUÉ

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85

It has come to the notice of the Bank of Mauritius that an organization

calling itself by the name of Atlantic Trust Bank has advertised itself on the

website www.atlantictrustbank.com as a provider of a range of financial services, including

private banking, investment management and offshore fund management, claiming that it is

located in Mauritius.

The Bank advises the public that the said Atlantic Trust Bank has never applied for,

nor been issued with, a licence to carry on banking or deposit taking business under the

Banking Act. The Bank is informed that no company bearing a similar name has been

licensed by the Financial Services Commission. Only duly licensed institutions by the Bank

of Mauritius and the Financial Services Commission are permitted to undertake financial

business in Mauritius. Consequently, it is a deliberate misrepresentation on the part of the

said Atlantic Trust Bank to claim that it would be located in Mauritius for the purposes of

providing financial services. No transactions should therefore be conducted with it under the

misapprehension that an organization under the name of Atlantic Trust Bank would have

been licensed as a financial institution in Mauritius.

The Bank of Mauritius provides a regular update of all banks and non-bank financial

institutions authorized by it and a list of those institutions which have been authorized can

be found on the Bank’s website http://bom.intnet.mu.

Bank of Mauritius

28 May 2003

3. PRESS RELEASE

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It has come to the notice of the Bank of Mauritius that an organisation calling

itself by the name of Trans Intercontinental Finance has advertised itself on the website

www.tif-online.com as a provider of a range of financial services for the personal,

professional and corporate client, including private banking, fiduciary and corporate services,

stockbroking, investment management and offshore management, claiming that it is located

in Mauritius.

The Bank advises the public that the said Trans Intercontinental Finance has never

applied for, nor been issued with, a licence to carry on banking or deposit taking or any other

business under the Banking Act 1988. Only institutions duly licensed by the Bank of

Mauritius are permitted to undertake deposit taking and banking business in Mauritius.

Consequently, it is a deliberate misrepresentation on the part of the said Trans

Intercontinental Finance to claim that it would be located in Mauritius for the purposes of

providing banking and deposit taking services. No transactions should therefore be

conducted with it under the misapprehension that an organisation under the name of Trans

Intercontinental Finance would have been licensed as a deposit taking financial institution

in Mauritius.

The Bank provides a regular update of all banks and non-bank financial institutions

authorised by it and a list of those institutions, which have been authorised, can be found on

the Bank's website http://bom.intnet.mu

Bank of Mauritius

19 December 2003

4. PRESS RELEASE

It has come to the notice of the Bank of Mauritius that a group calling

itself by the name of The Armstrong Group has advertised itself on the

website www.the-armstrong-group.com as having set up offices in Mauritius and providing a

range of private banking services.

The Bank advises the public that the said The Armstrong Group has never applied for,

nor has been issued with, a licence to carry on banking or deposit taking business in

Mauritius. Only institutions duly licensed by the Bank of Mauritius are permitted to undertake

banking or deposit taking business in Mauritius. The advertisement made by The Armstrong

Group to the effect that it has set up offices in Mauritius for the purposes of providing private

banking services is misleading. The public is therefore advised that no transactions should be

conducted with the Group on the premise that it would have been licensed to carry on private

banking services in Mauritius.

The Bank of Mauritius provides a regular update of all banks and non-bank deposit

taking institutions authorized by it and a list of those institutions can be found on the Bank’s

website http://bom.intnet.mu

Bank of Mauritius

24 December 2003

5. PUBLIC NOTICE

87

88

Appendix II

The following is an official list of banks holdinga Category 1 Banking Licence, banks holding aCategory 2 Banking Licence, institutions other thanbanks which are authorised to transact deposit-taking business and authorised money-changersand foreign exchange dealers in Mauritius andRodrigues as at 30 June 2003.

Banks holding a Category 1 Banking Licence

1. Bank of Baroda

2. Barclays Bank PLC

3. First City Bank Ltd

4. Habib Bank Limited

5. Indian Ocean International Bank Limited

6. Mauritius Post and Co-operative Bank Ltd

7. South East Asian Bank Ltd

8. State Bank of Mauritius Ltd

9. The Hongkong and Shanghai BankingCorporation Limited

10. The Mauritius Commercial Bank Ltd

Banks holding a Category 2 Banking Licence

1. Bank of Baroda

2. Banque Internationale des Mascareignes Ltée

3. Barclays Bank PLC

4. Deutsche Bank (Mauritius) Limited

5. Investec Bank (Mauritius) Limited

6. P.T Bank Internasional Indonesia

7. RMB (Mauritius) Limited

8. SBI International (Mauritius) Ltd.

9. SBM Nedbank International Limited

10. Standard Bank (Mauritius) OffshoreBanking Unit Limited

11. Standard Chartered Bank (Mauritius) Limited

12. The Hongkong and Shanghai Banking Corporation Limited

Non-Bank Financial Institutions Authorised toTransact Deposit-Taking Business

1. ABC Finance & Leasing Ltd

2. Barclays Leasing Company Limited

3. Finlease Company Limited

4. General Leasing Co. Ltd

5. Global Direct Leasing Ltd

6. Island Leasing Co. Ltd

7. La Prudence Leasing Finance Co. Ltd

8. Mauritius Housing Company Ltd

9. Mauritian Eagle Leasing Company Limited

10. MUA Leasing Company Limited

11. SBM Lease Limited

12. SICOM Financial Services Ltd

13. The Mauritius Civil Service Mutual AidAssociation Ltd

14. The Mauritius Leasing Company Limited

Money-Changers (Bureaux de Change)

1. Direct-Plus Ltd

2. Shibani Finance Co. Ltd

3. Grand Bay Helipad Co. Ltd

4. Max & Deep Co. Ltd

5. Gowtam Jootun Lotus Ltd

Foreign Exchange Dealers

1. British American Mortgage Finance HouseCo. Ltd

2. Rogers Investment Finance Ltd

3. Thomas Cook (Mauritius) Operations Company Limited

4. CIEL Finance Ltd

6. List of Authorised Banks, Non-BankDeposit-Taking Institutions, Money-Changers and Foreign Exchange Dealers

bank of mauritius · and foreign exchange dealers 88 bank of mauritius. 3 statement from the...

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