Financial Inclusion & Infrastructure Global Practice Market Conduct Supervision in Small Countries: The Case of Armenia KEY MESSAGES ƒƒ In many small and low-income economies capacity and resource constraints require a flexible and practical approach in developing market conduct capacity and oversight. ƒƒ While a twin-peak model1 has the advantage of clearly defined objectives and mandates of the respective agencies an integrated model might be more feasible for small and low income economies. ƒƒ However, conflicts of interest need to be addressed: Market conduct supervision policy must be developed independently from prudential supervision. ƒƒ Market conduct supervision functions may be carried out by prudential supervisors on the basis of detailed market conduct manuals and adequate training. ƒƒ Market conduct supervision should assess both the existing business practices of financial institutions in dealing with their clients and the internal controls related to market conduct. ƒƒ With an ever-growing complexity of financial products and the utilization of new sales channels, adequate resources must be available to train supervisors accordingly. INTRODUCTION aspects of financial services require specialized staff with The institutional arrangements for market conduct sector-specific knowledge and expertise. regulation and supervision vary across countries. In some The optimal model in any given country will depend on countries the same supervisory agency is in charge of country-specific characteristics such as the size and structure prudential and market conduct supervision. Others have of the financial system, its stage of development, specific established a specialized financial consumer protection/ regulatory and supervisory activities, skills and institutional market conduct agency (so called ‘twin-peak’ structure). capacity, and prevailing political traditions. In many small A third approach is for a general consumer protection and low-income countries capacity and resource constraints agency to also deal with financial products and services. There are advantages and disadvantages to each model: Placing consumer protection in the same agency as prudential supervision typically ensures good flow of AUTHORS information and supervisory coordination while creating potential conflicts with the traditional and long-standing Johanna Jaeger prudential supervisory roles. The twin-peak model has the Financial Sector Specialist advantage of clearly defined objectives and mandates of jjaeger@worldbank.org the respective agencies. On the other hand, in particular, small countries often lack resources to establish a specialized Angela Prigozhina market conduct authority with the required knowledge and Country Sector Coordinator, South Caucasus expertise. The challenge of the general consumer protection aprigozhina@worldbank.org agency approach is to provide sufficient resources in order to handle financial services issues properly since technical 1 Twin peak model refers to a structure where a separate authority (outside prudential supervision) is responsible for market conduct supervision. Financial & Private Sector Development — March 2013 1 require a flexible and practical approach in developing consumer protection capacity and oversight. KEY FACTS: ARMENIA DEFINITION OF MARKET CONDUCT AND ƒƒ Population: 3.1 million CONSUMER PROTECTION SUPERVISION ƒƒ GNI per capita: 3,200 USD In broad terms, both market conduct and consumer ƒƒ Lower middle income country protection are the elements of financial regulation and ƒƒ Adult population with account at a formal financial supervision focusing on financial institutions’ behavior, institution: 17.5 % (compared to 44.9 % in Europe including non-distortive and non-abusive business practices & Central Asia) and information disclosure in providing services to the ƒƒ Financial sector: dominated by 21 banks that retail consumers.2 For the sake of simplicity, market conduct account for 91.1 percent of the private financial supervision here includes financial consumer protection system’s assets, with the share of non-bank credit supervision, and this term will be used as an integrating organizations at 4.8 percent, and insurance and concept throughout the technical note. capital market at 2.3 percent of the private financial system’s assets. WHICH INSTITUTION IS RESPONSIBLE ƒƒ Financial penetration remains low: banking sector FOR MARKET CONDUCT SUPERVISION IN ARMENIA? assets and loans to GDP in 2011 were 54.1 percent and 31.6 percent respectively. Financial depth is The Armenian financial market is regulated by the Central one of the lowest in ECA region, with deposits to Bank of Armenia (CBA). The CBA is also the integrated GDP accounting for 24.5 percent at the end of 2011 supervisor, thus combining the regulatory role of developing ƒƒ Credit to private sector/GDP: 26 percent (compared financial market rules with the supervisory role of enforcing these rules. The supervisory mandate of the CBA covers to about 33 percent in Georgia and Moldova, or 44 both the prudential supervision as well as the supervision of and 62 percent in Russia and Ukraine, respectively) market conduct of financial institutions. Both the prudential ƒƒ Household debt: In the first half of 2012 the supervision and market conduct mandate of the CBA stem household debt burden (total sum of liabilities from the Law on the Central Bank, defining the objective of of households to credit institutions) has slightly the CBA in these areas to “ensure necessary conditions for increased with the debt to GDP ratio and debt the stability, solvency, liquidity and normal activities of the to deposits ratio amounting to 17.0 percent banking system of the Republic of Armenia” and to “ensure and 102.2 percent, respectively. Nevertheless, it essential conditions for protection of rights and lawful remains lower than respective figures reported in interests of the financial system consumers.” Eastern European countries. ƒƒ Pension reform in 2014: the financial sector should The effectiveness of the consumer protection regime is also expand further in 2014 with the introduction of supported by the well operating Financial System Mediator (a a mandatory defined-contribution second pillar financial ombudsman) that addresses consumer complaints pension system for citizens under 40 years of age and contributes to the comprehensive financial consumer as well as voluntary schemes. protection framework. HOW IS MARKET CONDUCT SUPERVISION Sources: CBA, Global Findex 2012 ORGANIZED WITHIN THE CBA? In 2007, the CBA established the Consumer Protection and Market Conduct (CPMC) Division within the Financial The World Bank’s Good Practices for Financial Consumer Protection use the terms “consumer protection,” “business conduct,” and “market conduct” 2 supervision interchangeably. 2 Financial & Private Sector Development — March 2013 conducted inspections as well as being responsible for CASE STUDY 1 – MISLEADING ADVERTISING licensing of financial institutions in Armenia. The CPMC Division is also responsible for the development of As part of the regular monthly monitoring of all rules in the form of the market conduct supervision manual TV ads aired by financial institutions, a TV ad for a that guides CBA activities in this area. This manual forms an mortgage claimed that the loan is granted without integral part of the general on-site inspection manual. any downpayment, leading the consumers to believe that there are no additional requirements for getting WHICH SUPERVISORY TOOLS ARE BEING a loan. However, according to the bank’s website, USED? additional collateral was needed to obtain the loan. According to Regulation 8/03 an advertisement The available supervisory tools for the CBA include: should not influence consumers’ attitudes towards ƒƒ on-site examinations of financial sector providers, an advertised service by inaccuracies, overstatements ƒƒ monitoring of the content of websites of financial service and misrepresentations. providers, ƒƒ The advertisement was found in breach of the ƒƒ monitoring of advertising by financial service providers, regulation and the Licensing & Supervision including TV advertisements, Committee imposed a fine on the financial ƒƒ monitoring and analysis of published information, institution. including annual reports, financial statements, and other documents published by the financial institution, ƒƒ testing and verifying of disclosure and advertising System Stability and Development Department. The CPMC materials made publicly available by financial institutions, Division is currently staffed with six full-time employees, and including the head of the division.3 The responsibilities of this ƒƒ specific on-demand supervision actions (e.g. monitoring division include the creation and improvement of the legal of radio advertising during the launch of the motor third framework for market conduct regulation and supervision, party liability insurance, supervisory actions based on establishment of consumer rights protection infrastructure, received complaints or media coverage, etc). improvement of financial literacy of the population and establishment of the necessary market conduct supervision framework. The supervisory activities of the CBA, as well CASE STUDY 2 – MISCALCULATION OF THE as general consumer protection and financial education ANNUAL PERCENTAGE RATE FOR CONSUMER activities are funded from the CBA’s budget. CREDIT REGULATORY RESONPSIBILITIES OF THE As part of an on-site inspection, the inspectors verified CPMC DIVISION? the calculation of the Annual Percentage Rate (APR) of The CPMC Division is responsible for developing all legislation consumer loans, finding that some of the fees charged (laws and CBA regulations) related to consumer protection were omitted from the calculation by the bank, thus and market conduct supervision. lowering the presented APR from 32.41% to 30.51%. Any proposals for new regulatory requirements or for the ƒƒ As the miscalculation was based on an improper update of the existing rules are prepared by the CPMC calculation methodology of the bank, the Division in close cooperation with the Financial System Licensing & Supervision Committee imposed a Regulation Department and the Legal Department, which fine on the financial institution. provides legal opinions to both prepared regulations and 3 Compared to around 80 staff in the Financial Supervision Department. Financial & Private Sector Development — March 2013 3 HOW ARE THE SUPERVISORY TOOLS Results of the market conduct assessment are reflected in the APPLIED? Market Conduct Assessment Matrix (see box below) which On-site inspections focusing on both prudential and provides a classification of a financial institution’s market market conduct supervision are conducted by the staff of practices, internal controls, procedures and compliance. This the Financial Supervision Department based on an annual allows supervisors to take a more comprehensive view in workplan that takes into account key risk factors such as analyzing the financial institutions in terms of focusing on the size of the financial institution, complaints against the mitigation of key risks and taking supervisory actions. institution as well as inspection and monitoring results. When Off-site supervisory actions regarding market conduct – on limited resources allow, a staff member of the CPMC Division the other hand - are initiated by the CPMC Division. Some of joins on-site inspections based on the consumer protection the activities are more formalized and conducted regularly team’s risk assessment of the inspected institution. Otherwise on a monthly and quarterly basis (e.g. the monitoring of prudential supervisors conduct both the general on-site the websites of financial institutions and their compliance inspection, as well as the market conduct supervision, in with the rules) while others are more ad-hoc, based on the line with the guidelines of the market conduct supervision requests of the CBA Board or feedback from the market that manual. In this case an informal exchange of information may point out to a significant market conduct issue. with the CPMC Division takes place to discuss the inspection findings and possible further actions. Market Conduct Examination Manual The onsite supervision manual defines four key areas of interest for complex on-site market conduct inspections: ƒƒ Financial services rendered (terms and conditions, content of contracts, fees, etc.) ƒƒ Interaction with consumers (conduct of the sales process, information disclosure, staff qualifications, etc.) ƒƒ Internal redress mechanism ƒƒ Advertisements and other published information The examination includes two types of inspection and generates, accordingly, two types of assessments: 1. Inspection and assessment of the existing (actual) situation: A 5-score system of assessment (5 for fully satisfactory; 4 for mostly satisfactory; 3 for satisfactory; 2 for partly satisfactory; and 1 for unsatisfactory) is used to describe the compliance of the policy of financial institutions, how properly they carry out their activity, maintain their records, which risks they are exposed to, and legal compliance. 2. Inspection and assessment of risk management: The same 5-score system of assessment is used to assess the compliance of the internal control policy of financial institutions, how properly they carry out that policy, maintain their records, which risks they are exposed to, and the legal compliance. TEMPLATE MARKET CODUCT ASSESSMENT MATRIX PROPER POLICY PROPER PROPER EXPOSURE LEGAL AVERAGE IMPLEMENTATION RECORDS ASSESSMENT COMPLIANCE ESTIMATE FINANCIAL SERVICES 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 CONSUMER CONGRUENCE* 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 REDRESS MECHANISM 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 ADVERTISEMENT AND 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 OTHER PUBLISHED INFORMATION AVERAGE ESTIMATE 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 1-5/1-5 *Interaction with consumers 4 Financial & Private Sector Development — March 2013 of Financial Supervision Department, 4) Deputy Head of CASE STUDY 3 - WEBSITE CONTENT Financial Supervision Department, 5) Head of Financial System Regulation Department, 6) Head of Financial Stability As part of its off-site supervision activities, the CPMC and Development Department, and 7) Head of Legal Division monitors the content of websites of financial Department. institutions each quarter to ensure their compliance with Regulation 8/03, defining the procedures and Core on- site supervisory process minimum requirements for publication of information by financial institutions. They are required to comply with the following general principles: 1. Information is presented in font type and size easily legible for a representative consumer and in visible form; and 2. Information is presented in a way that allows a consumer to easily find information in which he/ she is interested. During the regular monitoring, one of the websites was found to have the following links placed in a hardly visible part of the homepage and in a small font: 1) Regulations, 2) Contact & Feedback, 3) Rights of consumers, and 4) Office of the financial ombudsman. ƒƒ As the setup of the homepage was in clear breach of the requirements of the relevant regulation, the The off-site supervisory actions follow a similar process. Licensing & Supervision Committee imposed a After confirmation of the inspections by the Head of the fine on the financial institution and the homepage CPMC Division and the Head of the Financial Stability had to be changed. and Development Department4 the inspection forms are submitted to the Legal and Supervisory Departments for quality control and the Licensing and Supervison Committee then decides on sanctions. ASSESSMENT OF SUPERVISION RESULTS CHALLENGES AND LESSONS LEARNED AND ENFORCEMENT ACTIONS Armenia has strong insights to offer as a model for market After confirmation of the inspection results by the Head of conduct supervision in small countries. Lessons learned and the Financial Supervision Department, the on-site inspection challenges include: report is shared by the Financial Supervision Department ƒƒ In many small and low-income countries capacity and with the Financial Stability and Development Department resource constraints require a flexible and practical and the Legal Department. The supervisory actions, as approach in developing consumer protection capacity proposed by the Legal Department, are then discussed and oversight. at the so-called “Licensing and Supervision Committee” ƒƒ While a twin-peak model has the advantage of clearly which is the primary CBA forum for discussing supervision defined objectives and mandates of the respective results and deciding on penalties. The Committee consists agencies, an integrated model might be more feasible for of 7 members: 1) Chairman. 2) Deputy Chairman, 3) Head small and low income economies. If the CPMC Division participates in on-site inspections the Head of CPMC Division signs the market conduct section of the report. 4 Financial & Private Sector Development — March 2013 5 ƒƒ In the case of Armenia, an integrated central bank legislation. As a result the supervisory enforcement on supervision of all financial institutions provides for the the basis of non-documentable requirements (one-on- implementation of a holistic financial sector development one sales practices, oral communication with clients, etc.) and regulation framework. cannot be effectively imposed. ƒƒ However, conflicts of interest need to be addressed: In ƒƒ With an ever-growing complexity of financial products Armenia, market conduct supervision policy is developed and the utilization of new sales channels, adequate independently from prudential supervision. resources must be available to train the supervisors ƒƒ As effectiveness of market conduct supervision and accordingly. timeliness in response is constrained by limited resources, market conduct supervision functions are carried out by prudential supervisors on the basis of detailed market conduct manuals and adequate training. ƒƒ Going forward, organization and staffing of the CPMC Division will need to be strengthened to further develop and enforce sound and efficient market conduct MORE INFORMATION AND RESOURCES supervision. ƒƒ Market conduct supervision in Armenia assesses both the existing business practices of financial institutions in Consumer Protection and Financial Capability: dealing with their clients and the internal controls related http://www.worldbank.org/responsiblefinance to market conduct. ƒƒ There are two key challenges faced by the current market conduct system in Armenia: lack of thematic market Financial Literacy & Education Russia Trust Fund: practices investigations and mystery shopping power. http://www.finlitedu.org/ ƒƒ While the supervisors have extensive powers in off-site supervision and on-site inspections, some supervisory Financial Inclusion: tools which are especially useful for market conduct www.worldbank.org/financialinclusion supervision such as mystery shopping or market practices investigations are not allowed by the Armenian The authors would like to thank Armenuhi Mkrtchyan and Sevak Mikayelyan from the Central Bank of Armenia as well as Tomas Prouza and Vahe Vardanyan from the World Bank for their contributions and helpful comments on this knowledge brief. Douglas Pearce and Aurora Ferrari provided overall guidance and comments. www.worldbank.org/fpd 6