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CONFIDENTIALRESTRICTED USE ONLY (NOT FOR USE BY THIRD PARTIES)

OFFSHORE FINANCIAL CENTERASSESSMENT PROGRAM

ANDORRA

MODULE 2ASSESSMENT

DETAILED ASSESSMENT OF

COMPLIANCE WITH THE BASEL CORE

PRINCIPLES FOREFFECTIVE BANKING

SUPERVISION

JANUARY 2007

INTERNATIONAL MONETARY FUNDMONETARY AND FINANCIAL SYSTEMS DEPARTMENT


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Contents Page

I. Introduction ...........................................................................................................................3General...............................................................................................................3Information and methodology used for assessment...........................................3Preconditions for effective banking supervision................................................4

Tables1. Detailed Assessment of Compliance of the Basel Core Principles........................................62: Summary Compliance with the Basel Core Principles........................................................263. Recommended Action Plan to Improve Compliance with the Basel Core Principles.........27


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I. INTRODUCTION

General

1. The assessment of Observance with the Basel Core Principles for EffectiveBanking Supervision (BCP) is based on the Core Principles Methodology (Basel

Committee on Banking Supervision, October 1999). The assessment was undertaken in

the context of the Offshore Financial Center (OFC) Assessment Program, Module 2.This assessment took place in September 2006 and was carried out by Messrs. RubenMendiolaza (Superintendency of Banks and Insurance Companies of Peru) and Walter Zunic(formerly with the Federal Reserve Bank of New York). The assessors benefited from thefull cooperation of the authorities and received all necessary information. Their cooperationis gratefully acknowledged.

Information and methodology used for assessment

2. The assessment is based on the following sources: (i) the legal and regulatoryframework, contained mainly in the four laws applicable to all financial institutions and thedirectives issued by the Institut Nacional Andorr de Finances (INAF); (ii) the Self-Assessment of compliance with the Core Principles as of August 2006 prepared by the INAF;(iii) the 2002 BCP assessment conducted by the IMF in the context of the assessment ofAndorras financial system; (iv) external audit reports, including a sample of ComplementaryReports1; (v) various reports prepared by INAF; and (vi) extensive discussions with thesenior and supervisory staff of the INAF, as well as meetings with bankers, external auditorsand other market participants.

3. This assessment of compliance with each Principle has been made on aqualitative basis. A five-part assessment system is used: compliant, largely compliant,materially noncompliant, noncompliant, and not applicable. To achieve a compliantassessment with a Principle, all essential criteria generally must be met without anysignificant deficiencies. There may be instances where a country can demonstrate that thePrinciple has been achieved through different means. Conversely, due to specific conditionsin individual countries, the essential criteria may not always be sufficient to achieve theobjective of the Principle, and, therefore, one or more additional criteria and/or othermeasures may also be deemed necessary by the assessor to judge that compliance isachieved. A largely compliant assessment is given if only minor shortcomings areobserved, and these are not seen as sufficient to raise serious doubts about the authoritys

ability to achieve the objective of that Principle. A materially noncompliant assessment isgiven when the shortcoming is sufficient to raise doubts about the authoritys ability toachieve compliance, but substantive progress has been made. A noncompliant assessment

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


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is given when no substantive progress towards compliance has been achieved, or wheninsufficient information was available to allow a reliable determination that substantiveprogress has been made towards compliance. An assessment of not applicable is renderedfor a Principle deemed by the assessors not to have current relevance.

Institutional and macroprudential setting, market structure, and overview

4. INAF is the sole authority of the Andorran financial system, and the law grantsit operational and budgetary independence, as well as powers to regulate, supervise,

and apply corrective actions to financial institutions. Only insurance companies areoutside of INAFs oversight responsibilities, but plans to transfer this responsibility to INAFare underway. INAF is governed by an Executive Board of six members all with wideexperience in economy, finance, and law. Board members are appointed by parliament, uponthe proposal the government. They are appointed for a six year period, nonrenewable. Half ofthe board members are renewed every three years. The day to day operations of INAF are

conducted by a director general, appointed by the government, upon the proposal of INAFsBoard. The appointment of the director general is for six years, renewable indefinitely. Thedirector general participates in INAFs Board, with voice but no vote.

5. There are seven banks operating in Andorra, which are the core of five bankinggroups. These banking groups generally control a collective investment entity and a life

insurance company. Bank related entities conduct 99 percent of the life insurance business(measured by gross premiums) and 99 percent of the collective investment business. In sum,the financial system is dominated by banking groups which control all the institutionsaccounting for the quasi-totality of their markets. Banking total assets and customer depositsamounted to 11.3 billion euros and 9.3 billion euros in 2005, respectively. About 2.7 billion

euros of total loans in 2005 were loans to nonresidents, mostly from Europe and NorthAmerica, and a significant share of deposits from nonresidents, primarily from the EuropeanUnion.2 Andorran banks have branches in Bahamas and Uruguay and a representative officein Panama, but these operations represent a very small share of the business of the bankinggroups.

Preconditions for effective banking supervision

6. The preconditions for effective banking supervision in Andorra are generally inplace. There are no identifiable macroeconomic vulnerabilities and risks that could

have implications for the structure and financial performance of the banking industry

or the effectiveness of prudential safeguards or the stability of the financial system.

7. The public infrastructure provides for an environment that fosters the honoringand enforcement of financial contracts. The small size of the local economy facilitates

assessment of credit risk in the loan portfolio, and the absence of a credit bureau does

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


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not seem to have affected loan evaluation, as evidenced by the low level of past due

loans (about 0.2 percent of total loans in 2005). Nevertheless, the authorities havementioned their intentions of working with the industry toward the implementation of acredit bureau. While there is no public registry in Andorra, the notaries perform the task ofrecording liens on real estate and other property suitable for collateral. The court system iseffective and efficient, and the execution of collateral reportedly takes less than one year.

8. The flow of information on banking institutions to market participants isconsidered adequate, albeit disclosure of higher frequency data would be desirable.While there is no publicly available official information on the financial strength andperformance of the banking industry, banks publish their annual audited financial statementsboth electronically and in printed form, and the Andorra Bank Association (ABA) publishesan annual report, which contains a section on the financial environment including financialindicators of individual banks and the banking system.

9. There are no official accounting standards in Andorra, except the Chart ofAccounts (CA) of the financial system issued by the INAF in 1999. These standards,

inspired by the Bank of Spain accounting standards of that time, are generally

adequate but an updating is warranted in the context of International Financial

Reporting Standards (IFRS). The authorities are preparing a draft accounting law by whichall Andorran companies would adopt standards consistent with IFRS, with implementationestimated by 2008. The INAF favors the adoption of IFRS by all banks, once draft legislationis passed by the Counsel Generaland plans to adapt prudential regulations as needed tonarrow the accounting choices available for banks.

10. Andorra has a legal and regulatory framework with flexible power for the government

to effect a resolution of problem banks. Nevertheless, an immediate challenge for theauthorities is to carry out modifications to the current regulation to empower the INAF as theonly authority in Andorra to undertake all types of remedial actions, including the revocationof a banks license.

11. There is no deposit insurance in place nor is there a lender of last resort.However, all banks are required to participate in a guarantee fund. The funds are

deposited in banks, and would be available to facilitate resolution of a troubled

financial institution. Whether and how the fund could be used in the event that there were aproblem with one of Andorras banks has not been defined. In the medium term, theauthorities foresee the implementation of a fully defined deposit and investments insurance

fund. Throughout its 75 years of banking history, Andorra has not experienced a bankingcrisis. One banking institution failed in 1968 (Sobanca), and the remaining banks stepped upto honor its liabilities in order to preserve the confidence in the system.


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

Principle 1. Objectives, Autonomy, Powers, and Resources

An effective system of banking supervision will have clear responsibilities and objectives for

each agency involved in the supervision of banks. Each such agency should possessoperational independence and adequate resources. A suitable legal framework for bankingsupervision is also necessary, including provisions relating to the authorization of bankingestablishments and their ongoing supervision; powers to address compliance with laws, aswell as safety and soundness concerns; and legal protection for supervisors. Arrangements forsharing information between supervisors and protecting the confidentiality of suchinformation should be in place.

Principle 1(1) An effective system of banking supervision will have clear responsibilities and objectives foreach agency involved in the supervision of banks.

Description The Law governing the creation of the Andorran National Institute of Finance (INAF) wasissued in June 1989 and amended in September 1993. In October 2003, Law14/2003 wasenacted. This Law (referred to as INAFS charter hereupon) redefines the INAF functions andgrants more independence and in general brings its jurisdiction in line with bank supervisory

entities of other countries. Article 3 of the charter indicates that the INAF is the Authority of theAndorran financial system and promotes and sees to the proper working and stability of thefinancial system.

A Law regulating the operational functions of the different components of the financial systemwas issued in December 1996 and establishes four components: (i) banking entities;(ii) nonbanking financial institutions for specialized credit; (iii) financial investment entities;and (iv) financial entities offering various services.

Decrees and Comunicats (Communications) issued periodically by the INAF complement andupdate the INAF Law.

Article 5 of INAFs charter indicates that the INAF exercises disciplinary and sanctioning

powers over the institutions integrated in the financial system. The INAF has the authority toissue regulations that provide a framework of prudential standards that banks must meet. The

charter indicated that the Communications issued by the INAF carry a weight similar to a law.The above laws, supported by the regulations provide a framework of minimum prudentialstandards that banks must meet and establish the participation of the INAF in deciding whenand how the necessary measures have to be taken to address a problem bank, including theintervention of the bank. INAF has not had a reason to intervene a bank, so laws and regulationsin this area have not been tested. INAFs senior management indicated that in the one casewhen a bank had to be liquidated, the other banks of the Andorran banking system assumed itsobligations and the depositors did not incur any losses. The Andorran banking system has over75 years of experience in this activity; and the case of liquidation of the one bank occurredbefore the creation of the INAF.

The INAF is the only financial agency in Andorra and there is a defied mechanism forexchanging information between the INAF and the Unitat de Prevenci del Blanqueig(UPBLaundering Prevention Unit), which is the independent body for the promotion and coordinationof money laundering prevention measures in Andorras (see CP1 (6)).

Currently, the INAF does not ensure that the information on the financial strength andperformance of the banking industry is publicly available. However, the ABA publishes anannual report, which contains a section on the financial environment including financialindicators of the banking system.


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INAFs charter includes the requirement that the INAF publish a periodic review of itsperformance against its responsibilities and objectives. This review is presented to parliamentthrough the minister of finance, however, it is not made public. The INAF has included in its2007 budget the necessary funds to ensure a transparent reporting and assessment process of its

activities.Assessment Compliant

Comments

Principle 1(2) Each such agency should possess operational independence and adequate resources.

Description Article 1 of the INAFs charter establishes the operational independence of INAF. Specifically,the charter mentions that the INAF acts with independence with respect to the government andparliament.

Article 27 of the charter establishes the right of INAF to prepare its own budget and submit it tothe government (the president and the various government ministers) that forwards it to thecounsel general(parliament) without making any changes.

The INAF is funded by the revenues derived from investment income of a fund provided for by

the Andorran Government. The size of the fund is approximately 12 million euros. The presentlevel of revenues derived from the fund can sustain the current level of staffing, but provideslittle flexibility for an increase as needed to fulfill supervisory responsibilities. Governmentrepresentatives indicated that, to the extent that additional resources are required to operateINAF, such resources will be made available through the government budget. This statement issupported by Article 26.2 of INAFs charter, which stipulates that INAF can be also funded byresources explicitly assigned to it in the government budget.

The INAFs senior management has indicated that since the inception of bank supervisionactivity in 1994, there has been no attempt by the government authorities to interfere in theoperational matters of the INAF and its ability to deploy the resources needed to carry out itsmandate.

The INAF is financed in a manner that does not undermine its autonomy or independence andpermits it to conduct effective supervision and oversight. This includes salary scales that iscomparable to market; the ability to hire outside experts to deal with special situations; atraining budget and program that provides regular training opportunities for staff; and a budgetfor equipment sufficient to equip its staff.

Conversations with representatives of the banking industry and a rating Agency disclosed thatthe supervisory agency and its staff have good credibility based on their professionalism andintegrity.

The director general and the sub-director general of the INAF and all the members of its boardof directors are appointed for a term of six years and in the event the director general isremoved from office, the reasons must be publicly disclosed.

Assessment CompliantComments

Principle 1(3) A suitable legal framework for banking supervision is also necessary, including provisionsrelating to authorization of banking establishments and their ongoing supervision.

Description The Law regulating the financial system, issued in 1993 and the INAFs charter, (discussed inCP1(1)) provide for the oversight functions by INAF of banks, specialized credit and otherfinancial institutions including investment and fund management companies. In accordancewith its charter, the INAF has the authority to sanction banks for minor and serious infractions.

Currently, the activities of insurance companies do not come under the supervision of INAF.


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Article 2 of the Law regulating the Creation of New Banking Institutions issued in June 1998,establishes the requirements for the authorization of new banking entities in Andorra. Thegovernment has the final authority to approve or deny permits for the issuance of new bankinglicenses. A report by INAF is required to make these decisions. The government so far has

always rendered his decisions based on the technical recommendations of the INAF.

The approval of a change in ownership of currently operating institutions is within the authorityof the INAF.

The existing laws authorize the government to issue prudential norms without requiring achange in the laws. Additionally, as indicated in CP 1(1), the INAF has the authority to issueregulations (comunicados) that provide a framework of prudential standards that banks mustmeet and over the years has issued a number of operational regulations to the financial system.Article 24 of INAFs charter empowers it to request information from the banks in the form andfrequency it deems necessary.

Assessment Largely Compliant

Comments In order for this CP to be considered compliant, the INAF should be the final authority to rendera decision covering the entry of a new institution in the country.

Principle 1(4) A suitable legal framework for banking supervision is also necessary, including powers toaddress compliance with laws, as well as safety and soundness concerns.

Description A number of laws, including the 1996 Law of regulations of the Solvency and LiquidityCriteria, the 1997 Law regulating the Disciplinary System of the financial system, and the 1998Bank Administration Law, enable the supervisory authority to address compliance with lawsand the safety and soundness of the banks under its supervision.

Articles 18 and 20 of its charter grants INAFs Board of Directors and its General Manager,among others, the authority to issue Communications that must be implemented by the financialinstitutions; issue recommendations and requirements to financial institutions and to its board ofdirectors; carry out onsite inspections, when required, in order to verify compliance with thelaws and regulations; initiate and implement prudential measures and impose disciplinarymeasures; and, allow the supervisors complete access to banks files in order to review

compliance with internal rules and limits as well as external laws and regulations, impose arange of sanctions (including the revocation of the banking license).

The charter permits the supervisor to apply qualitative judgment in forming his opinion.However, the implementation of very severe remedial measures such as the revocation of thelicense of the bank is proposed by the INAF to the government who has the authority to act onthe proposal. See CP 22Remedial Actions-for additional details.


Comments The Law of November 1997, regulating disciplinary rules of the financial system provides arange of powers to the INAF to bring about corrective action for noncompliance with laws.While INAFs charter, issued in October 2003, empowers it to take prompt remedial action, itcan only recommend the revocation of banking license which, under the law, requires theapproval of the government. Full compliance of this principle can only be reached when INAF

is empowered to undertake all types of remedial actions, including the revocation of a financialinstitutions license.

Principle 1(5) A suitable legal framework for banking supervision is also necessary, including legalprotection for supervisors.

Description Legal protection for the INAF employees is provided for through its charter, which makes areference to Chapter V of the Administrative Code (Articles 58 to 64), passed by law onJuly 13, 1987.

The protections of the INAF employees are the same as those available to all officials, civilservants, and agents under employ of the government. Generally, the administration is held


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liable for the actions of its employees, including INAF employees, when they are acting in anofficial capacity.

In the event of a lawsuit, it would be in almost all circumstances an action taken against the

government.

Article 61 of the Administrative Code specifies that any complaint by the public must be madewithin one year of the date of the initiation of the act by the government employee.

In exceptional circumstances, there is the potential that an INAF employee could be personallyliable for damages, however exceptional circumstances would need to consider damages causedby the employee due to an action or failure to act for reasons of malice or gross negligence.

The supervisory agency and its staff are adequately protected against the costs of defendingtheir actions while discharging their duties.

Assessment Compliant

Comments

Principle 1(6) Arrangements for sharing information between supervisors and protecting the confidentialityof such information should be in place.

Description Monthly meetings of the Director of the UPB, the INAF, the Ministry of Finance (MF) andInterior are held to discuss anti money laundering measures. In addition, Article 53 of the Lawof International Penal Cooperation and the Fight Against Money Laundering requires theexchange of information in this area. INAFs charter requires that regulation be issuedtransferring the responsibility of the supervision of insurance companies to the INAF.Currently, INAF has information covering the insurance companies through the informationreceived on a consolidated basis from banking groups, and the indirect supervision donethrough an analysis of the financial statements of life insurance companies that are subsidiariesof the banking groups. In addition, if and when necessary the INAF can ask the MF specificdetails covering an insurance company.

The exchange of information between the INAF and the UPB is established in Article 53 of theLaw of December 2000.

From time to time the INAF releases confidential information to other supervisors uponensuring that such information will be used for supervisory purposes and treated confidentiallyby the receiving party.


Comments

Principle 2. Permissible Activities

The permissible activities of institutions that are licensed and subject to supervision as banksmust be clearly defined, and the use of the word bank in names should be controlled as faras possible.

Description The term bank is clearly defined in the law, along with the operations and services that may beprovided by banking institutions supervised by the INAF.

The definition of banking activities and the proper use of the name bank are established in the1996 Law regulating the operational activities of the financial system institutions.

Article 2(a) defines a bank as an institution whose primary activity consists in receiving moneyfrom the public in the form of deposits or any other repayable funds, and to provide loans of anykind of its own funds. It also defines the nature of the other financial institutions to besupervised by the INAF.


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Article 2(b) of the noted law list the permissible operations that banks may provide, andArticle 9(a) prohibits any other nonbanking financial institutions from carrying out functions oractivities of banks such as receiving ordinary deposits and other repayable funds.

Similarly, Article 15(a) of the 1997 Law regulating the disciplinary regime for the financialsystem (Disciplinary Law) clearly establishes that reception of money from the public in theform of deposits or other repayable funds without legal authorization will be subject todisciplinary measures. The INAF is required to intervene in the premises where it is presumedthat the aforesaid unauthorized activities are carried out by any individual or entity.


Comments

Principle 3. Licensing CriteriaThe licensing authority must have the right to set criteria and reject applications forestablishments that do not meet the standards set. The licensing process, at a minimum,should consist of an assessment of the banking organizations ownership structure, directorsand senior management, its operating plan and internal controls, and its projected financialcondition, including its capital base; where the proposed owner or parent organization is a

foreign bank, the prior consent of its home country supervisor should be obtained.Description The 1998 Law regulating the creation of new banking institutions establishes the criteria(Articles 15 and 16) and the requirements for new banking licenses (Articles 13 and 14). Thecriteria are consistent with the applied for ongoing supervision.

The final decision to approve or withdraw licenses is taken by the government (Article 2). It hasto be based on the analysis and the recommendations of the INAF (Article 8).

Chapter III of the above law sets the conditions required for authorization, including theconstitution of a deposit in INAF as a guarantee of commitment during the process ofevaluation; Chapter IV specifies the (i) information required to the shareholders, who must passfit and proper test; (ii) the list of the members of the first Board of Directors that the organizershave to submit including the personal and professional records of each of them; and (iii) thetechnical and economical conditions demonstrating the viability of the project. This includes

financial and management feasibility studies that should include the business plan, theorganizational and administrative structure, general policies on internal control and internalaudit and the projected general balance sheet and income statements for the next three years.

The 1998 Bank Administration Law sets specific requirements for the generalmanagement (Article 4) and for the external auditing (Article 10). The minimum capital ofapproximately 30 million euros (5 billion pesetas) is established in the unique article of the1998 Law regulating the minimum capital requirement for banking institutions.

Regulation allows foreigners to acquire up to 51 percent of the ownership in Andorran bankinginstitutions. Currently, foreign participation in the total capital of the banking system accountsfor approximately 2 percent.


Comments From a supervisory point of view, considering that INAF is the institution that will supervisethe new bank, it would be more appropriate if the final decision in the licensing process is madeby the supervisory authority instead of the government.

Principle 4. OwnershipBanking supervisors must have the authority to review and reject any proposals to transfersignificant ownership or controlling interests in existing banks to other parties.

Description The Regulation has a clear definition of qualified ownership and requires the INAF approval inany change in ownership of a bank to be valid.


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Article 29 of the Bank Administration Law clearly defines qualified participation in the capitalof an institution as those owning 5 percent or more of the total capital.

The INAF has the power to obtain information on individuals and legal entities that purchase

stock of a banking institution at any amount. Its charter modifies Article 12(e) of the BankAdministration Law establishing that to be fully effective, from the administrative point ofview, changes at any level in the shareholders of a bank should be informed and approved bythe INAF. In Andorra, bank owners are not allowed to hold bearer shares.

Article 18 of the Bank Administration Law gives the INAF the powers to deny authorization tobecome a shareholder to any individual or to the shareholders of any legal entity.


Comments

Principle 5. Investment CriteriaBanking supervisors must have the authority to establish criteria for reviewing majoracquisitions or investments by a bank and ensuring that corporate affiliations or structures donot expose the bank to undue risks or hinder effective supervision.

Description The Regulation sets the criteria and various types of limits on investments that bankinginstitutions may carry out in relation to their own capital and in relation to the capital of thenonfinancial institutions.

Article 12(f) of the Bank Administration Law has been modified by INAFs charter to theextent that changes in the banks participation in other companies must be approved by theINAF in order to be registered in the Andorran Commercial Registry.

Article 2(e) of the 1996 Law regulating the operational activities of the financial systeminstitutions limits banks investments up to 25 percent of the capital of a nonfinancialinstitutions and Article 2(f) establishes a limit of 40 percent of banks capital on the aggregateinvestments in nonfinancial institutions. There are no limits for banks investments in financialinstitutions. According to Article 7 of the same law, nonlife insurance companies are notconsidered part of the financial system.

The Bank Administration Law establishes the investment criteria as those applied for newbanking licenses.


Comments

Principle 6. Capital AdequacyBanking supervisors must set minimum capital adequacy requirements for banks that reflectthe risks that the bank undertakes, and must define the components of capital, bearing in mindits ability to absorb losses. For internationally active banks, these requirements must not beless than those established in the Basel Capital Accord.

Description Prudential regulations and requirements are considered adequate and the INAF is legallyempowered to enforce them.

Capital requirements in Andorra are consistent with the Basel Capital Accord. Article 6 of the1996 Solvency and Liquidity Law requires a minimum capital ratio of 10 percent.Communication n 159/04 approved in October 2004 requires additional capital to cover marketrisks, extending the definition of regulatory capital (own funds) in Article 3 of the Solvencyand Liquidity Law and therefore changing the calculation method of the solvency ratio. Thisratio includes off-balance sheet exposures. Capital requirements apply also on a consolidatedbasis.


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Articles 15(d) and 16(e) of the 1997Disciplinary Law establishes disciplinary measures, suchas sanctions and other corrective actions, which are available to INAF should a bank fall belowminimum capital adequacy ratio. The INAF receives periodic information on the solvencysituation and capital adequacy of banks.

Assessment CompliantComments

Principle 7. Credit PoliciesAn essential part of any supervisory system is the independent evaluation of a banks policies,practices, and procedures related to the granting of loans and making of investments and theongoing management of the loan and investment portfolios.

Description The regulatory center piece related to the granting of loans is the Communication n157/03(Complementary Audit Report) issued by the INAF in December 2003. This communication ismeant to verify the requirement of on-going management of the loan and investment portfoliosand the policy of loan provisioning and investment provisioning. It also requires that banksmust have in place management information systems, although it is not explicit in thecomplementary audit scope that it should be done for the loan and investment portfolios.

According to its charter, INAF has full access to information regarding credit risk exposures. Ithas also the authority to assess credit granting and investment policies and procedures, ensuringadequate controls over credit policies.

However, the INAF does not perform on-site examinations and relies on the external auditors toprepare the Complementary audit report, which has to be submitted to the INAF on an annualbasis and is discussed in a tripartite meeting with the bank and the auditors. This delegatedrevision of credit policies may not necessarily provide the supervisory authority with sufficienttime to take prompt corrective actions regarding deficiencies observed in the banksmanagement of the loan and investment portfolios. INAFs senior management has indicatedthat it will commence to undertake regular on-site inspections by the end of 2007.


Comments

Principle 8. Loan Evaluation and Loan-Loss ProvisioningBanking supervisors must be satisfied that banks establish and adhere to adequate policies,practices, and procedures for evaluating the quality of assets and the adequacy of loan-lossprovisions and reserves.

Description The main regulation related to the adequacy of loan provisions and the quality of assets is theCA for the Financial System and the Communication n 104 issued in April 2000, respectively.

The CA states that banks subject to credit risk must charge the profit and loss account with thenecessary general or specific loan loss provisions. It also defines the classification of loans infour categories from lower to higher risk: (i) Pass; (ii) Past Due; (iii) Doubtful; and, (iv) VeryDoubtful (loss).

Provisioning is in accordance to these categories. Banks do not allocate specific provisions forPass loans and Past Due loans (from 1 day to 6 months in arrears). Specific provisions required

for Very Doubtful loans are at full scale (100 percent). Banks must allocate specific provisionsfor Doubtful loans according to the following table:

Months in Arrears Provisions (In percent)From 6 to 12 months 25From 12 to 18 months 50From 18 to 24 months 75From 24 months 100


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General provisioning for credits to international banks are at 0.5 percent of net loans as theportfolios are largely deposits to highly rated OECD-based financial institutions (a significantpart of the assets). For nonbank credit portfolios, general provisioning are at 1 percent(depending on collateral support). Classification and provisioning considers off-balance sheet

exposures.

The INAF does not perform on-site examinations and relies on the external auditors to verifythe Complementary Report for loan loss provisioning and quality of assets.

Communication n 104 requires the banks to provide INAF with detailed quarterly reporting onthe quality and composition of the loan and investment portfolios and information of collateraland provisioning. This information is evaluated by the off-site supervisors of INAFsDepartment of Analysis. In the Complementary audit report, external auditors are required toassess, on a sample basis, the quality of loans and investments, the adequacy of the allocationsof provisions and the valuation of collaterals to reflect the net realizable value. In this regard, itis a practice of the industry but not required in the regulation- to register collaterals at80 percent of the net realizable value. The INAF has the authority to require a bank to increaseits level of provisions and to correct any deviations from the above regulation if anoncompliance statement regarding asset quality is stressed in the external auditorscomplementary report.

While the level of past due loans at year end 2005 is low, INAF should review the adequacy ofits provisioning policy for Past Due Loans regarding the months in arrears of a loan beforerequiring a specific loan loss allocation. The level of past due loans at year end 2005 isapproximately 0.2 percent of total loans.


Comments

Principle 9. Large Exposure LimitsBanking supervisors must be satisfied that banks have management information systems thatenable management to identify concentrations within the portfolio, and supervisors must setprudential limits to restrict bank exposures to single borrowers or groups of related borrowers.

Description A related group is defined in the CA. Chapter XII defines an economic group of entities as onewhere: (i) there is direct or indirect control, (ii) business interrelations among entities as in thecases of common ownership, common control or administration, (iii) assumptions that creditsgranted will benefit all others; and (iv) there are assumptions based on the fact that variousparties have relationships which in fact constitute one economic interest unit.

According to Article 12 of the 1996 Solvency and Liquidity Law banks must avoid riskconcentration exposures. Article 13(a) of the same law establishes a limit on large exposures toa single borrower or related group of borrowers at 20 percent of the banks own funds. Article13(b) sets an aggregate limit of 400 percent of the own funds for those operations withindividuals over 5 percent of the own funds of the bank.

The Communication n 104 provides the INAF to quarterly reporting on concentration limits on

a consolidated basis, including sectoral and geographic risks.

In the Complementary report, external auditors are required to verify, on a sample basis, thevalidation of the information reported by banks on all reports of the Communication n 104,which includes a specific report on concentration limits (Article 13 of the Solvency andLiquidity Law).


Comments


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Principle 10. Connected LendingIn order to prevent abuses arising from connected lending, banking supervisors must have inplace requirements that banks lend to related companies and individuals on an arms lengthbasis, that such extensions of credit are effectively monitored, and that other appropriate steps

are taken to control or mitigate the risks.Description As mentioned in BCP 9, the CA contains a definition of an economic group (related parties) as

one where there is direct or indirect control by one of them over the others, businessinterrelations and assumptions that credits granted to one will benefit all others entities.

Additionally, Article 14 of the 1996 Solvency and Liquidity Law has a definition of relatedparty transactions as those asset operations with various parties that have relationships that infact constitute one economic interest unit. The INAF has the authority to dictate the necessarytechnical procedures and to apply the disciplinary measures to enforce the compliance of theaccuracy of this information.

According to the Communication 163/05 issued in February 2006, banks must comply with theguidelines and principles set in the Ethic Code. However, there is no clear evidence that bankscredits to insiders and related interests should not be granted at preferential rates.

Article 15 of the 1996 Solvency and Liquidity Law establishes an aggregate limit of 15 percentof bank capital over any kind of exposure with its board of directors. However, there is no clearevidence in this norm or in any other regulation issued by the INAF that credits to insiders,senior management or their respective related interests should always receive the approval ofthe banks board of directors.

In the Complementary audit report, it is required to the external auditors to verify, on a samplebasis, the validation of the information reported by banks on all reports of the Communicationn 104, which includes a specific report on exposures to connected lending (Article 15 of theSolvency and Liquidity Law). The Communication n 104 is reported to the INAF on aquarterly basis.


Comments The INAF must ensure that credits to insiders and related interests should not be granted atpreferential rates, and that transactions to insiders, such as the credits to the members of thebanks board of directors, require the approval by the Board.

Principle 11. Country RiskBanking supervisors must be satisfied that banks have adequate policies and procedures foridentifying, monitoring, and controlling country risk and transfer risk in their internationallending and investment activities, and for maintaining appropriate reserves against such risks.

Description The INAF's Communication 122/00 issued in 2000, covering country risk, establish theprocedures for monitoring and controlling country risk and transfer risk. Country exposures areidentified and monitored by bank management.

The external auditors of the financial institutions verify on behalf of the INAF informationsystems, risk management systems and internal controls to comply with the policies and the

Department of Analysis of INAF obtains and reviews information on country risk on a quarterlybasis.

Detailed quarterly reports are forwarded to the INAFs Department of Analysis by the financialinstitutions. The reports cover their exposure in each country and the rating agencies rating ofthe country. In addition, the quarterly reports provide information regarding on and off-balancesheet items that may be affected by country risk, transactions subject to hedging, and countryexposure data for off-site analysis.


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The instructions in thePla Comtable (Chart of Accounts) authorize INAF to request specificprovisions on a country by country basis. Currently, Andorran banks exposure to country risk isnot material.

The INAF obtains and reviews information on a quarterly basis covering country risk/transferrisk of individual banks.The INAF has indicated that it will establish minimum provisioning for each country in the nearfuture.


Comments

Principle 12. Market RisksBanking supervisors must be satisfied that banks have in place systems that accuratelymeasure, monitor, and adequately control market risks; supervisors should have powers toimpose specific limits and/or a specific capital charge on market risk exposure, if warranted.

Description Communication 104 issued in April 2000, Communication 104b is issued in April 2004, andCommunication 59/04 issued in 2004, cover policies and procedures related to theidentification, measuring, monitoring and controlling risks in interest rates and foreign

exchange rates. The above communications require financial institutions to supply detailedinformation on the character and volume of market risk transactions on a quarterly basis. Thesereports enable INAF to monitor open positions in futures markets and instruct banks to supplybalances of assets and liabilities accounts and contingent accounts broken down in five maturitybuckets and for the following currencies: EUR, US$, YEN, GBP and CHF.

External auditors review compliance with above communications, as part of the complementaryyearly audit that is prepared for each one of the banks. As previously indicated, thecomplementary audit details to the INAF the adequacy of market risk controls at financialinstitutions and those positions are revalued frequently using current market data. Commentsmade by the external auditors indicate that there is staff at the external auditors companies thathave the expertise to monitor the actual level of complexity in the market activities of the banks.

The INAF management, in accordance with Communication 159/04, has the authority to

impose specific market risk limits, but has not taken this measure. This is because INAF ismonitoring on a quarterly basis the interest risk and foreign exchange risk incurred by the banksand does not consider it excessive. Further, as part of the minimum risk-based capitalcalculation, financial institutions are required to factor in a 50 percent market risk weight onfutures operations with balances adjusted by maturity and type.


Comments

Principle 13. Other RisksBanking supervisors must be satisfied that banks have in place a comprehensive riskmanagement process (including appropriate board and senior management oversight) toidentify, measure, monitor, and control all other material risks and, where appropriate, to holdcapital against these risks.

Description Under the authority of the Disciplinary Law, the INAF has established prudential standards that

require individual financial institutions to limit, monitor, and report on various types of risksincluding credit concentrations, connected lending, credit classification and loan lossprovisioning, capital adequacy, liquidity, interest rates, and foreign exchange rates.The INAF has the authority to require financial institutions to submit information on theirfinancial condition on a periodic basis, including information on related interests and has theauthority to require financial institutions to hold additional capital against material risks.Communication 152/03 issued in May 2003 requires bank management to submitcomprehensive information covering internal controls and internal audit, that among otherincludes details on the board of directors, senior management, internal control systems, assets


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and liabilities committee information and internal audit systems. Based on the informationreceived, the INAF actively monitors compliance with risk limits covering liquidity, interestrate and operational risks , the accuracy of which is validated by the annual complementaryexternal audit

Communication 157/03, issued in December 2003, requires the external auditor to submit adetailed assessment to senior management of the bank of all the weak points uncovered duringthe complementary audit and recommendations for their improvement. The primary objective ofthe complementary report is to describe and analyze the financial and operational features thatthe external auditors cover in their annual audit review. In the complementary report, theexternal auditors evaluate, among others, liquidity, interest rate and operational risks and legalrisk and the risk management processes involved in these areas.

In the complementary audit report, external auditors are required to assess, on a sample basis,the quality of loans and investments, the adequacy of the allocations of provisions and thevaluation of collaterals to reflect the net realizable value.


CommentsPrinciple 14. Internal Control and AuditBanking supervisors must determine that banks have in place internal controls that areadequate for the nature and scale of their business. These should include clear arrangementsfor delegating authority and responsibility; separation of the functions that involvecommitting the bank, paying away its funds, and accounting for its assets and liabilities;reconciliation of these processes; safeguarding its assets; and appropriate independent internalor external audit and compliance functions to test adherence to these controls, as well asapplicable laws and regulations.

Description Communications 152/03 of May 2003 and 157/03, establish the information required from thebanks covering internal controls and internal audit functions. Communication 126 /01 coversthe attendance of the senior management in yearly meetings conducted with representatives ofINAF and the external auditors responsible for the preparation of the annual reports and thecomplimentary audit reports.

The complementary reportsprepared by the external auditors include reviews of banks internalcontrols and internal audit arrangements, the quality of systems, the quality of accounting andreporting systems and related matters and the resources of the back office relative to thebusiness origination area.

The INAF evaluates the composition of senior management and directors to determine that theyhave the necessary skills for the size and nature of the activities of the bank and that they canaddress external market developments.

The INAF has the legal authority to request changes in the composition of the board andmanagement when in its opinion such measures are required.

The external auditors indicate in the annual complementary reports that banks have anappropriate internal audit function responsible for reviewing that policies and proceduresestablished by management of the bank are complied with, and reviewing whether the existingpolicies, practices and controls are sufficient and appropriate for the banks business. Also, theexternal auditors provide information on the internal audit function. This information includesamong other: the independence of the internal auditors, their access to all the banks businesslines, and the resources of the internal audit department.


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On a quarterly basis, INAF requires the financial institutions to submit reports covering theiractivities as specified in Communication 152/03. This communication emphasizes theseparation of the functions of internal control and internal audit. The above communicationrequires information as to the involvement of the board of directors in the areas of internal

control and internal audit.Assessment Largely compliant

Comments The INAF should issue a communication indicating that members of the board of directorsshould participate in the yearly meetings conducted by senior representatives of INAF withsenior management and external auditors.

The INAF needs to: (a) describe the standards against which the banks performance can bemeasured, so that the auditor can report whether or not they have been achieved; (b) reach someunderstanding with the external auditors regarding the concept of materiality; (c) ensure that itis requesting that external auditors perform activities that arewithintheauditors competencesince without clear and specific guidance the auditor will not be in a position to makejudgments.

Enhancement of current communications regarding banks external audits is needed. DispersedCommunications should be combined into a single decree.

Principle 15. Money LaunderingBanking supervisors must determine that banks have adequate policies, practices, andprocedures in place, including strict know-your-customer rules that promote high ethical andprofessional standards in the financial sector and prevent the bank being used, intentionally orunintentionally, by criminal elements.

Description The anti-money laundering (AML) Law, issued in December 2000, established the creation ofthe UPB as an independent body for the promotion and coordination of money launderingprevention. This unit is responsible for the oversight of banks implementation of know-your-customer policies and internal controls and procedures to prevent susceptibility to criminalelements. The INAF has been divested of a role in this area.

The 2000 AML Law requires banks to verify identity through an official government documentwith a picture, obtain domicile and professional activity information. For legal entities, banksmust obtain certification of the registration in the registry of corporations and to obtain identityinformation from the individuals empowered to represent the entity. Information on beneficialownership is also required.

Since 2002, the UPB requests external auditors to submit annual complementary audit reportswhere they must: (i) indicate the composition of the bank's internal control structure andfrequency of meetings of its top officers; (ii) detail control procedures in place for openingaccounts, identifying customers, controlling operations and updating transactions and theiradequacy; (iii) indicate the number of suspicious transactions reported by employees;(iv) indicate training given on AML to employees; (v)give an opinion about the degree ofefficiency of all the procedures applied by an entity for preventing, identifying andcommunicating transactions that might involve money laundering or financing of terrorism as

well as measures taken to improve the system. Also, the external auditors at the annualcomplementary audit determine that a bank has established lines of communication to a bank

senior officer with explicit responsibility for ensuring that the bank's policies and proceduresare, at a minimum, in accordance with the 2000 AML Law.

For the complementary audit reports of2006(which will be due by March 31, 2007), auditorsare also required to (i) indicate accounts with no identification or other identification problemsand (ii) verify, by testing 30 numbered accounts, 15 accounts of companies (personas juridicas)


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and 10 accounts of individuals (nominadas) -at random- that minimum documentation is kept inthe customer's file and that the customer's operations coincide with that declared at the time ofopening the account. The UPB also requests external auditors to inform what are the proceduresand systems that banks have in place to assess fit-and-proper of their key staff.

The UPB conducts on-site inspections in bank, nonbank financial institutions and insurancecompanies. Three inspections have been conducted to banking institutions. During these exams,the UPB reviews the banks money laundering controls and systems for preventing, identifyingand reporting fraud, and the methodology that identifies the key risks run by the bank in thisarea. UPB staff has access to the banks business lines and support departments and assesses thelines of communication to senior management and to the internal security function for thereporting of suspicious transactions.

In addition, the UPB periodically checks that banks money laundering controls and theirsystems for preventing, identifying and reporting fraud are sufficient. The UPB has adequateenforcement powers to take action against a bank that does not comply with its AMLobligations. Also, UBPs management has indicated that, after a slow start, currently banksreport to the UBP very minor suspicious activities and incidents of fraud material to the safety,soundness or reputation of the bank. Under Articles 57 through 59 of the 2000 AML Law, UPBhas authority to initiate a sanctioning process for three levels of compliance violations: veryserious, serious and minor violations. Very serious violations include the failure tosatisfy reporting requirements, tipping off, refusal, excuse or resistance to furnish information tothe UPB and repetition of a serious violation in the same year. Serious violations include thefailure to confirm the identity of clients, failure to demand client identification documentsrequired under Article 51, insufficient verification of the true beneficial owner of a transaction,lack of vigilance and failure to verify identity, failure to retain documents for the 10 periodestablished in Article 51, insufficient internal procedures and failure to carry out the specificaudit on AML compliance, and repetition of a minor violation in the same year. Minorviolations include any violation of the standards of the Law not mentioned previously. UPBmakes recommendations on the sanction to the Council of Ministers, which administers thesanctions. Sanctions include fines of 600 to 600,000 euros and temporary or permanent

suspensions of directors or the person involved, or suspension of the capacity to carry outcertain transactions.

As indicated in Articles 53 and 55 the UPB is empowered to directly share with domesticjudicial authorities, INAF, and foreign FIU counterparts information related to suspected oractual criminal activity. In addition, the Director of the UPB, senior management of INAF, theMinisters of Finance and Interior hold a formal monthly meeting in order to discuss AMLmeasures. INAFs management has indicated that cooperation, including the exchange ofinformation on matters covering know your customer is carried out on a constant basisbetween the staffs of INAF and UPB.

Officers of the UPB enjoy legal protection and the central government is responsible for payingall claims when resulting from the faithful exercise of UPBs supervisory work.

A minimum reporting limit for suspicious transactions has not been established. Banks staffhas been instructed to report any transaction that in their opinion is suspicious.

The UPB has the authority to meet directly with external auditors as deemed needed, usually, inthe presence of the entitys compliance officer, and the authority to inquire about changes ofauditors; require that auditors follow-up on recommendations they have given in previous auditreports (Informes de Cumplimiento) or request that auditors perform special audits/reviews, adhoc.


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For foreign counterparts the information is provided subject to reciprocity, a commitment to usethe information only for the purpose requested, and commitment to maintain professionalsecrecy (Article 56).

Assessment Compliant.

Comments The INAF has been divested of a significant role in the anti money laundering process. TheUPB, with the assistance of external auditors, conducts the review of the AML policies,procedures and practices of banks. The external auditors prepare special reports for the UPBcovering AML compliance at the financial institutions. The INAF relies on the externalauditors complementary report in order to ensure compliance by the bank in the area of knowyour customer.

Principle 16. On-Site and Off-Site SupervisionAn effective banking supervisory system should consist of some form of both on-site and off-site supervision.

Description Due to the growth of the banking system and the increased complexity of a number of financialtransactions entered into by the banks, the INAF has increased the supervisory staff from8 persons to 12, of which 4 were hired within the last year. All the professional staff has aUniversity degree. INAF is headed by two experienced senior executives, and is divided in two

major units:

Department of Analysis which consists of three persons. Department of Supervision and Control which consists of four persons. In addition

there is a staff member responsible accounting and administrative work of INAF andtwo secretaries.

The mission is satisfied that there is an appropriate mix of on-site and off-site supervision andthe two departments function in a way to maximize the synergy and avoid supervisory gaps.

INAF's supervision of the financial sector consists of off-site compilation and analysis ofquarterly data submitted by financial institutions in accordance with the CA. This task isconducted by the Department of Supervision and Control. INAF has not conducted its own on-

site examinations since its creation in 1993, and has relied on the on-site work of externalauditors who, since 2000, prepare complementary reports according to INAFs requirements.Over the years the audit work has been instrumental in confirming the reliability of quarterlybank data submitted to INAF, and has provided an important measure of independentverification on the existence of risk management and internal controls, in credit underwritingand the evaluation of treasury activities, and off-balance sheet operations. However, A reviewof various complementary audit reports reveals their uneven quality.

The staff of the Department of Supervision and Control is responsible for the review of theannual onsite complementary external audits conducted by the large international accountingfirms pursuant to INAF's complementary audit requirements.

The supervisors conduct an annual meeting with each individual bank and the banks external

auditors to discuss, among other, the developments in the financial institution, the extent of itsrisks, its compliance with the laws and regulations and the scope of complementary audits. Inaddition INAFs officers and supervisory staff has formal and informal communications withbank managers, directors and bank association leaders during the year to discuss the conditionand risks affecting their institution.

The staff of the department of Supervision and Control is in frequent contact with the banks,and at times visits management of banks in order to verify the quarterly information submittedby the banks, and to review the information reported in the complementary audit report.

Assessment Largely compliant


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Comments INAFs staff is very lean and management should take steps to gradually increase the number ofits supervisors in order to be able to conduct onsite inspections of the financial institutions withits own supervisory staff, thus placing less reliance on the external audit firms to conductcomplementary audits on its behalf. In order to insure the reliability of risk management

controls, INAF should hire an IT specialist to support the activities of the onsite and offsitesupervisors.

Principle 17. Bank Management ContactBanking supervisors must have regular contact with bank management and a thoroughunderstanding of the institutions operations.

Description Communication 126/01 issued in 2001 establishes INAFs authority to require financialinstitutions and their auditors to hold an annual meeting with INAF in order to discuss the scopeof the external audits, the contents of the external auditors complementary audit report, and thequarterly information on the financial institutions condition, submitted by the financialinstitutions. In addition, financial institutions submit on quarterly basis information on relatedinterests.

The financial information submitted by the financial institutions is used to compile quarterly

monitoring reports and statistics which provide, among other, detail on the evolution of banks'balance and off-balance sheet activities, earnings performance and movements in capitalaccounts, asset quality, liquidity and market risk positions, solvency and liquidity ratios andother useful information on individual institutions as well as the financial sector as a whole.Article 15 (g) and 16(h) of the Disciplinary Law provide penalties for banks failing to providethe information on a timely basis or if they knowingly provide inaccurate or misleading data.INAF requires that financial statement information be submitted quarterly both on an individualand a consolidated basis.

The CA, implemented in 2000, delineates the accounting principles for Andorran financialinstitutions as well as the reporting requirements. Financial statements may be requested on asolo or consolidated basis. Information on solvency, liquidity, large borrowers, market risks,loan classification and provisioning are submitted on a consolidated basis.

INAF has a good understanding of the activities of its banks. In addition, INAF requires banksto notify it of any substantive changes in their activities or any material adverse developments,including breach of legal and prudential requirements.

As required by Communication 126 issued in September 2001, INAF has implemented a policyto conduct in October of each year a meeting with each one of the banks of the system and theirexternal auditors. The banks senior management members attend the meetings. Members of theboard of directors do not attend the annual meetings. INAF management presents majorconclusions of the off-site analyses prepared by the supervisors and discusses thecomplementary external audit reports. In addition, the performance of the financial institution,and strategic plans and strategies affecting the risk profile of the institutions are discussed. Atany time, when deemed necessary, the INAF has requested meetings with the members of theboard of directors of the financial institutions.

Due to the small size of the population of Andorra, the small size of the capital and theproximity of all the financial institutions to the headquarters of INAF, there are very frequentpersonal contacts between the management of the INAF and members of the board of directorsand senior management of all the local financial institutions. While INAF does not document itsassessment of management of the six local banks, senior management of INAF is familiar withthe strengths and weaknesses of the senior management of all the Andorran banks.



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Comments Members of the board of directors should attend the Annual meetings established byCommunications 126 issued in September 2001.

Principle 18. Off-Site SupervisionBanking supervisors must have a means of collecting, reviewing, and analyzing prudential

reports and statistical returns from banks on a solo and consolidated basis.Description The INAF has the authority to require financial institutions to submit information on their

financial condition on a periodic basis, including information on related interests. Article 15(g)and 16(h) of the Disciplinary Law provide for penalties for banks failing to provide theinformation on a timely basis or if they knowingly provide inaccurate or misleading data. INAFrequires that financial statement information be submitted quarterly both on an individual and aconsolidated basis.

The CA, implemented in 2000, delineates the accounting principles for Andorran financialinstitutions as well as the reporting requirements. Financial statements may be requested on asolo or consolidated basis. Information on solvency, liquidity, large borrowers, market risks,loan classification and provisioning are submitted on a consolidated basis.

Article 15(g) and 16(h) of the Disciplinary Law provide penalties for banks failing to providethe information on a timely basis or if they knowingly provide inaccurate or misleading data.INAF requires that financial statement information be submitted quarterly both on an individualand a consolidated basis.

The CA, implemented in 2000, delineates the accounting principles for Andorran financialinstitutions as well as the reporting requirements. Financial statements may be requested on asolo or consolidated basis. Information on solvency, liquidity, large borrowers, market risks,loan classification and provisioning are submitted on a consolidated basis. The technicalcommunications issued by the INAF complement and update the legislation relating to the CA.so that it does not become outdated.

The quarterly information submitted by financial institutions is used by INAF to compilequarterly monitoring reports and statistics which provide, among other, detail on the evolution

of banks' balance and off-balance sheet activities, earnings performance and movements incapital accounts, asset quality, liquidity and market risk positions, ratios on capital solvency andliquidity, on individual institutions as well as the financial sector as a whole.


Comments

Principle 19. Validation of Supervisory InformationBanking supervisors must have a means of independent validation of supervisory informationeither through on-site examinations or use of external auditors.

Description INAF relies on external auditors to conduct the on-site independent validation of information.INAF has issued policies and procedures in place to ensure that the complementary annualaudits are conducted on a thorough and consistent basis with clear responsibilities, objectivesand outputs. This process is reviewed each year at the October meetings with seniormanagement of all banks.

Articles 15(g) and 16(h) of the Law governing the disciplinary system of the financial systemissued in November 1997 establish the sanctions to be levied against banks that do not providein a timely manner the requested information or that supply inaccurate information purposely.The information is supplied by the financial institutions to the INAF on a quarterly basis, andcontains a number of key supervisory returns, such as that for capital adequacy, and is analyzedby the INAFs Department of Analysis.


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Throughout the year, if deemed necessary, INAF holds meetings with banks management, andin October of each year holds a large and formal meeting with senior management of each bankand with their external auditors to discuss, among other items, the supervisory informationsubmitted in the complimentary audit reports and the information remitted by the banks.

The Department of Analysis, on an ad hoc basis, visits the banks in order to verify the accuracyof the quarterly information submitted by the banks, or to clarify comments made by the banksmanagement.

INAF has the legal right of access to all bank records for the furtherance of its supervisorywork, and its supervisors have visited each financial institution to discuss with managementdiscrepancies in the quarterly reports they submit. INAF monitors the quality of work done bythe external auditors through the quarterly reports it receives from the financial institutions.INAF has the authority to directly appoint external auditors and the authority to oppose nexternal auditor that is deemed to have inappropriate expertise or independence. As establishedin Law 14/2003, INAF has the legal right of full access to all banks records required in itssupervisory work and has access to the board, senior management and staff, when required.

There is a constant evolution in the scope of information requested by the INAF.


Comments

Principle 20. Consolidated SupervisionAn essential element of banking supervision is the ability of the supervisors to supervise thebanking group on a consolidated basis.

Description The INAF carries out off-site consolidated supervision by requesting the quarterly submissionof balance sheets and other financial information on a consolidated basis. Based on the quarterlyinformation received, INAF has an understanding of the material activities of a group.

According to its charter, the INAF has the authority to perform on-site inspections though thishas been delegated to the external auditors through the annual verification of the process ofconsolidation of the banking groups in the Complementary audit report. In this report, external

auditors are required to furnish details on each one of the subsidiaries of a bank including,among other, the method of consolidation, the percentage of participation and financial detailsof the subsidiaries.

The INAF has a supervisory framework for banking groups that evaluates the risks of its non-banking activities. The CA, implemented in 2000, clearly establishes that Financial Statementsof banks periodically reported to INAF must be prepared on a solo and at consolidated basis.Banking groups are required to submit financial information for each of their subsidiaries foroff-site analysis, including life insurance companies and other financial institutions.

The charter empowers the INAF to undertake any necessary action to implement consolidatedsupervision. The INAF has periodic meetings with the MF, to discuss common interest matters,including the condition and adequacy of risk management of insurance companies. However, it

does not have the authority to act directly on insurance companies, mainly life insurers, if anyspecific risk from their non-banking activities may affect the condition and solvency of abanking group.

The Law of Solvency and Liquidity and Communication n 104 requires banks to comply withcapital requirements on a consolidated basis and to submit periodic reports on credit exposuresand concentration limits, respectively.



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Comments The supervision of insurance companies should come under the direct control of the INAF.While the quarterly reports and the Complementary audit report provide the INAF with a usefultool for assessing consolidated risks of banking groups, an effective consolidated supervisoryframework requires the INAF to have access to and responsibility for the insurance subsidiaries.

Principle 21. Accounting StandardsBanking supervisors must be satisfied that each bank maintains adequate records drawn up inaccordance with consistent accounting policies and practices that enable the supervisor toobtain a true and fair view of the financial condition of the bank and the profitability of itsbusiness, and that the bank publishes on a regular basis financial statements that fairly reflectits condition.

Description The charter empowers the INAF to set up bank accounting standards, including consolidatedfinancial statements, in accordance with generally accepted accounting principles, and allowsthe INAF to carry out on-site inspections. Currently, the INAF does not conduct onsiteinspections and relies on the work done by the external auditors.

Accounting standardsin Andorra are satisfactory though they may require updating in someaspects such as the accounting for derivatives, which are currently reported as off-balance sheetitems.

The CA, implemented in 2000, delineates the accounting principles for Andorran financialinstitutions as well as the reporting requirements. Financial statements must be reported on asolo or consolidated basis. Information on solvency, liquidity, large exposures andconcentration, market risks, loan classification and provisioning are submitted on a consolidatedbasis.

External audit firms must audit the financial institutions (Communication 24 issued in February1997). External auditors are required to evaluate the reasonableness of the financial statementsin accordance with the guidelines issued by the INAF in the CA. As indicated previously, theINAF has the authority to revoke the appointment of a banks auditors.

Article 10(a) of the Bank Administration Law require banks to work on a permanent basis withan external auditor. Article 10(e) of the same Law sets the scope of sanctions that can beimposed to external auditors if they do not comply with the requirements of the INAF. Thedisciplinary measures may include the revocation of the license of the external auditor.

The INAF is in favor of all banks adopting IFRS issued by the International AccountingStandards Board (IASB). The aim is to adopt and implement IFRS in all banks in Andorra assoon as draft legislation is passed by the Counsel Generaland to adapt prudential regulations asneeded to narrow the accounting choices available to banks.


Comments

Principle 22. Remedial MeasuresBanking supervisors must have at their disposal adequate supervisory measures to bring abouttimely corrective action when banks fail to meet prudential requirements (such as minimumcapital adequacy ratios), when there are regulatory violations, or where depositors arethreatened in any other way. In extreme circumstances, this should include the ability torevoke the banking license or recommend its revocation.

Description The charter grants the INAF the authority to issue Communications and to initiate andimplement prudential measures and impose disciplinary measures.

The 1997 Disciplinary Law provides a wide range of powers to INAF to bring about correctiveactions for noncompliance with laws and regulations.


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Under the terms of the above law, the INAF has the authority to impose sanctions upon banks inaccordance with the seriousness of the transgression committed. These sanctions include finesapplied to the bank or to the staff responsible; suspension, dismissal or disqualification of the

banks board members or staff responsible; prohibition from distributing dividends; amongother type of disciplinary measures.

The Disciplinary Law establishes three types of sanctions: mild, severe and very severedisciplinary measures. The INAF has the authority to issue mild and severe sanctions andensures that remedial actions are taken in a timely manner. However the implementation of verysevere disciplinary measures is proposed by the INAF to the government who has the authorityto act on the proposal.


Comments The sanctions in the category of very severe related to the compliance of solvency, liquidity,concentration risk, among other prudential regulation, that currently are within the authority ofthe government, should be within the jurisdiction of the INAF.

Principle 23. Globally Consolidated Supervision

Banking supervisors must practice global consolidated supervision over their internationallyactive banking organizations, adequately monitoring and applying appropriate prudentialnorms to all aspects of the business conducted by these banking organizations worldwide,primarily at their foreign branches, joint ventures, and subsidiaries.

Description Article 12(b) of the Bank Administration Law (modified by INAFs charter) requires banks toinform the INAF of the establishment abroad of foreign branches and subsidiaries. The INAFhas the authority to deny the constitution of the foreign branches or subsidiaries of the localbank, as stated in Article 18 of the abovementioned law.

The INAF ensures the adequacy of banks management review of consolidated risks through theanalysis of the financial information obtained from banks quarterly reports on a consolidatedbasis, which includes financial information of subsidiaries; and through the evaluation made bythe external auditors on this respect.

Communication 152/03 issued May 2003 requires banks to assess the internal control andauditing procedures of foreign subsidiaries of Andorran banks, and external auditors arerequired to validate, on an annual basis, the information submitted to the INAF in compliancewith Communication 152/03.

The INAF has the authority to require any prudential measure to its supervised banking groups,with the only exception of the measures defined as very severe in the law, that are under thejurisdiction of the government, as set in the Disciplinary Law.


Comments

Principle 24. Host Country SupervisionA key component of consolidated supervision is establishing contact and informationexchange with the various other supervisors involved, primarily host country supervisory

authorities.Description Article 9 of its charter grants the INAF the authority to establish relations and cooperation

agreements within the scope of its functions and powers with central banks and financialsupervisory authorities in other countries and with international official bodies.

Article 12b) of the Bank Administration Law (modified by the Law 14/2003) requires banks toinform the INAF of the establishment abroad of foreign branches and subsidiaries.


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The INAF has the authority to deny the constitution of the foreign branches or subsidiaries ofthe local bank, as stated in Article 18 of the above mentioned law.

Andorran banks have branches in Bahamas and Uruguay and a representative office in Panama.

Though these operations represent a very small share of the business of the banking groups, theINAF has initiated formal contacts with the banking supervisory authority of Uruguay in orderto enter into an MOU that would allow the INAF to have full access and capacity to supervisethe foreign activities of an Andorran banking group.


Comments To fully implement the supervision of foreign subsidiaries of local banks, the INAF must setformal agreements with the host country supervisor. The INAF should enter into an MOU withthe Banking Supervisory authority of Uruguay and other relevant supervisory authorities to setthe scope of information sharing, in order to have the necessary information for an adequatesupervision of foreign subsidiaries.

Principle 25. Supervision Over Foreign Banks EstablishmentsBanking supervisors must require the local operations of foreign banks to be conducted withthe same high standards as are required of domestic institutions and must have powers to

share information needed by the home country supervisors of those banks for the purpose ofcarrying out consolidated supervision.

Description Under its charter, the INAF applies a similar supervisory framework to all banking andnonbanking financial institutions regardless the origin of the capital (foreign or domestic).

Similarly, for purposes of licensing, the INAF takes into consideration if the home countrysupervisor practices consolidated supervision. Further, the INAF considers in its opinion to thegovernmentas the authority to have the final decision in the licensing process- if the homecountry supervisor has approved the establishment in Andorra of the foreign bank, as it was thelatest case of a Spanish bank, where a written communication was submitted to INAF by theBank of Spain on this regard.

Over the last few years, the INAF has actively tried to sign MOUs with the French and Spanishbank supervisors. However, the efforts have not been successful. The French supervisory

authorities indicated that French financial institutions have no presence in Andorra andtherefore in their opinion there was no need to enter in an MOU. The Central Bank of Spainproposed to the INAF some specific requirements on transparency of information on customeraccounts that the Andorran authorities considered onerous to meet. The INAF has indicated thatit is willing to facilitate nominative information of large exposures and that it would welcomethe opportunity to conduct joint on-site inspections with foreign supervisors.

Lately, some Spanish institutions have sold their interest in local institutions to Andorraninterests. Currently, the foreign banks presence in the financial system is represented by oneSpanish bank that accounts for approximately 2 percent of the total capital of the bankingsystem.

Assessment Materially noncompliant

Comments The INAF should intensify its efforts to enter into a formal agreement with various banking

authorities that will allow full compliance of Andorra as a host country supervisor. This shouldinclude sharing information with the relevant home country supervisors about the localoperations of the foreign banks, provided INAFs confidentiality is protected.


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Table 2: Summary Compliance with the Basel Core Principles

Core Principle C1/ LC2/ MNC3/ NC4/ NA5/

1. Objectives, Autonomy, Powers, and Resources1.1 Objectives X

1.2 Independence X

1.3 Legal framework X

1.4 Enforcement powers X

1.5 Legal protection X

1.6 Information sharing X

2. Permissible Activities X

3. Licensing Criteria X

4. Ownership X

5. Investment Criteria X

6. Capital Adequacy X

7. Credit Policies X

8. Loan Evaluation and Loan-Loss Provisioning X9. Large Exposure Limits X

10. Connected Lending X

11. Country Risk X

12. Market Risks X

13. Other Risks X

14. Internal Control and Audit X

15. Money Laundering X

16. On-Site and Off-Site Supervision X

17. Bank Management Contact X

18. Off-Site Supervision X

19. Validation of Supervisory Information X

20. Consolidated Supervision X

21. Accounting Standards X

22. Remedial Measures X

23. Globally Consolidated Supervision X

24. Host Country Supervision X

25. Supervision Over Foreign BanksEstablishments

X


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Table 3. Recommended Action Plan to Improve Compliance with the Basel Core Principles

Reference Principle Recommended Action

CP1 (2) Independence Publish a periodic review of INAFs performanceagainst its responsibilities and objectives.

CP1 (3) Legal Framework Amend INAFs charter to empower INAF to issuelicenses and conduct an orderly resolution of a problembank. Introduce a legal supervisory framework thatcovers insurance companies.

CP1 (4) Enforcement Powers Amend INAFs charter to empower INAF to undertakeall types of remedial actions, including the very serioussanctions and the revocation of a bank license.

CP 10 Connected Lending The INAF must ensure that credits to insiders andrelated interests should not be granted at preferentialrates and that transactions to insiders, such as thecredits to the members of the banks Board of

Directors, should be required to be approved by theBoard.

CP 14 Internal Control and Audit Members of the Board of Directors of financialinstitutions should participate in the yearly meetingswith auditors and the INAF.

CP16 On-site and Off-site supervision INAF should gradually increa

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