Compliance in Progress Summary

The International Monetary Fund (IMF) undertook a Financial System Stability Assessment (FSSA) of Luxembourg and released its findings in its 2002 Report on the Observance of Standards and Codes. According to the report, Luxembourg had a high level of compliance with all of the Basel Core Principles (BCPs) for effective banking supervision. However, the report did not specifically address Luxembourg's compliance with the individual BCPs. The report did note that the preconditions for effective banking supervision were in place, and that the supervisory framework of the Commission for the Supervision of the Financial Sector (CSSF), which is responsible for the prudential supervision and regulation of credit institutions, was comprehensive. However, a subsequent IMF 2004 Article IV Consultation report identified weaknesses in the area of anti-money laundering and combating the financing of terrorism, and recommended remedial actions given that Luxembourg is one of the most important financial centers in the world. A subsequent (2009) Article IV Consultation report by the IMF also recommends strengthening the prudential framework and supervisory capacity, as well as enhancing on-site inspections. In response to the global financial crisis, the CSSF, in its 2008 annual report, considers broadening its prudential regulation to enable more direct intervention in the banks’ commercial policies and business models. The CSSF also advocates and strives towards strengthening and harmonizing the EU regulatory framework that Luxembourg is a part of.

General Overview

In 2002, the International Monetary Fund’s (IMF) Financial System Stability Assessment (FSSA) concluded that Luxembourg generally had a high level of compliance with all of the Basel Core Principles. However, according to the Commission for the Supervision of the Financial Sector’s (CSSF) 2008 annual report, the recent global financial crisis has put to test its acclaimed banking supervisory framework. While Luxembourg is faring much better than most countries, its financial sector is facing its worst recession since the 1970s. Liquid profits have reduced significantly, and this has called into question the effectiveness of the current regulatory framework in the banking/financial sector. The FSSA undertaken in 2002 noted that the preconditions for effective banking supervision were in place, and that the supervisory framework of the CSSF, Luxembourg’s financial sector supervisor, was comprehensive. In a subsequent 2004 Article IV Consultation report, the IMF noted that a series of measures had been taken in Luxembourg following the 2002 assessment to improve financial supervision. Luxembourg authorities enhanced the scope of supervision, increased staff and on-site inspections, and adopted an internal Code of Conduct for banks’ supervisory staff regarding the trading and holding of securities. Important weaknesses remained, however, regarding the procedure and implementation of anti-money laundering (AML) and combating the financing of terrorism (CFT) practices, and remedial actions. During the Article IV Consultation mission, the authorities formally requested an update of the 2002 FSAP exercise.

Despite notable strengths in the banking supervisory framework as identified by the 2002 FSSA, the global crisis has brought to light some weaknesses in the EU framework of regulation that applies to Luxembourg as well, as the CSSF’s 2008 annual report observes. Importantly, EU banking directives are overly detailed though not necessarily more efficient. The annual report also mentions weaknesses in the Basel II and the international accounting standards, International Financial Reporting Standards (IFRS), frameworks in adequately regulating banking and accounting practices. As for the CSSF’s prudential supervisory model, the 2008 annual report advocates enhancing it so as to grant the CSSF the power to intervene directly in banks’ commercial policies, or question entire business models, if deemed necessary. It also favors strengthening the deposit guarantee scheme so as to more effectively handle bankruptcy of distressed banks with minimal negative impact. TheIMF’s 2009 Article IV also points out that the financial sector in Luxembourg faces significant risk due to its close integration with the EU (since a majority of banks in the country are subsidiaries of European conglomerates), that include reputational risks; liquidity risks resulting from an over-reliance on wholesale funding; and substantial systemic risks, due to the high volume of money market and other financial products solely from the Financial Center to the European Banking Sector. The 2009 IMF Article IV recommends that for Luxembourg to maintain its financial stability, the prudential and regulatory regimes need to be strengthened and cautions that any policy introduced will need to be phased in carefully given the procyclical effects and uncertainty of banks’ balance sheets. In addition, the IMF suggests raising capital buffers and setting leverage ratios that are coordinated on an international level. The IMF’s 2009 Article IV concurs with the 2008 CSSF annual report with regards to strengthening the CSSF’s supervisory capacity, pointing out that the heavy reliance on external auditors for on-site work will need to be reconsidered and suggests that auditing skills be built in-house. It strongly recommends having a strong on-site supervisory program for identifying and managing risks.

Laws governing the banking sector include the 1993 Law on the Financial Sector (Financial Sector Law, or FSL), as amended through November 2007, and the 1998 Law Concerning the Supervision of the Markets of Financial Assets (as amended). Furthermore, according to a 2009 U.S. Department of State’s (DoS) International Narcotics Control Strategy Report, Luxembourg's financial sector legislation is based to a large extent on European Union (EU) directives. The CSSF started its activities on January 1, 1999, under the authority of the Minister of Treasury and Budget, within the Ministry of Finance (MoF). It is an independent agency, integrating the supervisory tasks of the Central Bank of Luxembourg (BCL) and the Exchanges Commission. The CSSF is responsible for the prudential supervision and regulation of credit institutions, including banks, securities markets, undertakings for collective investment, operators of payment or securities settlement systems, and pension funds. The CSSF's supervisory responsibilities and objectives are regulated under the 1998 Law Creating a Commission for the Supervision of the Financial Sector, and the 1993 FSL. Furthermore, regulatory work is the responsibility of the CSSF's internal committees, which include internal and external representatives.

Luxembourg is one of the most important financial centers in the world, and, according to the 2009 U.S. Department of Commerce’s (DoC) Country Commercial Guide, has a “sound and strong” (p. 37) banking system. The report further noted that "cross- shareholding" and "stable shareholder" arrangements to restrict foreign investment are nonexistent. As of December 31, 2008, per the CSSF’s 2008 annual report, there were 152 banks, with total assets amounting to Euro 930.857 billion. Furthermore, foreign bank subsidiaries from countries such as Germany, Belgium, France, Italy, and Switzerland, constitute the majority of banks registered in Luxembourg.

The Principles

II1. (1) Clear responsibilities and objectives for each supervisory agency.

The IMF's 2002 assessment concluded that Luxembourg maintains a high level of compliance with all of the Basel Core Principles. Further, the report indicated that the CSSF's supervisory responsibilities and objectives are regulated under the 1998 Law Creating a Commission for the Supervision of the Financial Sector, and the 1993 FSL. Responsibilities include the prudential supervision and regulation of banking activities, as stated in the IMF's 2002 report. Despite the above conclusions, there is insufficient information directly addressing Luxembourg's compliance with this principle.

II1.(2) Operational independence and adequate resources.

According to the IMF's 2002 assessment, the CSSF is given full operational independence to conduct prudential supervision of the banking system under the 1998 Law Creating a Commission for the Supervision of the Financial Sector, and the 1993 FSL. However, the 2009 IMF Article IV concurs with the 2008 CSSF annual report with regards to strengthening the CSSF’s supervisory capacity, pointing out that the heavy reliance on external auditors for on-site work will need to be reconsidered and suggests that auditing skills be built in-house. It strongly recommends having a strong on-site supervisory program for identifying and managing risks. Despite the foregoing, there is insufficient information publicly available specifically addressing Luxembourg's compliance with this principle.

II1.(3) A suitable legal framework for authorization and ongoing supervision.

The CSSF's supervisory responsibilities and objectives are regulated under the 1998 Law Creating a Commission for the Supervision of the Financial Sector, and the 1993 FSL. In its 2002 report, the IMF notes that "laws are current and revised as necessary" (p. 35). Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II1.(4) A suitable legal framework to address compliance with laws as well as safety and soundness concerns.

See Principle 1.3.

II1.(5) Legal protection for supervisors.

There is insufficient information publicly available addressing Luxembourg's compliance with this principle.

II1.(6) Arrangement for sharing of information between supervisors and protection of confidentiality of shared information.

Although the IMF’s 2002 assessment report does not expressly address Luxembourg’s compliance with this principle, the CSSF’s 2008 annual report states that per Memoranda of Understanding (MoUs), Luxembourg shares information with other banking supervisory authorities through bilateral meetings, and has strengthened multilateral cooperation. This was strengthened by Article 129 of Directive 2006/48/EC, which requires intensive cooperation between the relevant competent authorities of cross-border banking groups.

II2. Clearly defined permissible activities for banks and control of the use of the word 'bank'.

Permissible activities for banks are defined under the 1993 FSL, which also restricts the use of the word "bank" to licensed banking institutions. Apart from the above statement from the IMF’s 2002 report, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II3. Criteria for structure, directors, operating plan, controls, financial condition and capital base.

According to the IMF’s 2002 assessment report, the Treasury and Budget Minister, approves licensing upon recommendation of the CSSF and controlled by judicial recourse. Criteria for licensing are set out in the 1993 FSL. Per the same report, banks operate either as locally incorporated banks, or branches of foreign banks. The IMF assessment, however, does not directly address Luxembourg's compliance with this principle.

II4. Authority to review and reject transfer of ownership.

While there is insufficient information publicly available addressing Luxembourg’s compliance with this principle, the IMF’s 2002 assessment noted that non-bank controlling shareholders were not subject to strict prudential supervision and review standards as banks, and alerted that this posed a risk to the banking sector.

II5. Authority to review major acquisitions and investments.

See Principle 4.

II6. Minimum capital adequacy requirements (meet Basle Capital Accord for internationally active banks).

Prudential regulations and requirements are in place, according to the IMF's 2002 FSSA. Further, Luxembourg maintains a high level of compliance with all of the Basel Core Principles. Although there is insufficient information publicly available addressing Luxembourg’s explicit compliance with this principle, the CSSF, in its 2008 annual report, recognizes the need to broaden its supervisory duties regarding capital adequacy. Currently, it can request a capital surplus only when there is a negative review result. In addition, in the light of the global financial crisis, the IMF’s 2009 Article IV report also suggests raising capital buffers and setting leverage ratios that are coordinated on an international level.

II7. A method exists for the evaluation of procedures related to loans, investments and portfolio management.

According to the IMF‘s 2002 FSSA, prudential regulations and requirements are in place and Luxembourg maintains a high level of compliance with all of the Basel Core Principles. While there is no explicit mention of Luxembourg’s compliance with this principle in the CSSF’s 2008 annual report, the CSSF does mention that it has unrestricted authority to review and evaluate banks’ policies and procedures at any time.

II8. Policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and reserves.

According to the CSSF’s 2008 annual report, the new international accounting standards, IFRS, have had a negative effect on provisioning by no longer recognizing lump sum provisions and provisions reserved with the Luxembourg Deposit Guarantee Scheme (AGDL), so that total provisioning in the banking sector recorded a decrease of 42.3 percent in 2008. Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II9. Prudential limits and management information system on concentration of exposure.

See Principle 7.

II10. Arm's length rule and monitoring for connected lending.

See Principle 7.

II11. Policies and procedures for country risk and transfer risk.

See Principle 7.

II12. Measuring and monitoring market risk. Limit and/or specific capital charge on market risk exposure.

See Principle 7.

II13. Comprehensive risk management processes.

See Principle 7.

II14. Adequate internal controls.

The IMF’s 2002 FSSA does not directly address Luxembourg’s compliance with this principle. However, the CSSF’s 2008 report mentions that the CSSF is required to take into account the work of the internal audit when assessing the quality of the organization and risk management by analyzing the summary report which the internal auditor must prepare every year, including the report of the Compliance officer.

II15. Strict "know-your-customer" rules and high ethical and professional standards.

The IMF, in its 2004 report states that Luxembourg is characterized by "a well developed supervisory framework that encompasses Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) preventive measures broadly in line with international standards" (p. 7). The same report notes that legal provisions on suspicious transaction reports (STRs) are "largely in line with the standard" (p. 8), and the identification of beneficial owners is required under the AML Law, without a distinction between natural and legal persons. However, the 2004 IMF assessment was based on the Financial Action Task Force’s 2002 methodology that has since been revised. The 2009 U.S. DoS report states that there are laws in place addressing identification, recordkeeping and STR requirements, as well as strict “know your customer” stipulations. The report also notes that the new law of 2008 transposing the EU's Third Directive contains provisions on enhanced customer due diligence and risk management measures. Despite the above information, none of the sources mentioned above directly address Luxembourg's actual compliance with this principle.

II16. Effective supervisory system consisting of on-site and off-site supervision.

According to the IMF's 2002 assessment, the CSSF is given powers under the 1993 FSL to require all information needed to conduct both on-site and off-site supervision. The CSSF 2008 annual report states that inspections to be carried out are setup at the beginning of the year and are based on assessment of the risk areas of various credit institutions. The report also mentions that since 2004, the powers of the CSSF were broadened to include supervision of the internal governance of credit institutions to ensure adherence to proper procedure. The CSSF also visits newly established banks on their premises in addition to actual on-site inspections. However, the IMF’s 2009 Article IV concurs with the CSSF’s 2008 annual report with regards to strengthening the CSSF’s supervisory capacity, pointing out that the heavy reliance on external auditors for on-site work will need to be reconsidered, and suggests that auditing skills be built in-house. It strongly recommends having a strong on-site supervisory program for identifying and managing risks. Despite the above information, none of the sources mentioned directly address Luxembourg's actual compliance with this principle.

II17. Regular contact with bank management and understanding of bank's operations.

As stated in the IMF's 2002 assessment, there was a lack of regular dialogue between the CSSF, the auditors and the banks. The IMF report recommended convening tripartite meetings more frequently to discuss and analyze report findings. The CSSF’s 2008 annual report mentions that the CSSF holds regular meetings with banks’ executives to discuss business and other problems. It also requires prompt notification by the banks if a serious issue arises. Furthermore, external auditors draw up management letters for the attention of the banks’ management and these are regarded as important sources of information, with respect to the credit institutions’ organization. The external auditors’ reports point out weaknesses observed in the internal control system during the course of their assessment. Despite the foregoing, there is insufficient information publicly available that directly addresses Luxembourg's compliance with this principle.

II18. Analytical reports and statistical returns on solo and consolidated basis.

Although the MF’s 2002 FSSA does not directly address this principle, the CSSF’s 2008 annual report states that the CSSF requires an analytical report on a yearly basis for all Luxembourg and non-EU credit institutions. Moreover credit institutions supervised on a consolidated basis are required to submit yearly consolidated and individual analytical reports of each subsidiary included in the consolidation and carrying out financial sector activities. Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II19. Independent validation of supervisory information through on-site examination or external auditors.

The IMF’s 2002 report notes that although Luxembourg relies heavily on the use of external auditors for on-site supervision, this has not resulted in any apparent cases of conflict of interest. Per the same report, the CSSF works closely with external auditors, which "provide independent verification on corporate governance (including risk management and internal control systems), and validate supervisory information" (p. 36). Under the 1993 FSL, banks are subject to an annual audit by one or more external auditors, and the CSSF is required to check the competence of auditors and, if needed, remove them from their functions. The CSSF’s 2008 report adds to the above information by noting that all professionals supervised shall communicate all the reports issued by the external auditors during the course of the audit of the accounting documents to the CSSF. Also, external auditors are required by law to inform the CSSF swiftly of any serious facts that come to their attention in the course of their duties. Since 2002, the CSSF holds annual meetings with the main audit firms to exchange opinions on specific issues encountered within supervised institutions, while addressing the quality of the reports produced and the results of the inspections. Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II20. Ability to supervise on a consolidated basis.

According to the IMF's 2002 assessment, "the CSSF imposes prudential requirements on a consolidated and individual basis for the banking group and subsidiaries" (p. 38). This is further substantiated by the CSSF’s 2008 annual report that confirms that there is consolidated supervision in place. However, the IMF assessment does not directly address Luxembourg's compliance with this principle.

II21. Consistent accounting policies and practices that provide a true and fair view of the financial condition of the bank.

As stated in the IMF's 2002 assessment, banks were required "to produce annual audited financial statements based on accounting principles and audited in accordance with internationally accepted audit practices and standards" (p. 37). The IMF report encouraged the CSSF to review its relations with external auditors, and organize periodic review meetings with them regarding their long-form reports.

According to the May 2007 update of the 2005 Deloitte & Touche IAS Plus website publication, Luxembourg companies listed on an EU/European Economic Area stock exchange, including banks and insurance companies, are required to comply with IFRSs as adopted by the EU. Deloitte & Touche further note that IFRSs "will be introduced into the local Luxembourg commercial law as an alternative to the current Luxembourg accounting principles," which per the 2007 Deloitte publication, differ from the international standards. The Luxembourg authorities have developed a draft law (bill No. 5976) which will give all commercial companies registered in Luxembourg the option to use IFRSs both for annual and consolidated accounts. As of December 2009 there is no information on the conversion of Luxembourg accounting principles with IFRSs.
The CSSF’s 2008 annual report states that the global financial crisis exposed deficiencies in IFRSs, which include “the prohibition to setup anti-cyclical provisions and the possibility to maintain the non value items in the assets of the balance sheet, like good will and differed taxes”. The report recommended an examination and strengthening of IFRSs. Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II22. Adequate supervisory measures to ensure timely corrective action.

According to the IMF's 2002 assessment, the CSSF "has an adequate range of informal and formal corrective measures" (p. 37) that it can impose against supervised institutions and individuals. The CSSF collaborates with bank management in applying informal measures, including additional reporting requirements and special audits, to improve the financial position of the bank. The IMF report notes that failure to comply with the required legal, regulatory, or statutory provisions can result in the potential suspension of the board or even the banking business if institutions do not make timely corrections. In addition, the CSSF has the authority to review the qualifications of the auditors, and, if needed, remove them from their functions. However, there is insufficient information publicly available specifically addressing Luxembourg's compliance with this principle.

II23. Banking supervisors must practice global consolidated supervision over their internationally-active banking organizations.

The IMF’s 2002 report notes that "there appear to be no impediments to direct or indirect supervision of all affiliates and subsidiaries of banking groups foreign or domestic" (p. 38).In addition, the CSSF’s 2008 report states that per Article 45(3) of the 1993 Law on the Financial Sector, the CSSF is required to supervise bank liquidity in cooperation with the competent authority of the home state. The report further states that the Law of 5 November 2006, which amends the 1993 Law, requires the CSSF to verify that credit institutions/financial holdings with head offices based in a third country are subject to consolidated supervision by a competent authority. In the absence of that, the CSSF is required to perform consolidated supervision to achieve the objectives of consolidated supervision. Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II24. International exchange of information with other supervisors.

As noted in the IMF's 2002 assessment, the CSSF holds regular bilateral meetings with home country supervisors, including Belgium, France, Germany, Switzerland, Ireland, the Netherlands, the United Kingdom, Italy, Denmark, Sweden, Norway, and Finland to exchange prudential information on supervised banks active in both countries. Furthermore, the CSSF has concluded a trilateral Memorandum of Understanding (MoU) with foreign supervisors with respect to the larger financial groups. Although the CSSF does not have MoUs with the supervisory authorities of countries such as the United States, Brazil, Hong Kong, Singapore, and Japan, it maintains regular contacts with them. At the time of the assessment, Luxembourg had signed 12 MoUs with foreign supervisory authorities that set out principles for cooperation and information sharing regarding prudential supervision. Per the same report, MoUs with Poland and Turkey were still pending. Per the CSSF 2008 report, the Directive 2006/48/EC relating to the taking up and pursuit of the business of credit regarding international cooperation on supervision was further strengthened. Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.

II25. Supervision of local operation of foreign banks and information sharing with home country supervisors.

The IMF’s 2002 report notes that "there appear to be no impediments to direct or indirect supervision of all affiliates and subsidiaries of banking groups foreign or domestic" (p. 38). For example, the CSSF’s 2008 report mentions that Article 129 of Directive 2006/48/EC requires that the CSSF plan and coordinate the prudential activities in co-operation with other relevant competent relevant authorities of cross-border banking groups and strive for a more centralized supervision at the EU level. Nonetheless, there is insufficient information publicly available directly addressing Luxembourg's compliance with this principle.