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FRAMEWORK FOR THE EVALUATION OF …

FRAMEWORKFOR THE EVALUATION OFINTERNAL CONTROL SYSTEMSB asle Committee on Banking SupervisionBasleJanuary 1998 Table of objectives and role of the internal controls framework8 III. The major elements of an internal control processA. Management oversight and the control culture10 1. Board of directors10 2. Senior management11 3. Control culture12B. Risk assessment13C. Control activities14D. Information and communication16E. Monitoring18IV. EVALUATION of internal control systems by and responsibilities of external auditors24 Appendix - Supervisory lessons learned from internal control25 FRAMEWORK for the EVALUATION of Internal Control part of its on-going efforts to address bank supervisory issues and enhancesupervision through guidance that encourages sound risk

Framework for the Evaluation of Internal Control Systems INTRODUCTION 1. As part of its on-going efforts to address bank supervisory issues and enhance

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1 FRAMEWORKFOR THE EVALUATION OFINTERNAL CONTROL SYSTEMSB asle Committee on Banking SupervisionBasleJanuary 1998 Table of objectives and role of the internal controls framework8 III. The major elements of an internal control processA. Management oversight and the control culture10 1. Board of directors10 2. Senior management11 3. Control culture12B. Risk assessment13C. Control activities14D. Information and communication16E. Monitoring18IV. EVALUATION of internal control systems by and responsibilities of external auditors24 Appendix - Supervisory lessons learned from internal control25 FRAMEWORK for the EVALUATION of Internal Control part of its on-going efforts to address bank supervisory issues and enhancesupervision through guidance that encourages sound risk management practices, the BasleCommittee on Banking Supervision1 is issuing this draft FRAMEWORK for comment by banksupervisors and other interested parties.

2 It is intended that this FRAMEWORK will be used bysupervisors in evaluating banks' internal control systems. A system of effective internalcontrols is a critical component of bank management and a foundation for the safe and soundoperation of banking organisations. A system of strong internal controls can help to ensurethat the goals and objectives of a banking organisation will be met, that the bank will achievelong-term profitability targets, and maintain reliable financial and managerial reporting. Sucha system can also help to ensure that the bank will comply with laws and regulations as wellas policies, plans, internal rules and procedures, and decrease the risk of unexpected losses ordamage to the bank's reputation.

3 The paper describes the essential elements of a soundinternal control system, drawing upon experience in member countries and principlesestablished in earlier publications by the Committee. The objective of the paper is to outline anumber of principles for use by supervisory authorities when evaluating banks' internalcontrol Basle Committee, along with banking supervisors throughout the world, hasfocused increasingly on the importance of sound internal controls. This heightened interest ininternal controls is, in part, a result of significant losses incurred by several bankingorganisations.

4 An analysis of the problems related to these losses indicates that they couldprobably have been avoided had the banks maintained effective internal control systems would have prevented or enabled earlier detection of the problems that led tothe losses, thereby limiting damage to the banking organisation. In developing theseprinciples, the Committee has drawn on lessons learned from problem bank situations inindividual member principles are intended to be of general application and supervisoryauthorities should use them in assessing their own supervisory methods and procedures for 1 The Basle Committee on Banking Supervision is a Committee of banking supervisory authorities whichwas established by the central-bank Governors of the Group of Ten countries in 1975.

5 It consists ofsenior representatives of bank supervisory authorities and central banks from Belgium, Canada, France,Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and theUnited States. It usually meets at the Bank for International Settlements in Basle, where its permanentSecretariat is 2 -monitoring how banks structure their internal control systems. While the exact approachchosen by individual supervisors will depend upon a host of factors, including their on-siteand off-site supervisory techniques and the degree to which external auditors are also used inthe supervisory function.

6 All members of the Basle Committee agree that the principlesset out in this paper should be used in evaluating a bank's internal control Basle Committee is distributing this paper to supervisory authoritiesworldwide in the belief that the principles presented will provide a useful FRAMEWORK for theeffective supervision of internal control systems. More generally, the Committee wishes toemphasise that sound internal controls are essential to the prudent operation of banks and topromoting stability in the financial system as a guidance previously issued by the Basle Committee typically includeddiscussions of internal controls affecting specific areas of bank activities, such as interest raterisk, and trading and derivatives activities.

7 In contrast, this guidance presents a frameworkthat the Basle Committee encourages supervisors to use in evaluating the internal controlsover all on- and off-balance sheet activities of banking organisations. The guidance does notfocus on specific areas or activities within a banking organisation. The exact applicationdepends on the nature, complexity and risks of the bank's operations. The Committeestipulates in sections III and IV of the paper fourteen principles for banking supervisoryauthorities to apply in assessing banks' internal control systems.

8 In addition, the Appendixprovides supervisory lessons learned from past internal control for the Assessment of Internal Control SystemsManagement oversight and the control culturePrinciple 1:The board of directors should have responsibility for approving strategies andpolicies; understanding the risks run by the bank, setting acceptable levels forthese risks and ensuring that senior management takes the steps necessary toidentify, monitor and control these risks; approving the organisational structure;and ensuring that senior management is monitoring the effectiveness of theinternal control 2:Senior management should have responsibility for implementing strategiesapproved by the board; setting appropriate internal control policies.

9 Andmonitoring the effectiveness of the internal control 3 -Principle 3:The board of directors and senior management are responsible for promoting highethical and integrity standards, and for establishing a culture within theorganisation that emphasises and demonstrates to all levels of personnel theimportance of internal controls. All levels of personnel at a banking organisationneed to understand their role in the internal controls process and be fully engagedin the AssessmentPrinciple 4:Senior management should ensure that the internal and external factors that couldadversely affect the achievement of the bank's objectives are being identified andevaluated.

10 This assessment should cover all the various risks facing the bank (forexample, credit risk, country and transfer risk, market risk, interest rate risk,liquidity risk, operational risk, legal risk and reputational risk).Principle 5:Senior management should ensure that the risks affecting the achievement of thebank's strategies and objectives are continually being evaluated. Internal controlsmay need to be revised to appropriately address any new or previouslyuncontrolled ActivitiesPrinciple 6:Control activities should be an integral part of the daily operations of a management must set up an appropriate control structure to ensureeffective internal controls, defining the control activities at every business should include: top level reviews; appropriate activity controls for differentdepartments or divisions; physical controls.


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