MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION

MBF-705LEGAL AND REGULATORY ASPECTS

OF BANKING SUPERVISION

OSMAN BIN SAIF

Session: FOURTEEN

Revision session 1

SECTION 1

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Why and How Should Banks Be Regulated?

• The health of the economy and the effectiveness of monetary policy depend on a sound financial system.

• Through supervising and regulating financial institutions, the State Bank is better able to make policy decisions.

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Why and How Should Banks Be Regulated? (Contd.)

• Bank supervision involves monitoring and examining the condition of banks and their compliance with laws and regulations.

• If a bank under the State Bank’s jurisdiction is found to have problems or be noncompliant, the State Bank may use its authority to request that the bank correct the problems.

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Why and How Should Banks Be Regulated? (Contd.)

• Bank regulation includes issuing specific regulations and guidelines to govern the operations, activities and acquisitions of banking organizations.

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How a Bank earns Profit?

• Just like any other business, a bank earns money so that it can run its operations and provide services.

• First, customers deposit their money in a bank account. The bank provides safe storage and pays interest on customers’ deposits.

• The bank is required to keep a percentage of deposits in reserve as cash in its vault or in an account at The State Bank.

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How a Bank earns Profit? (Contd.)• The bank can lend the rest to qualified borrowers.

Potential borrowers may wish to buy a house or a new car; • However, they may not have enough money to pay the full

price at one time. Instead of waiting to save the money to pay for a new house, which could take years, they take out a loan from a bank.

• Borrowers are charged interest on the loan – a bank’s primary source of income. Banks also make money from charging fees for other financial services, such as debit cards, automated teller machine (ATM) usage and overdrafts on checking accounts.

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Safety and Soundness

• Two major focuses of banking supervision and regulation are the safety and soundness of financial institutions and compliance with consumer protection laws.

• To measure the safety and soundness of a bank, an examiner performs an on-site examination review of the bank's performance based on its management and financial condition, and its compliance with regulations.

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CAMELS• The Banking Supervisor/examiner uses the CAMELS rating

system to help measure the safety and soundness of a bank.

• Each letter stands for one of the six components of a bank’s condition: – capital adequacy, – asset quality, – management, – earnings, – liquidity – and sensitivity to market risk.

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What are Banking Regulations?

• Bank Regulations are a form of government regulations which subject banks to certain requirements, restrictions and guidelines.

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Key Objectives of Bank Regulation• The objectives of bank regulations, and the emphasis, varies

between jurisdiction. The most common objectives are:– Prudential—to reduce the level of risk bank creditors are

exposed to (that is, to protect depositors); – Risk Reduction—to reduce the risk of disruption resulting from

adverse trading conditions for banks causing multiple or major bank failures;

– Avoid Misuse of Banks—to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime;

– To Protect Banking Confidentiality; – Credit Allocation—to direct credit to favored sectors.

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Bank• Operation

– Take money as deposits on which they pay interests– Lend it to borrowers who use if for investment or consumption– Borrow money from other banks (inter bank market)– Make profit on the difference between interest paid and received

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Potential problems in Bank

• Most of bank liabilities have shorter maturity period than assets – This can be a potential cause of bank failure incase all depositors take out

money at once (bank run)

• Credit risk – Possibility that borrowers will be unable to repay their loans– More risk in prosperity period as lending terms tends to be relaxed

• Interest rate risk– Most deposits at floating rate– Loans at fixed rate – If floating rate is more than fixed rate bank loses ( S&LI ,America 1979)

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Criticality of Banking system

• As bank provide credit and operate payments- failure can have a more damaging effect on the economy than the collapse of other businesses

• Hence need for more regulation by government– Reserve requirement – holding a proportion of bank deposits at the central bank (CRR)– Match a proportion of risky assets (i.e loans) with capital in form of equity or retained

earnings

• Capital of internationally active banks should amount to at least 8% of the value of risky assets. (Basel Accord)

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Investment Banks• Help firms raise money in the capital markets (equity and

bonds market)

• Advise firms whether to finance themselves with debt or equity

• Underwrite such issues by agreeing often with other banks in syndicate, to buy any unsold securities

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• At most basic , they are simply vast pools of money

• Institutional investors are– Pension funds

– Mutual funds

– Insurance companies

• Dominate the securities( stocks, bonds) market

• Control a huge chunk of most rich countries retirement savings and other wealth

• These have been growing at the expense of banking system

• As biggest owners of stocks and bonds they have growing influence in corporate finance and hence corporate governance

Institutional investors

Banking CRISIS

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Sub-prime mortgage – What’s that?

• Home loans made to borrowers with poor credit ratings — a group generally defined by FICO scores below 620 on a scale that ranges from 300 to 850

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Sub-prime mortgage (Contd.)

• FICO - a number that is based on a statistical analysis of a person's credit report, and is used to represent the creditworthiness of that person.

(FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol "FIC") that created the best-known and most widely used credit score model in the US.)

• Creditworthiness—the likelihood that the person will pay his or her debts. Calculated by credit reporting agencies. Ex. Equifax, Experian, and TransUnion in US

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Evolution of home mortgage

1930s

Lender-Banks Borrower-Individuals

Home loan funding

Principal + interest payable over long term

• Owning a house was not affordable to many • Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling

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New Model of mortgage lending

Lender-Banks

Home loan funding

Principal + interest payable over long term

Bought loan

Cash

Transfer of credit & market risk

MB

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Cas

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Transfer of market risk

SPV

Sec

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zatio

n fe

es

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New Model of mortgage lending (Contd.)

• Advantages• More liquidity in market• Risk spread out • Long term funding for mortgage lending• MBS- allows originators to earn fee income from

underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make

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Further evolution

• Big private players in this field were– Wells Frago

– Lehman Brothers

– Bear Stearns

– JP Morgan

– Goldman Sachs

– Bank Of America

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Big assumptions• Belief that modern capital markets had become so

much more advanced than their predecessors that banks would always be able to trade debt securities. This encouraged banks to keep lowering lending standards, since they assumed they could sell the risk on.

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Big Assumptions (Contd.)

• Many investors assumed that the credit rating agencies offered an easy and cost-effective compass with which to navigate this ever more complex world. Thus many continued to purchase complex securities throughout the first half of 2007 – even though most investors barely understood these products.

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Big Assumptions (Contd.)

• Most crucially, there was a widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable. Policymakers thought that because the pain of any potential credit defaults was spread among millions of investors, rather than concentrated in particular banks, it would be much easier for the system to absorb shocks than in the past.

• Housing prices will keep going up all time

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Good days turn bad. Crisis at the door (mid 2006 onwards):

• Through financial innovations loans issued to borrowers at minimal rate, adjusted rate. By mid 2006 time to pay bigger amounts comes

• Household income did not increase in same proportion as house prices

• Subprime mortgage owners start defaulting

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Good days turn bad. Crisis at the door (mid 2006 onwards):

• Rating agencies revise ratings of MBS/CDO as expected number of defaults turn out higher. Many ratings are lowered

• Bewildered investors lost faith in ratings, many stop buying MBS/CDO altogether

• Alarm bell at SIV/SPVs• Banks find themselves in non-comfortable position , stop

making loans• Housing prices plummet owing to increase in foreclosure,

delinquency and stoppage of loans

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what a mess….

• More frenzy in market and more defaults, again revised ratings, again further stoppage of funding and further stoppage of loans, further fall in house prices as demand and supply mismatch....problem feeding itself in circular fashion.

• As MBS/CDO market is shaken….investors start debating other derivatives true worth…panic spreads across and people start getting out….further hurting the banks

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What a mess

• The crisis unfolded as silent Tsunami on Wall Street where by the time people realized the graveness of the mess they were in , it had gone beyond control.

• Since, most of the player in the market, mortgage brokers, investment banks were running in debts. They are suddenly caught unaware and are in insolvency and start tumbling down….many are saved by nationalization as their fall would spread the contagion way far .

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What a mess

• Central government start pumping in money as last resort but one thing is surely not returning soon and which is very vital in financial industry -FAITH.

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In Short• When homeowners default, the amount of cash

flowing into MBS declines and becomes uncertain.• Investors and businesses holding MBS have been

significantly affected.• The effect is magnified by the high debt levels

maintained by individuals and corporations, sometimes called financial leverage.

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Build up into a financial crisis…

• In 2003, Bank of International Settlements(BIS) repeatedly warned that risk dispersion might not always be benign. But US Federal Reserve was convinced that financial innovation had changed the system in a fundamentally beneficial way.

• No efforts made to correct debt to equity ratios of bank• Huge trust in the intellectual capital of Wall Street –supported

by the fact that banks were making big money. • When high rates of subprime default emerged in late 2006,

market players assumed that the system would absorb the pain.

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Types of Regulations

• Banks in one form or another have been subject to the following non exhaustive list of General regulatory provisions:

1) restrictions on branching and new entry;

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Types of Regulations (Contd.)

2) restrictions on pricing (interest rate controls and other controls on prices or fees);

3) line-of-business restrictions and regulations on ownership linkages among financial institutions;

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Types of Regulations (Contd.)

4) restrictions on the portfolio of assets that banks can hold (such as requirements to hold certain types of securities or requirements and/or not to hold other securities, including requirements not to hold the control of non financial companies);

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Types of Regulations (Contd.)

5) compulsory deposit insurance (or informal deposit insurance, in the form of an expectation that government will bail out depositors in the event of insolvency);

6) capital-adequacy requirements;

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Types of Regulations (Contd.)

7) reserve requirements (requirements to hold a certain quantity of the liabilities of the central bank);

8) requirements to direct credit to favored sectors or enterprises (in the form of either formal rules, or informal government pressure);

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Types of Regulations (Contd.)

9. expectations that, in the event of difficulty, banks will receive assistance in the form of “lender of last resort”;

10. special rules concerning mergers (not always subject to a competition standard) or failing banks (e.g., liquidation, winding up, insolvency, composition or analogous proceedings in the banking sector);

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Types of Regulations (Contd.)

11) other rules affecting cooperation within the banking sector (e.g., with respect to payment systems).

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Other Types of Regulations

• Privacy Regulations• Anti-money laundering and anti-terrorism

regulation• Community re-investment regulation• Deposit account regulation

– Deposit insurance regulation– Consumer protection– Withdrawal limit and reserve requirement– Interest on demand deposits

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Other Types of Regulations(Contd.)

• Lending Regulations– Consumer protection– Debt collection– Credit cards– Lending limits

• Central bank regulations• Regulation of bank affiliates and holding

companies

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• SECTION 2:

• REGULATING BANK CAPITAL ADEQUACY

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CAPITAL ADEQUACY

• Capital requirement (also known as Regulatory capital or Capital adequacy) is the amount of capital a bank or other financial institution has to hold as required by its financial regulator.

• This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets.

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CAPITAL ADEQUACY (Contd.)

• These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent.

• Capital requirements govern the ratio of equity to debt, recorded on the right side of a firm's balance sheet.

• They should not be confused with reserve requirements, which govern the left side of a bank's balance sheet--in particular, the proportion of its assets it must hold in cash.

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Regulations

• A key part of bank regulation is to make sure that firms operating in the industry are prudently managed.

• The aim is to protect the firms themselves, their customers and the economy, by establishing rules to make sure that these institutions hold enough capital to ensure continuation of a safe and efficient market and able to withstand any foreseeable problems.

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Regulations (Contd.)

• The main international effort to establish rules around capital requirements has been the Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements.

• This sets a framework on how banks and depository institutions must calculate their capital.

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Regulations (Contd.)

• In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I.

• This framework has been replaced by a significantly more complex capital adequacy framework commonly known as Basel II.

• After 2012 it was replaced by Basel III.• Another term commonly used in the context of the

frameworks is Economic Capital, which can be thought of as the capital level bank shareholders would choose in the absence of capital regulation.

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Regulations (Contd.)

• The capital ratio is the percentage of a bank's capital to its risk-weighted assets.

• Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Basel II requires that the total capital ratio must be no lower than 8%.

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Regulations (Contd.)

• Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework.

• Most developed countries implement Basel I and II and now III , stipulate lending limits .

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• BASEL I

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Basel I

• Basel I is the round of deliberations by central bankers from around the world, and in 1988.

• The Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks.

• This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 .

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Basel I (Contd.)

• Basel I is now widely viewed as outmoded.• The world has changed as financial

conglomerates, financial innovation and risk management have developed, and a more comprehensive set of guidelines, known as Basel II, are in the process of implementation by several countries.

• Basel III was developed in response to the financial crisis.

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Background

• The Committee was formed in response to the messy liquidation of a Cologne-based bank (Herstatt Bank) in 1974.

• On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Herstatt Bank in exchange for dollar payments deliverable in New York.

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Main framework

• Basel I, that is, the 1988 Basel Accord, is primarily focused on credit risk and appropriate Risk Weighting of Assets.

•

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