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Bank regulation

From Wikipedia, the free encyclopedia

Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. As regulation focusing on key actors in the financial markets, it forms one of the three components of financial law, the other two being case law and self-regulating market practices.[1]

Given the interconnectedness of the banking industry and the reliance that the national (and global) economy hold on banks, it is important for regulatory agencies to maintain control over the standardized practices of these institutions. Supporters of such regulation often base their arguments on the "too big to fail" notion. This holds that many financial institutions (particularly investment banks with a commercial arm) hold too much control over the economy to fail without enormous consequences. This is the premise for government bailouts, in which government financial assistance is provided to banks or other financial institutions who appear to be on the brink of collapse. The belief is that without this aid, the crippled banks would not only become bankrupt, but would create rippling effects throughout the economy leading to systemic failure. Compliance with bank regulations is verified by personnel known as bank examiners.

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Transcription

There are all kinds of businesses in our economy. They all have one thing in common: They want to earn money so they can run their operations, provide service for their customers, and get a reasonable return for their owners. A bank is no different. So, how does a bank earn money? It lends money to members of the community who can pay back what they borrow. These borrowers are charged interest. This is the main way banks make money and stay healthy. The Fed wants to keep the economy growing so that's why they want to make sure all banks stay healthy. The healthier the bank, the healthier the economy and the communities that it serves. The way the Fed supervises and regulates banks keeps evolving. Since the financial crisis of 2008, the Fed, along with other bank supervisors, conducts stress tests on the nation's largest financial institutions making sure they have the capital they need to stay healthy in case of an economic downturn. These days the Fed and other regulators are looking at risk across multiple banks, not just at individual institutions, watching out for the stability of the entire financial system. This broader review model is called macro-prudential regulation, and it makes the financial system more resilient to systemic shocks. That's why the Fed, along with other federal and state authorities, keeps an eye on banks. These agencies make sure banks do business safely and provide fair and equitable services to their communities. How? First, the Fed makes sure all deposits are safe by requiring all banks to keep a percentage of deposits in reserve as cash in their vaults or in accounts at a federal reserve bank. Then, to make sure banks stay safe and sound, the Fed sends out examiners to inspect banks, both big and small. They check on how well a bank is run by asking basic questions. For example, Does a bank make good investments? Does it take care of people's money? Does it follow safe banking rules? The Fed gets all this information from the banks in the form of Bank Call Reports. Fed examiners review these reports first off site, and then go on site to inspect bank records and facilities. Then the Fed examiners combine all this information to measure the health of the bank. Once the information is collected, the examiners study the bank's condition by applying the Camels Rating. Each letter stands for one of the 6 components of a bank's health. Capital adequacy: Do they have enough capital to do business? Capital acts like a cushion to absorb losses that could otherwise cause a bank to fail. Asset quality: Are their loans and other investments safe and sound? Management: Do their managers know what they're doing? Earnings: Are they making a profit? Liquidity: Do they have enough funds on hand to pay back their depositors? And Sensitivity to market risk: Do they make wise decisions based on their understanding of risk? This Camels Rating gives banks a confidential assessment from 1 to 5, with 1 being the top rating and 5 being the lowest. What happens if a bank gets a poor rating? The Fed goes back, does more examinations and offers guidance to the bank in question. Sometimes the Fed and the bank have written agreements on how to rectify the situation. If banks continue to perform badly, they can become insolvent and be shut down, but the depositors are protected. The FDIC ensures depositors' money from loss up to $250,000. Another part of ensuring that banks are serving their communities? Making sure banks are lending fairly. That's where the Fed's Consumer Compliance comes in. They make sure loan applications are judged on the consumer's ability to repay the loan, not on their race, religion or neighborhood. The Fed also makes sure banks are complying with consumer protection laws by disclosing the correct interest rate on loans. This is to make sure customers don't get charged any hidden fees when they borrow money. The Fed is committed to safe and sound banking, so if consumers have a complaint about a financial institution, they can contact the Federal Reserve. The Fed will look into banking practices and investigate those complaints keeping our banking system safe and sound and the economy and all communities growing. For more information, visit the Atlanta Fed online at frbatlanta.org.

Contents

Objectives

The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common objectives are:

General principles

Banking regulations vary widely between jurisdictions.

Licensing and supervision

Bank regulation is a complex process and generally consists of two components:[4]

The first component, licensing, sets certain requirements for starting a new bank. Licensing provides the licence holders the right to own and to operate a bank. The licensing process is specific to the regulatory environment of the country and/or the state where the bank is located. Licensing involves an evaluation of the entity's intent and the ability to meet the regulatory guidelines governing the bank's operations, financial soundness, and managerial actions.[5] The regulator supervises licensed banks for compliance with the requirements and responds to breaches of the requirements by obtaining undertakings, giving directions, imposing penalties or (ultimately) revoking the bank's license.

The second component, supervision, is an extension of the licence-granting process and consists of supervision of the bank's activities by a government regulatory body (usually the central bank or another independent governmental agency). Supervision ensures that the functioning of the bank complies with the regulatory guidelines and monitors for possible deviations from regulatory standards. Supervisory activities involve on-site inspection of the bank's records, operations and processes or evaluation of the reports submitted by the bank. Examples of bank supervisory bodies include the Federal Reserve System and the Federal Deposit Insurance Corporation in the United States, the Financial Conduct Authority and Prudential Regulation Authority in the United Kingdom, the Federal Financial Markets Service in the Russian Federation, the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) in Germany.[6]

Minimum requirements

A national bank regulator imposes requirements on banks in order to promote the objectives of the regulator. Often, these requirements are closely tied to the level of risk exposure for a certain sector of the bank. The most important minimum requirement in banking regulation is maintaining minimum capital ratios.[7] To some extent, U.S. banks have some leeway in determining who will supervise and regulate them.[8]

Market discipline

The regulator requires banks to publicly disclose financial and other information and depositors and other creditors are able to use this information to assess the level of risk and to make investment decisions. As a result of this, the bank is subject to market discipline and the regulator can also use market pricing information as an indicator of the bank's financial health.

Instruments and requirements

Capital requirement

The capital requirement sets a framework on how banks must handle their capital in relation to their assets. Internationally, the Bank for International Settlements' Basel Committee on Banking Supervision influences each country's capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accords. The latest capital adequacy framework is commonly known as Basel III.[9] This updated framework is intended to be more risk sensitive than the original one, but is also a lot more complex.

Reserve requirement

The reserve requirement sets the minimum reserves each bank must hold to demand deposits and banknotes. This type of regulation has lost the role it once had, as the emphasis has moved toward capital adequacy, and in many countries there is no minimum reserve ratio. The purpose of minimum reserve ratios is liquidity rather than safety. An example of a country with a contemporary minimum reserve ratio is Hong Kong, where banks are required to maintain 25% of their liabilities that are due on demand or within 1 month as qualifying liquefiable assets.

Reserve requirements have also been used in the past to control the stock of banknotes and/or bank deposits. Required reserves have at times been gold, central bank banknotes or deposits, and foreign currency.

Corporate governance

Corporate governance requirements are intended to encourage the bank to be well managed, and is an indirect way of achieving other objectives. As many banks are relatively large, and with many divisions, it is important for management to maintain a close watch on all operations. Investors and clients will often hold higher management accountable for missteps, as these individuals are expected to be aware of all activities of the institution. Some of these requirements may include:

  • to be a body corporate (i.e. not an individual, a partnership, trust or other unincorporated entity)
  • to be incorporated locally, and/or to be incorporated under as a particular type of body corporate, rather than being incorporated in a foreign jurisdiction
  • to have a minimum number of directors
  • to have an organizational structure that includes various offices and officers, e.g. corporate secretary, treasurer/CFO, auditor, Asset Liability Management Committee, Privacy Officer, Compliance Officer etc. Also the officers for those offices may need to be approved persons, or from an approved class of persons
  • to have a constitution or articles of association that is approved, or contains or does not contain particular clauses, e.g. clauses that enable directors to act other than in the best interests of the company (e.g. in the interests of a parent company) may not be allowed.

Financial reporting and disclosure requirements

Among the most important regulations that are placed on banking institutions is the requirement for disclosure of the bank's finances. Particularly for banks that trade on the public market, in the US for example the Securities and Exchange Commission (SEC) requires management to prepare annual financial statements according to a financial reporting standard, have them audited, and to register or publish them. Often, these banks are even required to prepare more frequent financial disclosures, such as Quarterly Disclosure Statements. The Sarbanes–Oxley Act of 2002 outlines in detail the exact structure of the reports that the SEC requires.

In addition to preparing these statements, the SEC also stipulates that directors of the bank must attest to the accuracy of such financial disclosures. Thus, included in their annual reports must be a report of management on the company's internal control over financial reporting. The internal control report must include: a statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the company; management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year; a statement identifying the framework used by management to evaluate the effectiveness of the company's internal control over financial reporting; and a statement that the registered public accounting firm that audited the company's financial statements included in the annual report has issued an attestation report on management's assessment of the company's internal control over financial reporting. Under the new rules, a company is required to file the registered public accounting firm's attestation report as part of the annual report. Furthermore, the SEC added a requirement that management evaluate any change in the company's internal control over financial reporting that occurred during a fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting.[10]

Credit rating requirement

Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and to disclose it to investors and prospective investors. Also, banks may be required to maintain a minimum credit rating. These ratings are designed to provide color for prospective clients or investors regarding the relative risk that one assumes when engaging in business with the bank. The ratings reflect the tendencies of the bank to take on high risk endeavors, in addition to the likelihood of succeeding in such deals or initiatives. The rating agencies that banks are most strictly governed by, referred to as the "Big Three" are the Fitch Group, Standard and Poor's and Moody's. These agencies hold the most influence over how banks (and all public companies) are viewed by those engaged in the public market. In recent years, following the Great Recession, many economists have argued that these agencies face a serious conflict of interest in their core business model.[11] Clients pay these agencies to rate their company based on their relative riskiness in the market. The question then is, to whom is the agency providing its service: the company or the market?

European financial economics experts – notably the World Pensions Council (WPC) have argued that European powers such as France and Germany pushed dogmatically and naively for the adoption of the "Basel II recommendations", adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD). In essence, they forced European banks, and, more importantly, the European Central Bank itself, to rely more than ever on the standardized assessments of "credit risk" marketed aggressively by two US credit rating agencies – Moody's and S&P, thus using public policy and ultimately taxpayers' money to strengthen anti-competitive duopolistic practices akin to exclusive dealing. Ironically, European governments have abdicated most of their regulatory authority in favor of a non-European, highly deregulated, private cartel.[12]

Large exposures restrictions

Banks may be restricted from having imprudently large exposures to individual counterparties or groups of connected counterparties. Such limitation may be expressed as a proportion of the bank's assets or equity, and different limits may apply based on the security held and/or the credit rating of the counterparty. Restricting disproportionate exposure to high-risk investment prevents financial institutions from placing equity holders' (as well as the firm's) capital at an unnecessary risk.

Activity and affiliation restrictions

In the US in response to the Great depression of the 1930s, President Franklin D. Roosevelt's under the New Deal enacted the Securities Act of 1933 and the Glass–Steagall Act (GSA), setting up a pervasive regulatory scheme for the public offering of securities and generally prohibiting commercial banks from underwriting and dealing in those securities. GSA prohibited affiliations between banks (which means bank-chartered depository institutions, that is, financial institutions that hold federally insured consumer deposits) and securities firms (which are commonly referred to as “investment banks” even though they are not technically banks and do not hold federally insured consumer deposits); further restrictions on bank affiliations with non-banking firms were enacted in Bank Holding Company Act of 1956 (BHCA) and its subsequent amendments, eliminating the possibility that companies owning banks would be permitted to take ownership or controlling interest in insurance companies, manufacturing companies, real estate companies, securities firms, or any other non-banking company. As a result, distinct regulatory systems developed in the United States for regulating banks, on the one hand, and securities firms on the other.[13]

Too big to fail and moral hazard

Among the reasons for maintaining close regulation of banking institutions is the aforementioned concern over the global repercussions that could result from a bank's failure; the idea that these bulge bracket banks are "too big to fail".[14] The objective of federal agencies is to avoid situations in which the government must decide whether to support a struggling bank or to let it fail. The issue, as many argue, is that providing aid to crippled banks creates a situation of moral hazard. The general premise is that while the government may have prevented a financial catastrophe for the time being, they have reinforced confidence for high risk taking and provided an invisible safety net. This can lead to a vicious cycle, wherein banks take risks, fail, receive a bailout, and then continue to take risks once again.

By country

See also

References

  1. ^ Joanna Benjamin, Financial Law (2007, Oxford University Press), 7
  2. ^ Federal Deposit Insurance Corporation. "Risk Management Manual of Exam Policies, Section 1.1". Retrieved 17 August 2011.
  3. ^ Section 115, Dodd–Frank Wall Street Reform and Consumer Protection Act. "Pub. L. 111-203" (PDF). Archived (PDF) from the original on 8 July 2011. Retrieved 17 August 2011.
  4. ^ Richard Apostolik, Christopher Donohue, and Peter Went (2009), Foundations of Banking Risk. Hoboken, New Jersey: John Wiley and Sons, p. 62.
  5. ^ Richard Apostolik, Christopher Donohue, and Peter Went (2009), Foundations of Banking Risk. Hoboken, New Jersey: John Wiley and Sons, p. 63.
  6. ^ Richard Apostolik, Christopher Donohue, and Peter Went (2009), Foundations of Banking Risk. Hoboken, New Jersey: John Wiley and Sons, p. 63.
  7. ^ Investopedia:Capital Requirement
  8. ^ Federal Reserve Bank of Chicago, The Relationship Between Regulators and the Regulated in Banking, June 2001
  9. ^ "Basel II Comprehensive version part 2: The First Pillar – Minimum Capital Requirements" (pdf). November 2005. p. 86.
  10. ^ Section 404, Management's Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports. "Final Rule". Retrieved 18 October 2011.
  11. ^ The Guardian (22 August 2011). "Ratings agencies suffer 'conflict of interest', says former Moody's bos". London. Retrieved 19 February 2012.
  12. ^ M. Nicolas J. Firzli, "A Critique of the Basel Committee on Banking Supervision" Revue Analyse Financière, Nov. 10 2011 & Q2 2012
  13. ^ Carpenter, David H. and M. Maureen Murphy. "The “Volcker Rule”: Proposals to Limit “Speculative” Proprietary Trading by Banks". Congressional Research Service, 2010.
  14. ^ Rochet, Jean-Charles (2009). Why Are There So Many Banking Crises?: The Politics and Policy of Bank Regulation. Princeton University Press. ISBN 9781400828319.

External links

Reserve requirements

Capital requirements

Agenda from ISO

Various countries

This page was last edited on 5 May 2019, at 15:27
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