Topic 6: Prudential Control and Regulation in Banking

1. Topic 6: Prudential Control and Regulation in Banking

2. Lecture Outline • Arguments for prudential control / regulation • Problems with external prudential regulations • Prudential control and regulations in the UK, USA and BG

3. Regulation: Introduction • All companies have to ensure capital adequacy, and (banks in particular) have to also ensure sufficient liquidity. • Control is necessary due to two conflicting objectives: • Profit - high to keep shareholders happy. • Liquidity- low/high to earn profit/serve better and insure depositors.

4. Introduction • Should prudential controls or regulation be compulsory? • Should these regulations be imposed by the state? • Should they be imposed by the bank management itself? • Bank also has an interest in long-term survival.

5. Why Should we Regulate? • Protection of the public’s savings. • Control of the money supply. • Asymmetric information and vulnerability of depositors.

6. Why Should we Regulate? • Contagion (panic or domino) effects. • Bank’s ability to diversify assets. • Competition and excessive risk taking.

7. Problems with Regulation • Cost • Competition • Hampers competition and innovation. • Competence? • Question mark over competence of supervisor. • Complexity

8. Problems with Regulation • Moral hazard • Asymmetric information • Government Guarantee • Deposit insurance has ended risk of systematic failure (?) • Capital adequacy • Capital adequacy has ended credit risk (?)

9. A Case for Free Banking • The Scottish System (1716 – 1844). • Banks allowed to enter the market w/o chartering or licensing. • Results: • intense competition, innovation and economic growth • system introduces branch banking, interest paid on deposits, overdraft facilities and private deposit insurance.

10. Regulation in the UK: Pre-1979 • No specific banking law in the UK • Private banks treated like any other commercial concern • Individual agents or firms could accept deposits without any formal licence.

11. Regulation in the UK: The Banking Act 1979 • Identified two classes of institutions: • recognised banks and • licensed deposit takers • Main Features: • Act created a Deposit Protection Fund (DPF), to which all recognised banks to contribute. • Funds compensate 75% of any deposit up to £10,000.

12. Regulation in the UK: 1987 Amendment • Collapse of Johnson Matthey Bank (JMB) paved the way for amendment to the 1979 Act. • Main Features: • Created supervisory board headed by the Governor of BOE. • Eliminated the distinction between deposit takers and banks.

13. 1987 Amendment • Private auditors were given greater access to BOE information. • Exposure to a single borrower > 10% of banks capital reported to BOE. Supervisor consulted directly on any lending which exceeds 25% of bank capital to a single borrower. • Act also specified BOE control over the entry of foreign banks.

14. 1987 Amendment • Act increased the deposit insurance limit to £20,000. • Under Act, BOE acts as a regulator. • The asset side of a bank balance sheet is regulated through capital adequacy and liability side through liquidity adequacy.

15. 1987 Amendment • Capital Adequacy • Gearing Ratio Bank’s deposits + external liabilities Bank’s capital + reserves • Risk Assets Ratio (Basel Risk assets ratio) Capital_________ Weighted Risk Assets • Liquidity Adequacy • Example: Net open position in any one currency may not exceed 10% from adjusted capital

16. Parallel regulations in BG • Main Regulator – the Bulgarian National Bank • Basic regulations: • Law on Bank Deposit Guarantee: • Last modified as of 31.12.2010 • Amount secured: up to BGN 196.000 • Exceptions: • Depositors with preferential terms • Owners of shares entitling them with more than 5% of the votes in General Meeting • Members of the bank’s Management Board • Auditors • Own bank’s deposits

17. Parallel regulations in BG • Law on Bank Deposit Guarantee: • Managed by the Deposit Insurance Fund • The Fund is: • collecting entry and annual contributions from banks • Investing the money in government bonds and/or deposits in banks or the BNB • Contributions: • Entry contribution – 1% of bank’s capital, not less than BGN 100.000 • Annual contribution – 0.5% of the total amount of the deposit base • Contributions are non-refundable

18. Parallel regulations in BG • Ordinance N8 on the Capital Adequacy Capital Adequacy Ratio = Own Funds___ Risk Weighted Assets Own Funds = Tier One Capital + Tier Two Capital – specific investments in shares Assets are granted specific weights according to their risk profile – 0%, 10%, 20%, 50% and 100% The overall capital adequacy ratio may not be less than 12% Tier One Capital adequacy ration may not be less than 6%

19. Parallel regulations in BG • Ordinance N11 on Bank Liquidity Management and Supervision • Banks shall manage their liquidity in a manner that ensures they can regularly and without delay meet their daily obligations, both in a normal banking environment and in a crisis situation. • Banks shall submit to the BNB monthly liquidity reports on a ‘going concern basis’ showing projected BGN cash flows and correspondingly the BGN equivalent of foreign currency-denominated assets and liabilities. • The Bulgarian National Bank shall monitor the amount and composition of banks’ liquid assets and, where appropriate, establish minimum liquidity ratios on a bank-by-bank basis

20. Parallel regulations in BG • Ordinance N11 on Bank Liquidity Management and Supervision • Each bank shall establish liquidity management system, which shall include: • rules and procedures for identification, measurement, management and monitoring of the liquidity • Liquidity management body • Management information system • Maturity ladder • Cash Flow assessment • Where an individual bank experiences liquidity difficulties or systemically fails to fulfill requirements, the Deputy Governor heading the Banking Supervision Department may set minimum liquid asset ratios to be attained by the bank within a limited time frame.

21. USA Banking Regulation • Different to UK banking regulation: • Regularly turn to legislation to iron out perceived inefficiency • Protection of small depositors more important. • Concern about potential collusion – ‘anti-trust’.

22. Regulatory Responsibility – The ‘FRS’ • Federal Reserve - State ‘Member’ Banks • Controller of the Currency - National ‘Member’ Banks • FDIC examines the ‘Non-Member’ insured Banks. • Banks performance is monitored and assessed on a scale ranging from 1 to 5.

23. National Banking Act (1863,1864) • Passed during the civil war to help raise funding. • Created the treasury and the comptroller of the currency. • Created national banks with a Federal Charter.

24. Federal Reserve Act (1913) • Created the FRS • Created to provide a number of services to member banks. • E.g. the authority to act as the lender of last resort. • Today the FED controls the money supply and base interest rates.

25. You may remember… • McFadden-Pepper Act (1927) • Prevented banks from expanding across state lines. • Made national banks subject to the branching laws of their state. • International Banking Act (1978) tidied this up with respect to international banks • Glass-Steagall Act (1933) • Passed during the great depression. • Separated investment and commercial banking. • Created the FDIC. • Fed given the power to set margin requirements. • Prohibited interest to be paid on checking accounts.

26. US Banking Act (1933) • Created the FDIC • membership compulsory for FRS members • Non-members can join if they meet admission criteria • Members pay an annual insurance premium to the FDIC • FDIC purchases securities to provide a stream of funds (to cover deposits of up to $100,000).

27. Major USA Banking Regulation • FDIC Act 1935 • Gave the FDIC the power to examine banks and take necessary action. • Bank Merger Acts • All mergers must be approved by the appropriate regulating body. • Mergers must be evaluated in three areas: • Effect on competition. • Effect on the convenience and needs of the community. • Effect on the financial condition of the banks.

28. Bank Holding Company Act (1956) • Federal Reserve given the power to regulate bank holding companies • 1966 Amendment reduced the tax burden of bank holding companies • 1970 - Amended the definition of bank holding companies to include one-bank holding companies

29. Social Responsibility Acts • 1968 – full information on terms of loans must be given. • 1974 – cannot be denied a loan based on age, sex, race, national origin or religion. • 1977 – cannot discriminate based on the neighborhood in which borrower resides. • 1987 – banks must disclose full terms on deposit and savings accounts.

30. Riegle-Neal Act (1994) • Bank holding company can acquire banks nationwide. • Consolidation of inter-state BHCs into branches. • Smaller well managed banks only need to be examined every 18 months. • Community development fund created to promote development of depressed local communities.

31. Gramm-Leach-Bliley Act (1999) • Permits banking-insurance-securities affiliations • Protections for consumers purchasing insurance through a bank. • Must disclose policies regarding the sharing of customers’ private information. • Customers are allowed to ‘opt out’ of private information sharing.

32. Conclusions • Regulation is a necessary tool for managing the modern bank and controlling risk exposure • Drawbacks of Regulation – is the process necessary after all? • There are historical examples of free banking markets working to the advantage of society • The Scottish Example • In the UK, we have observed a gradual shift in regulatory attitudes from relatively lax to relatively stringent. • Particularly from 1978 (pre Banking Act) – 1987 • However…….

33. Conclusions • There is a degree of contrast in terms of attitudes to regulation in the UK and USA • This is evidenced by the number of important regulations in each country • What about Germany? • Follows EU regulation on Banking (See Page 245-250 in Modern Banking in Theory and Practice) • Attitudes towards Universal Banking have helped shape EU policy