Bank Management

BFIN404
INTRODUCTION TO BANKING

BA R BA R A CA S U – CL AU DI A G I R A RDONE – P HI L I P M OLYN EU X
P R E NTICE HA L L
P EA SRSON E DUCAT ION L I M I T ED

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 Chapter Five - Bank regulation and supervision
1- Introduction

The regulation of financial markets in general and of banking

institutions in particular is considered a controversial issue.
The financial sector is one of the most heavily regulated sectors in
the economy and banking is by far the most heavily
regulated industry. In Chapter 1 we presented some of the reasons
why banks are considered ‘special’; outlined the existence of market
imperfections (such as information asymmetries, moral hazard and
adverse selection) and noted how the existence of banks can help
minimize such problems.

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Before we discuss the rationale for regulation it is useful to
introduce various terms that are often used to describe the
regulatory environment :
A -Regulation relates
to the setting of specific rules of behavior that firms have to abide by – these
may be set through legislation (laws) or be stipulated by the relevant
regulatory agency
(for instance, the Financial Services Authority in the UK).
B - Monitoring of these regulations
refers to the process whereby the relevant authority assesses financial
firms to evaluate whether these rules are being obeyed.

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C - Supervision is a broader
term used to refer to the general oversight of the behavior of financial firms.
In practice one should note that these terms are often used interchangeably
in general discussion of the regulatory environment.

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 2. The rationale for regulation

Financial systems are prone to periods of instability. In recent years, a

number of financial crises around the world (South-east Asia, Latin
America and Russia) have brought about a large number of bank
failures. Some argue that this suggests a case for more effective
regulation and supervision.
However, the financial services industry is a politically sensitive one
and largely
relies on public confidence. Because of the nature of their activities
(illiquid assets and short-term liabilities), banks are more prone to
troubles than other firms. Further, because of the interconnectedness
of banks, the failure of one institution can immediately affect others.
This is known as bank contagion and may lead to bank runs. Banking
systems are vulnerable to systemic risk, which is the risk that
problems in one bank will spread through the whole sector.

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In summary, regulation is needed to ensure consumers’ confidence in the
financial sector. the main reasons for financial sector regulation are:

A- to ensure systemic stability;

B- to provide smaller, retail clients with protection; and
C- to protect consumers against monopolistic exploitation.

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3. Types of regulation
It is possible to identify 3 different types of regulation:
A- Systemic regulation
systemic regulation as regulation concerned mainly with the safety and
soundness of the financial system. Under this heading we refer to all public
policy regulation designed to minimize the risk of bank runs that goes under
the name of the government safety net. In particular, this safety net
encompasses two main features – deposit insurance arrangements and
the lender-of-last-resort function.
1- Deposit insurance is a guarantee that all or part of the amount
deposited by savers in a bank will be paid in the event that a bank fails.
2- The lender-of-last-resort (LOLR) function is one of the
main functions of a central bank. The central bank, or other
central institution, will provide funds to banks that are in
financial difficulty and are not able to access any other
credit channel.

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B - Prudential and conduct of business regulation

Prudential regulation is mainly concerned with consumer protection.

It relates to the monitoring and supervision of financial institutions,
with particular attention paid to asset quality and capital adequacy. The
case for prudential regulation is that consumers are not in a position to
judge the safety and soundness of financial institutions due to imperfect
consumer information and agency problems associated with the nature
of the intermediation business.

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C- Conduct of business regulation
focuses on how banks and other financial institutions conduct their business. This
kind of regulation relates to information disclosure, fair business practices,
competence, honesty and integrity of financial institutions and their employees.
Overall, it focuses on establishing rules and
guidelines to reduce the likelihood that:
1- consumers receive bad advice (possible agency problem);
2- supplying institutions become insolvent before contracts mature;
3- contracts turn out to be different from what the customer was anticipating;
4- fraud and misrepresentation takes place

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 4. Limitations of regulation:

might be political costs associated with enforcing regulations and

therefore an incentive to delay action. There are some benefits of
forbearance. First, not publicizing the bank’s problems may help
avoiding systemic risk caused by bank runs. In addition, the bank
may be worth more as a ‘going concern’, that is, remaining in
operation rather than going out of business and liquidating its assets.
To stay operational, a bank must be able to generate enough
resources. As we have seen, banks assets are highly illiquid and
therefore their sale might not generate enough cash to satisfy
creditors.

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There are, however, costs associated with forbearance are :
A- moral hazard:
forbearance in one case may lead to expectations of similar behavior in future
cases, causing other financial institutions to observe regulations less carefully.
Furthermore, regulators and regulated firms may become locked into an ever-
worsening spiral, resulting in a loss of public confidence in how banks and the
financial system in general are being regulated.
B- agency capture:
that is the regulatory process can be ‘captured’ by producers (in this case by
banks and other financial institutions) and used in their own interest rather
than in the interests of consumers. For example, some have argued that the
new Basle Capital Accord has had too much input from banking sector
participants and large banks in particular.

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C- costs of compliance

with the regulatory process will be passed on to consumers,

resulting in higher costs of financial services and possibly less
intermediation business. In addition, regulatory costs may act
as a barrier to entry in the market and this may consolidate
monopoly positions.

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5- Causes of regulatory reform

During recent years, the scope and complexity of financial regulation has
tended to grow almost continually. This has been partially in response to
public reaction to financial scandals and the consequent political
pressures generated.
Other factors that have an impact on regulatory reform are:
A - the internationalization trends. The increased international activity
of financial firms means that foreign institutions play an increasing role
in many domestic financial sectors. Throughout the world financial
liberalization has provided a passport for banks to offer services cross-
border. The increased presence of foreign financial firms raises issues
relating to how they should be regulated

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B- the globalization phenomenon

The growth in international activities and trade of multinational

corporations has increased the demand for services from financial
institutions that operate cross-border and therefore financial firms
continue to expand their international presence. This means that
various financial firms operate globally (e.g., HSBC, Citibank)
C- Another factor such as financial innovation.
As new financial products and services emerge and gain in market
significance, there are often calls for new regulation for instance the US
Federal Reserve in early 2005 called
for greater regulation of hedge funds (which are private investment
funds that
trade and invest in various assets such as securities, commodities

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6- Financial regulation in the United Kingdom

The regulatory environment in the UK banking and financial services industry has
changed dramatically since the mid-1980s. In general, new legislation has covered
three main areas.
First, a range of regulatory changes have been sought to reduce
demarcation lines between different types of financial service firms (especially
between banks and building societies) as well as commercial and investment banking
business.
Second, the UK has also implemented various pieces of EU legislation
into domestic banking law facilitating the introduction of the single banking
license and harmonizing prudential regulation for both commercial banks and
investment firms.
Finally, the most recent legislation laid down in the Financial
Services and Markets Act 2001 has been put in place to transfer regulatory
responsibility
for the whole financial system to a ‘super-regulator’ – the Financial Services
Authority – in the light of the Labor government’s decision to make the Bank of
England independent for monetary policy purposes. The

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The UK Financial Services Authority (FSA)

The FSA is an independent non-governmental body, it is a limited company

financed by levies on the industry. The FSA is accountable to Treasury ministers
and to Parliament. The overall FSA policy is set out by the board, which consist
of the chairman, three executive directors and eleven non-executive directors,
all appointed by the Treasury. The FSA exercises its statutory powers under the
Financial Services and Markets Act (FSMA). The FSMA assign the FSA four main
objectives:
1- to maintain confidence in the UK financial system;
2- to promote public understanding of the financial system;
3- to secure an appropriate degree of protection for consumers while
recognising their own responsibilities

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7- EU financial sector legislation

The main focus of this legislation has been to harmonize

rules and regulation aimed at promoting a single market
in financial services throughout the European Union. In
January 1993 the Second Banking Co-ordination Directive
came into force. This legislation had crucial implications
for banking activities within the
European Union because it introduced:

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European Union because it introduced:

A- A single European banking license which ensures that EU-incorporated banks which
are authorized within their own country’s regulations
B- Home country supervisors which are now responsible for the supervision of all
operations within the European Union of banks incorporated in the home country.
Consequently, a bank that is authorized within the United Kingdom by the Financial
Services Authority is now able to set up branches in any other EU Member State.
Therefore, the Second Banking Co-ordination Directive sets out:
1- Minimum levels of capital required before authorization can be granted.
2- Supervisory requirements in relation to major shareholders and banks’
participation in the non-banking sector.
3- Accounting and internal control requirements.

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 8 - Bank capital regulation
The role of capital in the financial sector, and for banks in particular,
is a central element of regulation. A bank’s capital may be defined as
the value of its net assets (i.e., total assets minus total liabilities). In
practice, this capital is the sum of the bank’s paid-up share capital
and its accumulated capital reserves. A bank’s capital is vital for the
protection of its depositors, and hence for the maintenance of general
confidence in its operations, and the underpinning of its longer-term
stability and growth
The role of capital in banking can be illustrated by a simple balance
sheet diagram as shown below where Bank Greedy has assets of £55
billion and £5 billion of capital. The bank has £54 billion in loans and
£50 billion held in deposits as follow :

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A) Bank Greedy balance sheet

Liabilities (£) Assets (£)

Capital 5 billion Cash and liquid assets 1 billion

Deposits 50 billion Loans 54 billion

––– ––– ––– –––
Total 55 billion Total 55 billion

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Now let us assume that the bank has made some risky loans and £4
billion-worth of loans go bad. The bank believes they will never be
repaid (the bank cannot recover the loans)
B) Bank Greedy balance sheet after £4 billion loans go bad :

Liabilities (£) Assets (£)

Capital 1 billion Cash and liquid assets 1 billion

Deposits 50 billion Loans 50 billion

––– ––– ––– –––
Total 51 billion Total 51 billion

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In this case Bank Greedy can bear the loss of £4 billion as it has
sufficient capital to cover these losses. Note that we assume that
cash and liquid assets remain at £1 billion.
If, however, the losses exceed £5 billion then Bank Greedy does not
have enough capital to cover these losses and it cannot meet
depositor obligations. See what happens if instead of a £4 billion
loss Bank Greedy has £7 billion loans go bad. This is shown as
follow :

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C) Bank Greedy balance sheet after £7 billion loans go bad

Liabilities (£) Assets (£)

Capital 0 billion Cash and liquid assets 1 billion

Deposits 48 billion Loans 47 billion

––– ––– ––– –––
Total 48 billion Total 48 billion

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It can be seen that Bank Greedy has used all its £5 billion capital to cover these
losses and deposits of £2 billion have also had to be used to make up the
shortfall– this means that the bank cannot repay all its depositors as the value
of deposits have fallen from the original £50 billion to £48 billion – in theory
the bank would have to tell its depositors that it had some bad news and
unfortunately some will not be able to withdraw their deposits (or that all
depositors will bear a loss). Of course, in reality this does not happen as the
bank is insolvent (bust).

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9- Conclusions

In this chapter we have reviewed the issue of financial regulation,

with specific focus on the regulation of the UK and EU banking
sectors. The chapter began with review of the rationale for
regulation, introducing the reader to different types of regulation.
The limitations of regulation were also analyzed, in particular the
moral hazard issue connected with the government safety net
arrangements such as deposit insurance and the lender-of-last-resort
function.

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