Table of Contents

Introduction   What is the actual function of a bank within an economy?   The function of an efficient Financial Sector in the economy   Efficient Financial Sector Principles   The Credit Crunch   Financial Institutions hit by the Credit Crunch   Bank Regulations and Supervision   Bank Regulations and Risk Management   Banking Supervision   Basel II   Consequences of lack of Supervision   Considerations

Introduction

Banking is an important institution in the economy and plays a very important role in the economic life and economic growth of any society. While it is of common understanding that banking is not “The Economy”, it is agreed that the health of the country’s economy is closely related to the soundness of its banking system which can be sustained through strict regulations and supervision in order to monitor and control business risks such as Capital Risks, Liquidity Risks, Credit Risks, Exchange Risks, Operational Risks, Market Risks and Legal Risks.

Bank regulations and bank supervision are required to facilitate a ‘Systematic Risk Reduction’ approach thus reducing the risk of adverse trading conditions and to ensure that Financial Institutions satisfy at least the minimum ‘Prudential’ requirements in order to reduce the risk factor that creditors are exposed to. Lack in regulations and slack in supervision may lead to Financial Institutions risking bankruptcy thus exposing their clients of potentially losing their investments and financial assets while distressing the country’s economy.

What is the actual function of a bank within an economy?

Banks' traditional role is primarily that of an intermediary for money, i.e. granting loans, processing payments, accepting deposits, carrying out investments, etc...

Although banks do not create new wealth, through borrowing, lending and related activities they facilitate the process of production, distribution, exchange and consumption of wealth. In this way banks become very effective partners in the process of economic development. (BlurtIt.com, 2007)

Banks act as the backbone of the economy. Instead of keeping peoples’ savings idle, banks inject this working capital in the economy; as long as capital is kept flowing in the economy, both the banks and the economy will remain sound and healthy.

The function of an efficient Financial Sector in the Economy

The function of an efficient financial sector can be defined as promoting economic growth and reducing poverty by widening and broadening access to finance and by allocating society's savings more efficiently.

Efficient Financial Sector Principles

An efficient economy requires an efficient Financial Sector to operate. This can be sustained through the enforcement of governmental/regulatory bodies’ regulations, control and regular supervision.

Fostering stable and efficient financial systems revolve around 5 principles:

• Macroeconomic Stability - This stability has been accompanied by dramatic changes in financial structure over the past 20 years. The simultaneous improvement in the efficiency of monetary policy and stabilisation of the macro-economy is the result of the reduction in direct state ownership of banking system assets and by the introduction of explicit deposit insurance. (National Bureau of Economic Research, 2001)
• Legal Framework - Financial contracts depend on certainty of legal rights and predictability and speed of their fair and impartial enforcement. (World Bank, Undated)
• Transparency – Transparency of bank accounts through supervision.
• Banking Market Structure – Banking competition and the transmission of monetary policy through the bank lending channel. (Federal Reserve, 2005)
• Financial Safety Net – The financial safety net should provide protection against the collapse of the financial system that would endanger the entire economy and can be achieved through the implementation of regulations and through supervision. (Business Network, 2008)

The late 1990’s financial crises stressed the linkages between macroeconomic developments and the financial system soundness. Weak Financial Institutions resulted in inadequate bank regulations and supervision together with lack of transparency. In light of these crises the International Monetary Fund (IMF) designed the Financial Sector Assessment Framework with the scope to help countries identify and implement policies and regulations in order to build sound financial systems.

Financial Sector Assessment Framework

Based on the core Financial Sector Principles the International Money Fund designed a financial sector assessment framework based on 3 pillars:

• Pillar I - Macro-prudential surveillance and financial stability analysis. Authorities are to monitor the impact of potential macroeconomic and institutional factors on the soundness and stability of financial systems.
• Pillar II - Financial system supervision and regulation to help manage the risks and vulnerabilities, protect market integrity, and provide incentives for strong risk management and good governance of financial institutions.
• Pillar III - Financial system infrastructure:
• Legal infrastructure for finance, including insolvency regime, creditor rights, and financial safety nets.
• Systemic liquidity infrastructure, including monetary and exchange operations.
• Transparency, governance, and information infrastructure.
  
  (International Monetary Fund, 2008)

The elements within all the three pillars support both development and stability. These three pillars ensure that there are adequate bank regulations and supervision in place in an effort to reduce unforeseen risks such as the recent Credit Crunch scenario which lead Financial Institutions to financial crises.

The Credit Crunch

Lack of confidence by investors in Financial Institutions lead to an economic condition referred to as the ‘Credit Crunch’ whereby investment capital will be difficult to obtain, deposits tend to decrease, and as a consequence banks will be limited in their lending power due to lack of liquidity and working capital.

A credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, which results in higher rates, i.e. driving up the price of debt products for borrowers. (Investopedia, Undated)

Today, due to the credit crunch manifestation in recent years, various Financial Institutions are facing problems in the running of their business operations. Traditionally, Financial Institutions based their lending on customer deposits, in modern banking this concept shifted to a new Inter-Banking concept, i.e. banks borrowing money from other banks. This gave rise to severe consequences since as soon as one bank was hit by the credit crunch phenomena, it also pulled down its inter related banks with it. This can only be avoided through stricter regulations and financial control.

Financial Institutions hit by the Credit Crunch

In the U.S. banks are finding it more difficult to borrow money from customers as a consequence of sub-prime mortgage market due to poor credit borrowers being unable to settle their loans. As a consequence, interest rates on lending went up thus impacting both the U.S. and the global economy.

As an example the U.S. private bank Bear Stearns sank into a grave liquidity crisis due to its failed speculation with the so-called sub-prime mortgages. These mortgages have involved heavy lending to parties with limited means to repay loans.

Due to Inter-bank markets practices the U.S. credit crunch went global and today the world is facing a major crises. There is a global growing concern that the global financial crisis could push more private banks into bankruptcy.

Worldwide private banks such as in the U.S., Britain, Germany, France, and elsewhere in Europe are facing similar difficulties due to failed investments in financial derivatives based on U.S. mortgages excesses.

Recently the U.K. government nationalised Northern Rock Bank which went bankrupt due to heavy investments in the U.S. mortgage market. Another example is the IKB Deutsche Industrienbank which has received a state guarantee of 15 billion dollars to avert collapse over failed investments in the U.S. mortgages. (BlogSpot, 2008)

Since January 2007, global banks reported a credit loss of about USD 387 billion due to this credit crunch crises, out of which USD 200 billion where incurred by European banks and the remainder by US banks (according to data from the Institute of International Finance). This revealed that US banks sold sub-prime security packages and other linked instruments to European banks in recent years. (Business Standard, 2008)

All this highlight the importance and the necessity of stricter bank regulations and supervision in banking operations.

Bank Regulations and Supervision

Bank regulations are a form of government regulations which subject banks to certain requirements, restrictions and guidelines, aiming to uphold the soundness and integrity of the financial system (Answers.com, Undated).

It is considered healthy that governments “get in the way” of banks and Financial Institutions as a measure of financial control being both directly or indirectly through regulators for the best interest of the country’s economy and customer protection.

Banking regulations can vary widely between countries but they all address similar policy goals and requirements. The following are the basic banking requirements for Financial Institution to operate in a healthy environment:

• The Reserve Requirements determines the amount of funds that a bank must hold in reserve against deposits made by its customers. The reserve requirement is one of the 3 main tools of the monetary policy together with ‘Open Market Operations’ (the buying and selling of government securities in the open market) and the ‘Discount Rate’ (the interest rate charged by a central bank on loans to its member banks).
• Capital Requirements determines how much liquidity is required to be held for a certain level of assets through regulatory agencies. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honouring withdrawals (Investopedia, Undated). Internationally, the Bank for International Settlements' Basel Committee on Banking Supervision influences each country's capital requirements. The latest capital adequacy framework is commonly known as Basel II.
• The Lending Limit is the maximum amount a bank can lend to a single borrower which is a measure for risk reduction.
• The Deposit Insurance provides three important benefits to the economy:
• It assures small depositors that their deposits are safe, and that their deposits will be immediately available to them if their bank fails.
• It maintains public confidence in the banking system, thus fostering economic stability. Without the confidence of the public, banks could not lend money, but would have to keep depositors' money on hand in cash at all times.
• It supports the banking structure. Deposit insurance makes it possible for a country to have a system of both large and small banks; if there were no deposit insurance, the banking industry would probably be concentrated in the hands of a very few large banks.
• The Bank Secrecy Act requires financial institutions to assist government agencies to detect and prevent money laundering and to report suspicious activity that might signify money laundering, tax evasion, or other criminal activities. (Answers.com, Undated)

All these requirements and regulations if well administered and supervised will help in the control and in the sustainability of banking operations. Other general banking rules and regulations include:

• Bank supervision rules.
• Basic rules for internal control of financial institutions.
• Guidelines for detection and prevention of illegal capital movement.
• Guidelines for credit granting to individuals or corporate entities, linked to ownership or management of financial institutions.
• Guidelines for the regulations of bank supervision with external and internal auditors of financial institutions.
• Minimum plan of accounts and information system for bank supervision.
• Regulations on capital adequacy regulation.
• Regulations on risk accumulation.
• Rules for asset rating and provision policy.
• Rules for the granting, control and repayment of financings.
• Rules to determine the minimum liquidity ratio.
• Rules to establish minimum capital to start operations etc...

These rules and regulations in essence are essential to safeguard and ensure soundness and stability in Financial Institutions.

Bank Regulations and Risk Management

Bank regulations help Financial Institutions better manage their risks and daily operations.

Salient points in regulations vis-à-vis risk management are the following:

• Good risk management is essential for a sound, vibrant banking system and is important to bank regulators.
• Good regulations are there to support the bank’s objectives and should not be considered as an annoyance or a compliance exercise for risk managers.
• Aligning regulations with good risk management practices enables Financial Institutions accomplish their objectives with lower compliance burden.
• Basel II is built on a foundation of modern risk management practices and is a good example of interplay between risk management and regulations. Basel II contribute towards the development of better risk management practices in order for banks to gain the required comfort in ensuring that the capital levels under Basel II are in fact adequate for the risks.
• The interaction between regulation and risk management helps both sides do a better job.

Banking Supervision

Banking supervision by governmental or regulatory bodies ensures transparency and compliance with banking regulations and policies thus nurturing customers’ confidence which is the key for survival for any Financial Institution.

Banking supervision should not be considered as a means of governmental intrusion but as an assurance of good banking practice to its customers as opposed to unregulated institutions. It is of common understanding that governmental intervention is essential for the protection of both the customers and the Financial Institutions.

The main objective of any Financial Institution is to control and reduce risk such as:

• Capital Risk which is the risk of insolvency or ultimate failure
• Credit Risk - assets losing value
• Crime Risk – fraud or misappropriation
• Compliance Risk – violations of rules and regulations
• Exchange Risk – foreign currency dealings exchange risks
• Interest Rate Risk – risk borne by an interest-bearing asset
• Legal Risk – legal related risks
• Liquidity Risk – not having enough cash to meet obligations & withdrawals
• Market Risk – decrease in investment’s value
• Operational Risk – discontinued service such as system failures
• Price Risk – decline in price for a security or portfolio
• Strategic Risk – variation in earnings due to adverse business decisions

Lack of supervision may give rise to bad banking practice, uncertainty and bad decision making thus putting investments and investors at risk. The main goal of Financial Institutions is maximising shareholder’s wealth and without adequate supervision, management may be tempted to take additional risks in exchange of a better return on investment since the return on investment is proportional to the risk factor.

Below is some interesting data extracted from the World Bank survey 2008 which can give us an indication on how local Maltese banks are regulated and supervised when compared to U.S. banks.

(An exhaustive list can be found on the World Bank’s web site.)

Basel II

The rules under Basel II - Pillar 2 create a new Supervisory Review Process. This requires financial institutions to have their own internal processes to assess their capital needs and appoint supervisors to evaluate an institutions’ overall risk profile, to ensure that they hold adequate capital.

The supervisory review process of the Framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

The 4 key principles of supervisory review:

• Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
• Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
• Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
• Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. (Basel II, 2004)

The supervisory review process provides supervisors with additional tools to assess banks' risk management and internal capital management processes. Supervisors now have the obligation and the responsibility to monitor, control and intervene at an early stage if they feel that a bank may be faced with some sort of capital risk beyond the normal acceptable parameters.
 

Consequences of lack of Supervision

Lack of control and supervision may lead to adverse consequences. It is not enough to have a regulator and a set of banking regulations in place, but these have to be abided with and supervised.

As a consequence of lack of control over speculative transactions banks such as Societe Generale lost money putting the whole organisation at risk. Due to lack of supervision and control Societe Generale lost more than 9 billion Dollars and was at risk of losing an additional 75 billion Dollars if no immediate corrective action was taken at the nick of time. The bank admitted that it had ignored about 74 internal alarms generated by their internal surveillance system and a single dealer was in a position to carry out various deals leading to loss of money and endangering the organisation. Should diligent supervision be in place, this scenario would have been avoided. (BlogSpot.com, 2008)

Another recent example in the UK is Northern Rock which clearly shows that it lacked of supervision. UK Financial Services Authority admitted its failures in its supervision of Northern Rock. The FSA said there was "a lack of adequate oversight and review" by the agency of the troubled bank (BBC News, 2008), stating that few regulators were assigned to monitor such a large organisation. The Commons Treasury Committee accused the Financial Services Authority of being guilty of a "systematic failure of duty" over the Northern Rock crisis (BBC News, 2008) and as a consequence this crisis could hurt the UK's financial services sector if it leads to any new rushed government regulations.

Similar failures of internal controls have occurred in banks across the globe and will continue to occur unless the regulators enforce their supervision over Financial Institutions.

Considerations

Bank regulations and policies are a form of governmental regulations and serve the purpose to safeguard Financial Institutions, its customers and ultimately the country’s economy. As everything in life finding a balance is very important, the government’s task is to find a balance between having too much bureaucracy thus interfering in banking operations and having too little regulations which may compromise the soundness of Financial Institutions. Internal and external supervision ensures accountability and transparency of operations thus instigating customer confidence in Financial Institutions.

Basel II also highlights the importance of supervision and emphasise the preconditions for:

• effective banking supervision,
• the methods for progressive banking supervision,
• the formal powers of supervisors.

• The turbulence that Financial Institutions faced during the last few years witnessed the need of effective supervision by governing and regulatory bodies by implementing and enforcing rules, policies and regulations which are essential tools for the success of Financial Institutions.

BIBLIOGRAPHY

Answers.com (Undated). Bank Regulations
URL: http://www.answers.com/bank%20regulations [26th June 2008]

Asia Times (2002). Global Economy
URL: http://www.atimes.com/global-econ/de14dj01.html [25th June 2008]

Bank for International Settlement (2004). Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework
URL: http://www.bis.org/publ/bcbs107.htm [26th June 2008]

BBC News (2008). Northern Rock lacked of Supervision
URL: http://news.bbc.co.uk/1/hi/business/7007076.stm [28th June 2008]

BCC (Undated). Bank Supervision
URL: http:// http://www.bc.gov.cu/English/bank_supervision.asp [ 28th June 2008]

Blogspot.com (2008). Globalisation: So, Back to Regulation, Then
URL: http://dantyrant.blogspot.com/2008/03/globalisation-so-back-to-regulation.html [26th June 2008]

BlurtIt.com ( 2007). What is the importance of the banks?
URL: http://www.blurtit.com/q197532.html [25th June 2008]

Business Network (2008). Defining the financial safety net: two dozen experts weigh in
URL: http://findarticles.com/p/articles/mi_m2633/is_1_22/ai_n24378376/pg_6 [26th June 2008]

Business Standard (2008). European Banks hit by credit crunch
URL: http://www.business-standard.com/ft/storypage_ft.php?&autono=325385 [26th June 2008]

Cambridge (Undated). Rethinking the Bank Regulations
URL: http://www.cambridge.org/catalogue/catalogue.asp?isbn=0521855764 [28th June 2008]

Continuity Central (Undated). Basel Committee on Banking Supervision announces steps to strengthen the resilience of the banking system.
URL: http://www.continuitycentral.com/news03884.htm [26th June 2008]

Federal Reserve (2005). The Effects of Local Banking Market Structure on the Bank-Lending Channel of Monetary Policy
URL: http://www.federalreserve.gov/Pubs/feds/2005/200516/200516pap.pdf [26th June 2008]

International Monetary Fund (2005). Financial Sector Assessments: Overall Framework
URL: http://www.imf.org/external/pubs/ft/fsa/eng/pdf/ch01.pdf [26th June 2008)

International Monetary Fund (2005). Financial System Soundness
URL: http://www.imf.org/external/np/exr/facts/banking.htm [26th June 2008)

Investopedia (Undated). Capital Requirements
URL: http://www.investopedia.com/terms/c/capitalrequirement.asp [26th June 2008]

Investopedia (Undated). Credit Crunch
URL: http://www.investopedia.com/terms/c/creditcrunch.asp [25th June 2008]

National Bureau of Economic Research (2001). Financial Structure, Macroeconomic Stability and Monetary Policy
URL: http://www.nber.org/papers/w8354 [26th June 2008]

Paris EuroPlace (2004). The Basel Committee paper : the importance of banks managing their know-your-customer (KYC) risks on a global consolidated basis
URL: http://www.paris-europlace.net/links/doc062841.htm [26th June 2008]

State of Connecticut Department of Banking (Undated). ABC’s of Banking
URL: http://www.ct.gov/dob/cwp/view.asp?a=2235&q=297890 [27th June 2008]

Swiss Banking (2002). The Role of bank in an Economy
URL: http://www.swissbanking.org/en/krayer_e_02_02_05.pdf [24th June 2008]

Time.com (2007). How a U.S. Credit Crunch Went Global
URL: http://www.time.com/time/printout/0,8816.1651865,00.html [26th June 2008]

US Department of Treasury (2007). Bank Regulation and Risk Management
URL: http://www.occ.treas.gov/ftp/release/2007-14a.pdf [26th June 2008]

The World Bank (2008). Bank Regulation and Supervision (updated June 2008)
URL: http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTRESEARCH/0,, contentMDK:20345037~pagePK:64214825~piPK:64214943~theSitePK:469382,00.html #Survey_III [26th June 2008]

World Bank (2006). Creating an Efficient Financial System: Challenges in a Global Economy
URL: http://siteresources.worldbank.org/DEC/Resources/Creating_An_Efficient _Fianancial_System.pdf [24th June 2008]

World Bank (Undated). Creating a More Efficient Financial System: Challenges for Bangladesh
URL: http://siteresources.worldbank.org/INTBANGLADESH/Resources/ Finance&Growth-TBeck.ppt [26th June 2008]