Banking regulation
Banking regulation is a form of government regulation that subjects banks to certain requirements, restrictions and guidelines, and is designed to create market transparency between banking institutions and the individuals and companies with whom they do business, among other things. Since regulation focuses on key factors in financial markets, it forms one of the three components of financial law, the other two being case law and self-regulating market practices.
Given the interdependence of the banking industry and the dependence of the national (and global) economy on banks, it is important for regulators to maintain control over the standard practices of these institutions. Another relevant example of interdependence is that financial industries law or financial law focuses on financial (banking), capital and insurance markets. Proponents of such regulation often base their arguments on the idea of ”too big to fail”.
This means that many financial institutions (particularly investment banks with a commercial arm) have so much control over the economy that they do not fail without dire consequences. This is the basis of government bailouts, in which government financial assistance is given to banks or other financial institutions that appear to be on the verge of collapse. The common belief is that without this help, not only will the crippled banks become bankrupt, but they will create ripple effects throughout the economy that lead to systemic failure. Compliance with bank regulations is checked by individuals known as bank examiners.
Licensing and supervision
Bank organization is a complex process and generally consists of two components:
- Licensing.
- Supervisor.
The first component, the license, sets out certain requirements for starting a new bank. The license gives license holders the right to own and operate a bank. The licensing process is specific to the regulatory environment of the country and/or country in which the bank is located. Licensing involves evaluating the entity’s intent and ability to meet regulatory guidelines that govern the bank’s operations, financial soundness, and administrative procedures. The regulator supervises licensed banks to comply with the requirements and responds to breaches of the requirements by obtaining covenants, giving directions, imposing penalties or (ultimately) revoking the bank’s license.
The second component, supervision, is an extension of the licensing process and consists of the supervision of a bank’s activities by a government regulatory body (usually a central bank or other independent government agency).
Minimum Requirements
A regulator of national banks imposes requirements on banks in order to further the objectives of the regulator. These requirements are often closely related to the level of risk exposure for a particular segment of the bank. The most important minimum requirement in banking regulation is to maintain minimum capital ratios. To some extent, US banks have some freedom in deciding who will supervise and regulate them.
Market discipline
The regulator requires banks to publicly disclose financial and other information, and depositors and other creditors can use this information to assess the level of risk and make investment decisions. As a result, 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.
Capital requirements
Capital requirements set a framework for how banks treat their capital in relation to their assets. Internationally, the Basel Committee on Banking Supervision of the BIS influences each country’s capital requirements. In 1988, the Committee decided to introduce a capital measurement system generally referred to as the Basel Capital Accords. The latest capital adequacy framework is known as Basel 3. This updated framework is intended to be more risk sensitive than the original, but also more complex.
Reserve requirements
The reserve requirement specifies the minimum reserves that each bank must maintain for demand deposits and banknotes. This type of regulation has lost the role it once had, as the focus has shifted towards capital adequacy, and in many countries there is no minimum reserve ratio. The purpose of minimum reserve ratios is liquidity, not security. An example of a contemporary minimum reserve ratio country is Hong Kong, where banks are required to hold 25% of their liabilities due on demand or within one month as qualifying liquid assets.
Reserve requirements have also been used in the past to control the stock of banknotes and/or bank deposits. Sometimes the required reserves were gold, banknotes or central bank deposits, and foreign currencies.
Corporate Governance
Corporate governance requirements are intended to encourage the bank’s good management, which is an indirect way to achieve other objectives. Since many banks are relatively large, and in the presence of many divisions, it is important that management closely monitors all operations. Investors and clients often blame senior management for errors, as these individuals are expected to be aware of all the activities of the enterprise. Some of these requirements may include:
Be a legal person (i.e. not an individual, partnership, trust or other non-institutional entity)
to be incorporated locally, and/or to be incorporated under as a specific type of legal person, rather than being incorporated in a foreign jurisdiction
To have a minimum number of managers
To have an organizational structure that includes different offices and officials, for example company secretary, treasurer/financial manager, auditor, ALM committee, privacy officer, compliance officer etc. Also those responsible for these offices may need authorized persons, or from approved category of persons
Have an approved constitution or articles of association, or contains or does not contain certain provisions, eg clauses that enable directors to act other than in the interests of the company (eg, in the interest of the parent company) may not be permitted.
Financial reporting and disclosure requirements
One of the most important regulations that are placed on banking institutions is the requirement to disclose the financial affairs of the bank. Especially 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 in accordance with a financial reporting standard, audit them, and record or publish them. Often, these banks are required to prepare more frequent financial disclosures, such as quarterly disclosure statements. The Sarbanes-Oxley Act of 2002 details the exact structure of the reports required by the Securities and Exchange Commission.