Banking regulation and supervision


Banking regulation and supervision refers to a form of financial regulation which subjects banks to certain requirements, restrictions and guidelines, enforced by a financial supervisory authority generally referred to as banking supervisor, with semantic variations across jurisdictions. By and large, banking regulation and supervision aims at ensuring that banks are safe and sound and at fostering market transparency between banks and the individuals and corporations with whom they conduct business.
Its main component is prudential regulation and supervision whose aim is to ensure that banks are viable and resilient so as to reduce the likelihood and impact of bank failures that may trigger systemic risk. Prudential regulation and supervision requires banks to control risks and hold adequate capital as defined by capital requirements, liquidity requirements, the imposition of concentration risk limits, and related reporting and public disclosure requirements and supervisory controls and processes. Other components include supervision aimed at enforcing consumer protection, sometimes also referred to as conduct-of-business regulation and supervision of banks, and anti–money laundering supervision that aims to ensure banks implement the applicable AML/CFT framework. Deposit insurance and resolution authority are also parts of the banking regulatory and supervisory framework. Bank supervision is a form of "microprudential" policy to the extent it applies to individual credit institutions, as opposed to macroprudential regulation whose intent is to consider the financial system as a whole.

Semantics

Banking supervision and regulation are closely intertwined, to the extent that in some jurisdictions the words "regulator" and "supervisor" are often used interchangeably in its context. Policy practice, however, makes a distinction between the setting of rules that apply to banks and the oversight of their safety and soundness, since the latter often entails a discretionary component or "supervisory judgment". The global framework for banking regulation and supervision, prepared by the Basel Committee on Banking Supervision, makes a distinction between three "pillars", namely regulation, supervisory discretion, and market discipline enabled by appropriate disclosure requirements.
Bank licensing, which sets certain requirements for starting a new bank, is closely connected with supervision and usually performed by the same public authority. 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 jurisdiction 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. The supervisor monitors licensed banks for compliance with the requirements and responds to breaches of the requirements by obtaining undertakings, giving directions, imposing penalties or revoking the bank's license. Bank supervision may be viewed as an extension of the licence-granting process. Supervisory activities involve on-site inspection of the bank's records, operations and processes or evaluation of the reports submitted by the bank. Arguably the most important requirement in bank regulation that supervisors must enforce is maintaining capital requirements.
As banking regulation focusing on key factors 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. Compliance with bank regulation is ensured by bank supervision.

History

Banking regulation and supervision has emerged mostly in the 19th century and especially the 20th century, even though embryonic forms can be traced back to earlier periods. Landmark developments include the inception of U.S. federal banking supervision with the establishment of the Office of the Comptroller of the Currency in 1862; the creation of the U.S. Federal Deposit Insurance Corporation as the first major deposit guarantee and bank resolution authority in 1934; the creation of the Belgian Banking Commission, Europe's first modern banking supervisor in 1935; the start of formal banking supervision by the Bank of England in 1974, marking the eventual generalization of the practice among jurisdictions with large financial sectors; and the emergence of supranational banking supervision, first by the Eastern Caribbean Central Bank in 1983 and the Banking Commission of the West African Monetary Union in 1990 and then, at a much larger scale, with the start of European Banking Supervision in 2014.

Objectives

Given the interconnectedness of the banking industry and the reliance that the national economy hold on banks, it is important for regulatory agencies to maintain control over the standardized practices of these institutions. Another relevant example for the interconnectedness is that the law of financial industries or financial law focuses on the financial, capital, and insurance markets. Supporters of such regulation often base their arguments on the "too big to fail" notion. This holds that many financial institutions 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.
The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common objectives are:
  • prudential—to reduce the level of risk to which bank creditors are exposed
  • systemic risk reduction—to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures
  • to avoid misuse of banks—to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime
  • to protect banking confidentiality
  • credit allocation—to direct credit to favored sectors
  • it may also include rules about treating customers fairly and having corporate social responsibility.
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". 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.

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. 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
  • 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 may not be allowed.