The Control of Banking

The Control of Banking

How governments control the economy? Monetary Policy – is one of the ways the government attempts to control the economy. If the money supply grows too fast, inflation will be too high. If its too slow, economic growth slows which affects the GDP (the indicator of economic health). Monetary policy is one of the tools that a national government uses to control its economy. Explanation: A government tries to control the overall level of economic activity relative to its political objectives by using its monetary authority to manage the money supply and its availability. This objective is “macroeconomic stability” – low unemployment, low inflation, economic growth, and a balance of external payments.

The Monetary Base and Open Market Operations • Monetary policy can be implemented by changing the size of the monetary base – this directly changes the total amount of money circulating in the economy. A CB can use open market operations to change the monetary base. The CB, in a open market operation, would buy or sell bonds in exchange for hard currency. When the CB disburses or collects this hard currency payments, it alters the amount of currency in the economy, thus altering the monetary base. Explanation: If the CB buys bonds, money supply increases and thus interest rates decreases; the opposite happens if bonds are sold. Monetary base

The Reserve Requirement • The Reserve Requirement – is the requirement regarding the amount of funds banks must hold in reserve. Reserve requirements must be viewed as a monetary policy tool of the central bank; relates to the stability of the money multiplier. (Note that the maximum expansion deposit multiplier is the function of the reciprocal of the required reserve ratio). If required reserves are stable, then the money multiplier will, with certain bounds, be stable. CBs can directly alter required reserves (within the limits set by Congress) and thereby alter the size of the money supply.

Explanation: If the reserve requirement percentage grows, money supply would decrease by requiring a larger percentage of the banks’ demand deposits to be held by the CB, thus making them out of supply. When reserve requirements increase, interest rates also increase; less money is also available to borrowers. RR = Int. Rates The Reserve Requirement

The Discount Window –is where banks are able to borrow reserves from the CB at a discount rate. Many CBs have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply. Note: Discounting – is the lending by CB to banks. The Discount Window Lending

Explanation: If the CB lends unlimited quantities at any given discount rate, it can directly control short-term interest rates. It can do so by setting the discount below market interest rates and lending unlimited reserves to banks. The money supply would be determined by the willingness of banks to borrow from the CB and make loans. The Discount Window Lending

The Interest Rates The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Explanation: The monetary authority may mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rates under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.

Interest rate stability is important because fluctuations in interest rates can lead to uncertainty in the economic environment and disrupt the plan for the future. Importance of Interest Rate Stability

Why control banks? By their very nature, banks are quasi-public institutions. This applies to banks which hold deposits of millions of people (which may request payment anytime). Banks, for this reason, are affected with public interest which explain and justify for their close examination and supervision. Banks, through its deposit creation, provides the economy with the greater bulk of money supply – makes it important and incumbent for gov’t to control them.

The Control of Money Supply In the olden times, the sovereign authority controls the quality and quantity of money coins. A registry listing all notes issued and redeemed had to be maintained, and to prevent the paper money outstanding at any single time from exceeding the amount that which has been authorized. Banks was able to introduce a new form of currency, the bank deposit currency (created whenever proceeds of loans are credited to borrowers’ account). With the advent of bank deposit currency, there is a need to regulate the nation’s money. Why control banks?

The Evolution of Banking Regulations Businesses fail (go bankrupt) for many different reasons, and when they do fail they cause all kinds of hardships to creditors, owners, workers, and customers. In the US, a significant and substantial number of banks failed counting from the 1920s up to present, the reason for the establishment of the FDIC (to pay back depositors of the failed banks). Since the creation of FDIC, the number of bank failures have significantly reduced over time. Note: At the heart of banking regulation was the desire to prevent future bank failures.

Journal Article Can we Still Bank on Banks? Many banks all over the world remain in business only because of extreme measures taken by their governments to bail them out (by way of millions of cash injection and guarantees). Banking is a business built on trust, faith that the money deposited there will be used wisely by way of loans to productive enterprises or investments in high-grade bonds or other financial instruments. The folding up of several banks locally calls to mind a similar spate of bank closures that arose from essentially bad management practices and the tendency of many bankers to treat deposits as a private piggy bank into which they can dip their grubby hands (to fund personal ventures). That is why it pains one when failed banks are allowed by government to get away with their crime and even file cases against regulators. Now, depositors have to think twice before committing funds that may never get back to them.

The Government's Role in the Regulation of Banking Banking is a licensed and regulated business. Many safeguards have been instituted by the government for the protection of stakeholders – the depositors, stockholders, the general public, etc. Note: What could be contrary to public interest would be undue competition between banks, dishonesty/ incompetence in bank management, and unnecessary duplication of banking facilities. The government should exercise control (i.e., external control) to promote the public’s general welfare.

Objectives of Bank Regulations 1. Prudential: To protect depositors. 2. Systemic Risk Reduction: To reduce the risk of disruption (the “ripple effect”). 3. Avoid Misuse of Banks: To reduce the risk of banks being used for criminal purposes. 4. Confidentiality: To protect secrecy of deposits. 5. Credit Allocation: To direct credit to favored sectors.

1. Supervision 2. Examinations 3. Reports 4. Reserve requirement Types of Regulation and Control

Some of the forms of control on banks – 1. Their establishment 2. Their operation 3. Their capitalization 4. The kind of loans and investments they make Unless there is economic justification, no new bank may be established. Control Forms

Banks have been subject to rigid and comprehensive regulation. Governmental actions may be – – Regulatory: based on laws of the land, monetary policies/theories – Preventive: Entry of new players in a monopolistic business, restrictions on expansion of branches, etc. Government Actions

Profitable operation. Capitalization – well capitalized; its risk-based capital adequacy ratio (CAR). Management should have adequate experience. Adequate reserves– should not incur “abuses” (4x or more reserve deficiency for 2 straight weeks) nor incur “chronic” deficiencies. Compliance with banking laws, rules and regulations. Asset quality and provisions for probable losses. Membership with PDIC Regulatory Expectations for Banks

Cont'd. 8. No float items nor past due obligation. 9. Risk management system (risk measurement, delineation of responsibilities, risk limits, internal control, etc.). 10. CAMELS Rating – at least “3” 11. No “unsafe and unsound” banking practices 12. Adequate accounting records, system procedures, and internal controls. 13. Good corporate governance – (2 independent directors, attendance requirements by directors, etc.) Regulatory Expectations for Banks

Weak Internal Control Misappropriation of deposits Irregular cash items Unauthorized withdrawals from depositors’ accounts Cash shortage Overstatement of cash on hand Cashing uncollectible checks Tellers’ errors Misappropriation of proceeds of collection items Forged checks 10. Others • Banks with weak internal control are prone to a number of frauds:

Physical Safeguards • Use of sirens and closed camera circuits are requirements for banks. • Employment of security guards (assigned on round-the-clock basis) to counter theft, burglary, etc. • Use of time delay (for vaults). • Others

Banks are required to: Financial Reporting & Disclosure Requirements Prepare annual financial statements (GAAP/international accounting standard) – have them audited, registered, and published. Prepare more frequent financial disclosures, e.g. Quarterly Disclosure Statements. Have directors or president/CEO attest to the accuracy of financial disclosures. Prepare and have registered prospectuses detailing the terms of securities it issues (e.g. deposits) including relevant facts (that will enable investors to better assess the level and type of financial risks in investing in those securities). Others

CB shall have appropriate supervising and examining departments charged with the supervision and periodic examination of banks. Examination may include “on-site inspection” and “special” examination. Some functions of the supervising and examining departments: Bank Supervision • Administer oaths to any director, officer, or employee of banks under their respective supervision. • Compel presentation of all books, documents, papers or records necessary in their judgment to ascertain facts relative to the true condition of banks/institutions.

The CB has adopted general guidelines on targets for bank examination. The frequency of examination is established by law. To examine simultaneously the head office and branches (to allow comprehensive analysis of operation). For banks owned by a same set of shareholders, examinations are made with the same cut-off date (avoid concealing violations, window dressing, transfer of funds, etc.). Bank Examination

Bank Examiners Responsible for the technical and arithmetical accuracy of the work. Chief Bank Examiner Responsible for the scheduling of examination work Supervises the examination team Makes the recommendations (including monetary penalty, if any), in consultation with the examination team and his superiors. Assistant Director in Charge Makes the overall evaluation. Bank Examination

Loans and Investment Accounts Particular attention is given to Loans and Investment Accounts for the following reasons: – to evaluate the quality of each item, estimating probable bad debt losses – to form a conclusion whether the capital is still adequate). – whether deposit/other liabilities are adequately cushioned by a comfortable balance on capital accounts, net of valuation reserves, and other examiners adjustments. Items in the Bank Examination

Cont'd. Banks may be restricted from having imprudently large exposures to individual counterparties or groups of connected counterparties. This may be expressed as a proportion of the bank's assets or equity, and different limits may apply depending on the security held and/or the credit rating of the counterparty. Items in the Bank Examination

Liquidity Examination on the liquidity – matching of the various assets and liability accounts. (Note: It is important that banks possess sufficient reserves of cash or near-cash items assets). This is achieved by: – Adequate level of reserve assets – Through a comparison of he nature form, maturity and liquidity patterns of asset and liability accounts. Items in the Bank Examination

Items in the Bank Examination Capital Adequacy • A bank’s capital – is the cushion for potential losses which protects depositors and other lenders. • Sometimes measured in terms of relative size of risk assets and capital accounts. • This is a legal requirement which calls for assets that may be subject to a decline in value (“risk assets”) to be a maximum of 10x acceptable capital accounts. Note: To ensure that capital is adequate and that capital account may be able to absorb even as much as loss of 10% on assets subject to such risks.

Items in the Bank Examination Cont’d. • CAR – is the ratio which determines the capacity of the bank in meeting its liabilities and other risks (i.e., credit risks, liquidity risks, etc.) • The Formula: • Banking regulators define and monitor CAR to protect depositors thereby maintaining confidence in the banking system

Items in the Bank Examination Cont’d. • Types of Capital (per Basel Rules): 1. Tier 1 (may be 4%) : Actual contributed + retained earnings 2. Tier 2 (may be 8%): Preferred shares + 50% of subordinated debts Note: There is a maximum Tier 2 Capital depending on the jurisdiction

Profitability Considered as a general test of a bank’s soundness (which can continue to exist only if its operations are sufficiently efficient and profitable). Capital can accumulate if the bank is profitable (eroded, if the opposite is true). Some ratios include the rates of return earned on assets and equity. Determine how a bank utilizes its resources or capital. Items in the Bank Examination

Compliance Test of compliance with MB regulations on the adequacy of reserves, maintenance of arms-length transactions with directors, officers, shareholders, and their related-interests (DOSRI), observance of ceilings on interest rates, and other regulations. Items in the Bank Examination

Corporate governance requirements are intended to encourage banks to be well managed and is an indirect way of achieving other objectives: Items in the Bank Examination • To be a body corporate (not individual, or unincorporated entity). • To be incorporated locally (rather than foreign jurisdiction). • To have a minimum number of directors. • To have an organizational structures including committees, offices and officers. Officers may need to be approved persons, or from an approved class or persons. • To have an approved charter or constitution that enable directors to act in the best interest of the corporation.

Banks may be restricted from incurring exposures to related parties such as the bank's parent company or directors. Typically the restrictions may include: Items in the Bank Examination Exposures to related parties must be in the normal course of business and on normal terms and conditions. Exposures to related parties must be in the best interests of the bank. Exposures to related parties must be not more than limited amounts or proportions of the bank's assets or equity.

Audit Methods Spot audit – examination made on the spot without any advance notice. The auditor takes immediate charge of all records in the department, verifies them whether they are in order. Continuous audit – requires a daily record of certain transactions, the maintenance of control accounts, and use of interdepartmental balancing (in order to verify the work).

Fundamental Aspects of Audit Verification of assets – involves verification of all bank assets and properties entrusted to the bank for custody. They should be reflected on the books of the bank as to their proper value. Verification of liabilities – involves verification of all existing bank liabilities. The actual and contingent liabilities should be reflected on the records of the bank. Verification of income – after assets and liabilities, it becomes incumbent to look into the income of the bank. Income should be proved to its various income account and reflected in the accounting records.

Fundamental Aspects of Audit 4. Verification of expense – involves verification of expenses covering the operation of the bank. All expenses should be properly authorized, made for legitimate purposes, disbursed properly, and paid to the proper parties. These accounts should be properly captioned in the accounting records. 5. Verification of net worth – involves the verification of the capital accounts, including stocks, surplus, undivided profits, and reserves.

Report of Examination (ROE) – contains the findings of the financial examination. Bank findings may include the following: Bank Examination Report • Summary of the financial condition of the bank • A listing of violations found (including financial findings) • Identification trends and underlying strengths/ weaknesses in the operation • Major financial ratios • Monetary penalties, if applicable • Recommendations – may be in the form of directives regarding violations and improvement of the bank’s operation.

Approval of the Report This represents the signal of the appropriate supervising and examining department of the central bank to require the board of directors and officers of the bank on the action or steps taken/ to be taken to correct exceptions. (Note: The central bank monitors the directives until final compliance is made). Examination findings that are serious (affecting stability of the bank) is reported immediately in advance to senior management in the central bank (for corrective measures for immediate implementation). Bank Examination Report

Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and to disclose it to investors and prospective investors. banks may also be required to maintain a minimum credit rating, such as the CAMELS Rating for banks. The Credit Rating Requirement

The CAMELS Rating • CAMELS – is referred to as the Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risks. • The 5-point rating include the following:

Truth in Lending Act Single Borrower’s Limit (SBL) Loans to Deposit Ratio Loans Secured by Real Estate Mortgage Ceiling on Real Estate Loans DOSRI Some of the Major Regulations 7. Agri-Agra 8. Small, Medium Enterprises (SMEs) 9. Allowance for Probable Losses (APL) 10. Money Laundering 11. Bank Secrecy Act 12. Required Deposit Reserves 13. Risk-Based Capital Adequacy Ratio (RBCAR)

Truth in Lending Act Banks, among others, shall furnish its borrowers the following information: The Truth in Lending Act • The cash price price of the property/service to be acquired • The amount to be credited • The total amount to be financed • The charges and finance charges ( which are to be paid in connection with the transaction) • Others

Single Borrower’s Limit (SBL) The total amount of loans and credit accommodations, say 25% of the bank’s net worth, that may be extended by a bank to a person, partnership, corporation or other entity. Net Worth– shall mean the bank’s unimpaired paid-in capital including paid-in surplus, retained earnings and undivided profit, net of valuation reserves and other adjustments. Ex. Bank X net worth as of month-end was P2.5 billion, compute the SBL if the provision is 25% of the bank’s net worth. Answer: P625 million (P2.5 billion x 25%) The Single Borrower’s Limit

Loans to Deposit Ratio Banks should lend a portion, say at least 75%, of its deposit. Note: Applicable to banks which are located outside NCR regions. FCDU Deposits and FCDU loans are excluded (so they can be included in the total loan portfolio). Loans Secured by Real Estate Mortgage Should not exceed 60% of the collateral’s appraised value. At least 60% of the improvements should be insured if improvements will be included as collateral. Loans Regulations

Exposure/Ceilings on Real Estate Loans Should not exceed 20% of the bank’s total loan portfolio, net of interbank loans. Agri-Agra (PD No. 717 – Agri-Agra Law) Requires banks to allocate 25% of their loanable funds (i.e., total capital + peso deposits) for agri-agra reforms. Agri – 15%; Agra – 10% An excess in Agra may offset deficiency in Agri but not vice-versa Loans Regulations

DOSRI Loans: The DOSRI Loan • Individual Ceiling: Shall be limited to an amount equivalent to their deposits. • Unsecured Individual Loan: Shall not exceed 30% of the total loans/ other credit accommodations. • Aggregate Ceiling: Shall not exceed 15% of the total loan portfolio of the bank or 100% of networth whichever is lower. • Aggregate Unsecured Loan: Shall not exceed 30% of the aggregate ceiling or the outstanding DOSRI loan whichever is lower

Anti-Money Laundering (AML) The rules and regulations stress the customer-identification requirements by requiring, among others, the proper identification of the payee of cashier’s or manager’s checks payable to cash or bearer. The maintenance of banks of parallel customer-identification records for numbered foreign currency deposit accounts Reporting of covered and suspicious transactions amounting (from P4M) to P500,000.01 and up. The AML Regulation

The Control of Banking