MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION

Session: THIRTY ONE MBF-705LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF

Key Learning Outcomes After the successful completion of this course, students will have: • Knowledge and understanding of: • Importance of Banking Supervision • Banking sector in Pakistan • Role of the Supervisor/ Regulator

Key Learning Outcomes (Contd.) • Laws which govern banking sector • Prudential Regulations • Banking Companies Ordinance • Other Banking Laws

How a Bank earns Profit? • Just like any other business, a bank earns money so that it can run its operations and provide services. • First, customers deposit their money in a bank account. The bank provides safe storage and pays interest on customers’ deposits. • The bank is required to keep a percentage of deposits in reserve as cash in its vault or in an account at The State Bank.

How a Bank earns Profit? (Contd.) • The bank can lend the rest to qualified borrowers. Potential borrowers may wish to buy a house or a new car; • However, they may not have enough money to pay the full price at one time. Instead of waiting to save the money to pay for a new house, which could take years, they take out a loan from a bank. • Borrowers are charged interest on the loan – a bank’s primary source of income. • Banks also make money from charging fees for other financial services, such as debit cards, automated teller machine (ATM) usage and overdrafts on checking accounts.

Safety and Soundness • Two major focuses of banking supervision and regulation are the safety and soundness of financial institutions and compliance with consumer protection laws.

What are Banking Regulations? • Bank Regulations are a form of government regulations which subject banks to certain requirements, restrictions and guidelines.

The objectives of bank regulations, and the emphasis, varies between jurisdiction. The most common objectives are: Prudential—to reduce the level of risk bank creditors are exposed to (that is, to protect depositors); Risk Reduction—to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures; 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. Key Objectives of Bank Regulation

Potential problems in Bank Most of bank liabilities have shorter maturity period than assets This can be a potential cause of bank failure incase all depositors take out money at once (bank run) Credit risk Possibility that borrowers will be unable to repay their loans More risk in prosperity period as lending terms tends to be relaxed Interest rate risk Most deposits at floating rate Loans at fixed rate If floating rate is more than fixed rate bank loses ( S&LI ,America 1979)

Evolution of home mortgage Home loan funding 1930s Principal + interest payable over long term Borrower-Individuals Lender-Banks • Owning a house was not affordable to many • Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling

New Model of mortgage lending Bought loan Home loan funding Cash Transfer of credit & market risk Lender-Banks Principal + interest payable over long term Securitization fees SPV Cash MBS Transfer of market risk

Good days turn bad. Crisis at the door (mid 2006 onwards): • Through financial innovations loans issued to borrowers at minimal rate, adjusted rate. By mid 2006 time to pay bigger amounts comes • Household income did not increase in same proportion as house prices • Subprime mortgage owners start defaulting

Good days turn bad. Crisis at the door (mid 2006 onwards): • Rating agencies revise ratings of MBS/CDO as expected number of defaults turn out higher. Many ratings are lowered • Bewildered investors lost faith in ratings, many stop buying MBS/CDO altogether • Alarm bell at SIV/SPVs • Banks find themselves in non-comfortable position , stop making loans • Housing prices plummet owing to increase in foreclosure, delinquency and stoppage of loans

What a mess…. • More frenzy in market and more defaults, again revised ratings, again further stoppage of funding and further stoppage of loans, further fall in house prices as demand and supply mismatch....problem feeding itself in circular fashion. • As MBS/CDO market is shaken….investors start debating other derivatives true worth…panic spreads across and people start getting out….further hurting the banks

What a mess • The crisis unfolded as silent Tsunami on Wall Street where by the time people realized the graveness of the mess they were in , it had gone beyond control. • Since, most of the player in the market, mortgage brokers, investment banks were running in debts. They are suddenly caught unaware and are in insolvency and start tumbling down….many are saved by nationalization as their fall would spread the contagion way far .

What a mess • Central government start pumping in money as last resort but one thing is surely not returning soon and which is very vital in financial industry -FAITH.

In Short • When homeowners default, the amount of cash flowing into MBS declines and becomes uncertain. • Investors and businesses holding MBS have been significantly affected. • The effect is magnified by the high debt levels maintained by individuals and corporations, sometimes called financial leverage.

Types of Regulations • Banks in one form or another have been subject to the following non exhaustive list of regulatory provisions: • restrictions on branching and new entry;

restrictions on pricing (interest rate controls and other controls on prices or fees); • line-of-business restrictions and regulations on ownership linkages among financial institutions;

Types of Regulations (Contd.) • restrictions on the portfolio of assets that banks can hold (such as requirements to hold certain types of securities or requirements and/or not to hold other securities, including requirements not to hold the control of non financial companies);

Types of Regulations (Contd.) • compulsory deposit insurance (or informal deposit insurance, in the form of an expectation that government will bail out depositors in the event of insolvency); • capital-adequacy requirements;

Types of Regulations (Contd.) • reserve requirements (requirements to hold a certain quantity of the liabilities of the central bank); • requirements to direct credit to favored sectors or enterprises (in the form of either formal rules, or informal government pressure);

Types of Regulations (Contd.) • expectations that, in the event of difficulty, banks will receive assistance in the form of “lender of last resort”; • special rules concerning mergers (not always subject to a competition standard) or failing banks (e.g., liquidation, winding up, insolvency, composition or analogous proceedings in the banking sector);

Types of Regulations (Contd.) • other rules affecting cooperation within the banking sector (e.g., with respect to payment systems).

Basel I • Basel I is the round of deliberations by central bankers from around the world, and in 1988. • The Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. • This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 .

Basel I (Contd.) • Basel I is now widely viewed as outmoded. • The world has changed as financial conglomerates, financial innovation and risk management have developed, and a more comprehensive set of guidelines, known as Basel II, are in the process of implementation by several countries. • Basel III was developed in response to the financial crisis.

Background • The Committee was formed in response to the messy liquidation of a Cologne-based bank (Herstatt Bank) in 1974. • On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Herstatt Bank in exchange for dollar payments deliverable in New York.

Background (Contd.) • On account of differences in the time zones, there was a lag in the dollar payment to the counterparty banks, and during this gap, and before the dollar payments could be effected in New York, the Herstatt Bank was liquidated by German regulators.

Background (Contd.) • This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland.

Main framework • Basel I, that is, the 1988 Basel Accord, is primarily focused on credit risk and appropriate Risk Weighting of Assets.

Basel II • Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

Basel II (Contd.) • Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face.

The accord in operation • Basel II uses a "three pillars" concept – • minimum capital requirements (addressing risk), • supervisory review and • market discipline.

Policy goals of Regulation • It is commonly understood that financial regulation should be designed to achieve certain key policy goals, including: (a) safety and soundness of financial institutions, (b) mitigation of systemic risk,

Policy goals of Regulation (Contd.) (c) fairness and efficiency of markets, and (d) the protection of customers and investors.

The Four Approachesto Financial Supervision • While no two jurisdictions regulate financial institutions and markets in exactly the same manner, the current models of financial supervision adopted worldwide can, as already noted, be divided into four categories: (a) the Institutional Approach, (b) the Functional Approach, (c) the Integrated Approach, and (d) the Twin Peaks Approach.

1. The Institutional Approach • The Institutional Approach is one of the classical forms of financial regulatory oversight. It is a legal-entity-driven approach.

1. The Institutional Approach (Contd.) • The firm’s legal status (for example, an entity registered as a bank, a broker-dealer, or an insurance company) essentially determines which regulator is tasked with overseeing its activity both from a safety and soundness and a business conduct perspective. • Example: CHINA… Bank of China

2. The Functional Approach • Under the Functional Approach, supervisory oversight is determined by the business that is being transacted by the entity, without regard to its legal status. • Each type of business may have its own functional regulator. • Example : France

3. The Integrated Approach • Under the Integrated Approach, there is a single universal regulator that conducts both safety and soundness oversight and conduct-of-business regulation for all the sectors of the financial services business.

3. The Integrated Approach (Contd.) • This model has gained increased popularity over the past decade. It is sometimes referred to as the “FSA model” because the most visible and complete manifestation is the Financial Services Authority (FSA) in the United Kingdom.

4. The Twin Peaks Approach The Twin Peaks Approach is based on the principle of regulation by objective and refers to a separation of regulatory functions between two regulators: • one that performs the safety and soundness supervision function and • the other that focuses on conduct-of- business regulation.

4. The Twin Peaks Approach (Contd.) • Under this approach, there is also generally a split between wholesale and retail activity and oversight of retail activity by the conduct-of- business regulator. • This is also viewed by some as supervision by objective. • Example : Australia

Governance Structure of State Bank of Pakistan • The governance framework of State Bank of Pakistan (SBP) is specified in the State Bank of Pakistan Act, 1956 amended at times to make it more autonomous. • The Act provides for an independent Central Board of Directors and empowers it with general superintendence and direction of affairs and business of the Bank.

Governance Structure of State Bank of Pakistan (Contd.) • The governor is the chairperson of the Central Board and manages the affairs of the Bank on its behalf. Except for the governor, all directors of the Central Board are non-executive.

Committees of the Central Board • Committees of the Central Board • Audit • Investment • Building Projects • Human Resource • Monetary and Credit Policies

Management Structure (Contd.) • Heads of Clusters: After restructuring and reorganization of State Bank of Pakistan, four separate clusters were formed, which are: • Banking Cluster • Monetary Policy & Research Cluster • Financial Market & Reserve Management Cluster • Corporate Services Cluster

Management Structure (Contd.) • The Corporate Management Team (CMT) acts as the principal forum for debate and decision on critical operational issues affecting the quality of work at the institutional level. • The CMT is headed by the governor and consists of deputy governors, corporate secretary, economic adviser, executive directors, director HRD and managing director, SBP Banking Services Corporation.

SBP SUBSIDERIES • Banking Services Corporation • National Institute of Banking and Finance (NIBAF) The governor SBP is the chairperson of Boards of both the subsidiaries.

Core Functions of State Bank of Pakistan (Contd.) • Under the State Bank of Pakistan Order 1948, the Bank was charged with the duty to "regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in Pakistan and generally to operate the currency and credit system of the country to its advantage".

MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION