Topic 6: Prudential Control

and Regulation in Banking

 Lecture Outline

Arguments for prudential control /

regulation
Problems with external prudential
regulations
Prudential control and regulations in
the UK, USA and BG
Regulation: Introduction

All companies have to ensure capital

adequacy, and (banks in particular)
have to also ensure sufficient liquidity.

Control is necessary due to two

conflicting objectives:
Profit - high to keep shareholders happy.
Liquidity- low/high to earn profit/serve
better and insure depositors.
Introduction

 Should prudential controls or regulation be

compulsory?
 Should these regulations be imposed by the
state?
 Should they be imposed by the bank
management itself?
Bank also has an interest in long-term survival.
Why Should we Regulate?

Protection of the public’s

savings.

Control of the money supply.

Asymmetric information and

vulnerability of depositors.
Why Should we Regulate?

Contagion (panic or domino)

effects.

Bank’s ability to diversify assets.

Competition and excessive risk

taking.
Problems with Regulation
 Cost

 Competition
Hampers competition and innovation.

 Competence?
Question mark over competence of
supervisor.

 Complexity
Problems with Regulation

 Moral hazard

 Asymmetric information

 Government Guarantee
Deposit insurance has ended risk of
systematic failure (?)

 Capital adequacy
Capital adequacy has ended credit risk (?)
A Case for Free Banking

The Scottish System (1716 – 1844).

Banks allowed to enter the market w/o chartering
or licensing.
 Results:
intense competition, innovation and economic
growth
system introduces branch banking, interest paid
on deposits, overdraft facilities and private
deposit insurance.
Regulation in the UK: Pre-1979

 No specific banking law in the UK

 Private banks treated like any other

commercial concern

 Individual agents or firms could accept

deposits without any formal licence.
Regulation in the UK: The Banking
Act 1979
Identified two classes of institutions:
orecognised banks and
olicensed deposit takers

Main Features:
oAct created a Deposit Protection Fund
(DPF), to which all recognised banks to
contribute.
oFunds compensate 75% of any deposit up
to £10,000.
Regulation in the UK: 1987
Amendment
Collapse of Johnson Matthey Bank (JMB)
paved the way for amendment to the 1979
Act.

Main Features:
oCreated supervisory board headed by the
Governor of BOE.

oEliminated the distinction between deposit

takers and banks.
1987 Amendment
Private auditors were given greater access to
BOE information.

Exposure to a single borrower > 10% of banks

capital reported to BOE. Supervisor consulted
directly on any lending which exceeds 25% of
bank capital to a single borrower.

Act also specified BOE control over the entry of

foreign banks.
1987 Amendment
Act increased the deposit insurance limit to
£20,000.

Under Act, BOE acts as a regulator.

• The asset side of a bank balance sheet is
regulated through capital adequacy and liability
side through liquidity adequacy.
1987 Amendment
Capital Adequacy
• Gearing Ratio
Bank’s deposits + external liabilities
Bank’s capital + reserves

• Risk Assets Ratio (Basel Risk assets ratio)

Capital_________
Weighted Risk Assets

Liquidity Adequacy
• Example: Net open position in any one currency may not
exceed 10% from adjusted capital
Parallel regulations in BG

Main Regulator – the Bulgarian National Bank

Basic regulations:

Law on Bank Deposit Guarantee:

• Last modified as of 31.12.2010
• Amount secured: up to BGN 196.000
• Exceptions:
 Depositors with preferential terms
 Owners of shares entitling them with more than 5% of
the votes in General Meeting
 Members of the bank’s Management Board
 Auditors
 Own bank’s deposits
Parallel regulations in BG
Law on Bank Deposit Guarantee:
• Managed by the Deposit Insurance Fund
• The Fund is:
 collecting entry and annual contributions from banks
 Investing the money in government bonds and/or
deposits in banks or the BNB
• Contributions:
 Entry contribution – 1% of bank’s capital, not less than
BGN 100.000
 Annual contribution – 0.5% of the total amount of the
deposit base
 Contributions are non-refundable
Parallel regulations in BG
Ordinance N8 on the Capital Adequacy

Capital Adequacy Ratio = Own Funds___

Risk Weighted Assets

Own Funds = Tier One Capital + Tier Two Capital – specific

investments in shares
Assets are granted specific weights according to their risk profile –
0%, 10%, 20%, 50% and 100%

The overall capital adequacy ratio may not be less than 12%

Tier One Capital adequacy ration may not be less than 6%

 Parallel regulations in BG
Ordinance N11 on Bank Liquidity Management and
Supervision
 Banks shall manage their liquidity in a manner that ensures they
can regularly and without delay meet their daily obligations, both in
a normal banking environment and in a crisis situation.

 Banks shall submit to the BNB monthly liquidity reports on a ‘going

concern basis’ showing projected BGN cash flows and
correspondingly the BGN equivalent of foreign currency-
denominated assets and liabilities.

 The Bulgarian National Bank shall monitor the amount and

composition of banks’ liquid assets and, where appropriate,
establish minimum liquidity ratios on a bank-by-bank basis
 Parallel regulations in BG
Ordinance N11 on Bank Liquidity Management and
Supervision
 Each bank shall establish liquidity management system, which shall
include:
 rules and procedures for identification, measurement,
management and monitoring of the liquidity
 Liquidity management body
 Management information system
 Maturity ladder
 Cash Flow assessment
 Where an individual bank experiences liquidity difficulties or
systemically fails to fulfill requirements, the Deputy Governor
heading the Banking Supervision Department may set minimum
liquid asset ratios to be attained by the bank within a limited time
frame.
USA Banking Regulation

 Different to UK banking regulation:

Regularly turn to legislation to iron out perceived

inefficiency
Protection of small depositors more important.
Concern about potential collusion – ‘anti-trust’.
Regulatory Responsibility – The
‘FRS’
 Federal Reserve - State ‘Member’ Banks

 Controller of the Currency - National

‘Member’ Banks

 FDIC examines the ‘Non-Member’ insured

Banks.

 Banks performance is monitored and

assessed on a scale ranging from 1 to 5.
National Banking Act (1863,1864)

 Passed during the civil war to help raise

funding.

 Created the treasury and the comptroller of

the currency.

 Created national banks with a Federal

Charter.
Federal Reserve Act (1913)

 Created the FRS

 Created to provide a number of services to

member banks.
E.g. the authority to act as the lender of last
resort.

 Today the FED controls the money supply

and base interest rates.
You may remember…

 McFadden-Pepper Act (1927)

 Prevented banks from expanding across state lines.
 Made national banks subject to the branching laws of
their state.
 International Banking Act (1978) tidied this up with
respect to international banks

 Glass-Steagall Act (1933)

 Passed during the great depression.
 Separated investment and commercial banking.
 Created the FDIC.
 Fed given the power to set margin requirements.
 Prohibited interest to be paid on checking accounts.
US Banking Act (1933)

 Created the FDIC

membership compulsory for FRS members
Non-members can join if they meet admission
criteria
 Members pay an annual insurance
premium to the FDIC
 FDIC purchases securities to provide a
stream of funds (to cover deposits of up
to $100,000).
Major USA Banking Regulation

 FDIC Act 1935

Gave the FDIC the power to examine banks
and take necessary action.
 Bank Merger Acts
All mergers must be approved by the
appropriate regulating body.
Mergers must be evaluated in three areas:
Effect on competition.
Effect on the convenience and needs of the
community.
Effect on the financial condition of the banks.
Bank Holding Company Act
(1956)
 Federal Reserve given the power to
regulate bank holding companies
 1966 Amendment reduced the tax
burden of bank holding companies
 1970 - Amended the definition of bank
holding companies to include one-
bank holding companies
Social Responsibility Acts

 1968 – full information on terms of loans

must be given.
 1974 – cannot be denied a loan based on
age, sex, race, national origin or religion.
 1977 – cannot discriminate based on the
neighborhood in which borrower resides.
 1987 – banks must disclose full terms on
deposit and savings accounts.
 Riegle-Neal Act (1994)

 Bank holding company can acquire banks

nationwide.
Consolidation of inter-state BHCs into branches.

 Smaller well managed banks only need to be

examined every 18 months.

 Community development fund created to

promote development of depressed local
communities.
Gramm-Leach-Bliley Act (1999)

 Permits banking-insurance-securities
affiliations
 Protections for consumers purchasing
insurance through a bank.
 Must disclose policies regarding the
sharing of customers’ private
information.
Customers are allowed to ‘opt out’ of private
information sharing.
Conclusions
 Regulation is a necessary tool for managing the
modern bank and controlling risk exposure
o Drawbacks of Regulation – is the process necessary
after all?

 There are historical examples of free banking markets

working to the advantage of society
o The Scottish Example

 In the UK, we have observed a gradual shift in

regulatory attitudes from relatively lax to relatively
stringent.
o Particularly from 1978 (pre Banking Act) – 1987
o However…….
Conclusions
 There is a degree of contrast in terms
of attitudes to regulation in the UK and
USA
 This is evidenced by the number of
important regulations in each country
 What about Germany?
Follows EU regulation on Banking (See
Page 245-250 in Modern Banking in Theory
and Practice)
Attitudes towards Universal Banking have
helped shape EU policy