Topic 5 Financial Supervision

Banking Supervision

1. Importance & Objectives of Banking Supervision

2. Licensing Process

3. Arrangements for Ongoing Banking Supervision

4. Dealing with Weak Banks

 1. Importance & Objectives of Banking
Supervision
A. The Role of Banks and Importance of Banking
Supervision
• Role of the bank
• Importance of Banking Supervision:
① Strong and effective banking supervision is an essential
component of strong economic environment;
② Providing a public good which may not be readily available in
the marketplace.
③ Banking supervision is critical to financial stability in any
country.
④ Banking are provided with official protection.
1. Importance & Objectives of Banking Supervision
B. Objectives of Banking Supervision
① To maintain stability and public confidence in the
financial system;
② To ensure bank's operating in a safe and sound
manner & bank's having sufficient capital & reserves
to cover potential risks.
③ To protect depositor's funds & to minimize the
losses to be absorbed by the deposit insurance fund
④ To foster an efficient & competitive banking system
⑤ To ensure compliance with banking laws and
regulations
 1. Importance & Objectives of Banking
Supervision
C. Preconditions for effective banking
supervision
i. Sound & sustainable macro-economic
policies
ii. Well-developed public infrastructure
iii. Effective market discipline
iv. Mechanism for providing an
appropriate level of systemic
protection (or public safety net)
 1. Importance & Objectives of Banking
Supervision
iii. Effective market discipline
– Flow of information ( accurate, meaningful,
transparent and timely information)
– Appropriate financial incentives to reward
well managed institutions
– Addressing corporate governance
 2. Licensing Process

A. Three phases of the Process of

Licensing or Chartering a Bank
B. Factors evaluated by the chartering
authorities
C. Basel Committee’s Requirements on
Bank Licensing
 2. Licensing Process

A. Three phases of the Process of

Licensing or Chartering a Bank
① Informal pre-filing stage
② Application stage
③ Organizing stage
 2. Licensing Process

B. Factors evaluated by the chartering

authorities
①Prospects for future earnings
②Qualifications of management
③Adequacy of capital structure
④Convenience & needs of the community to be
served by the bank
 Financial Statements
• Balance Sheet
• Profit & Loss Statement / Income
Statement
• Cash Flow Statement / Statement of Cash
Flow
 Balance Sheet
• One of the tools management, lenders and
investors use to asses a company’s
overall situation.
• To evaluate a company’s financial status
• Ask questions about the items listed
• Investors pay particular attention to
liabilities
• The type of debt is important as well.
 Income Statement
• Provide data on the profits generated by
the business within a given time frame
• Making note of any expense or losses that
occur during the same period.
• Quarterly basis for purpose of internal
monitoring
 Cash Flow Statement
• To highlight the major activities that directly
or indirectly impact cash flows and hence
affect the overall cash balance.
• Managers focus on cash flow
 2. Licensing Process

C. Basel Committee’s Requirements on Bank

Licensing
• Core Principles for Effective Banking
Supervision
• A framework of minimum
standards for sound supervisory
practices
• Universally applicable
3. Arrangements for ongoing banking
supervision
A. Risks in Banking

B. Key Prudential Issues

C. Methods of Ongoing Banking Supervision

3. Arrangements for ongoing banking
supervision
A. Risks in Banking
i. Credit Risk
ii. Market Risk
iii. Liquidity Risk
iv. Operational Risk
v. Legal Risk
vi. Reputation Risk
 3. Arrangements for ongoing banking
supervision
B. Key Prudential Issues
• Five Requirements are included
 Qualitative Requirements
① Risk Concentration
② Internal controls
 Quantitative Requirements
③ Capital Adequacy
④ Liquidity
 Qualitative & Quantitative Requirements
⑤ Asset Quality – Loan Classification System & Adequacy of loan los
reserves
B. Key Prudential Issues

① Risk Concentration
• One of the major supervisory concerns
• Setting prudential limits to bank exposures
to single borrowers, groups of related
borrowers and other significant risk
concentrations.
B. Key Prudential Issues

② Internal Controls
• Five Interrelated Elements:
① Management oversight & control culture;
② Risk recognition & assessment;
③ Control activities & segregation of duties;
④ Information & communication;
⑤ Monitoring activities & correcting deficiencies.
B. Key Prudential Issues

③ Capital Adequacy
① Most basic form of capital – ( net
worth) equity capital
② Minimum Capital Adequacy Ratio (MCAR)
③ Basle committee’s Core Principle for Effective
Banking Supervision

a. The 1988 Basel Accord ( the Accord, Bale

Capital Accord)
 different levels of credit risk on-balance sheet
 different levels of credit risk off-balance sheet
b. Basel II 巴塞尔 II
B. Key Prudential Issues

Purpose the equity capital serves:

• A permanent source of revenue for the
shareholders and funding for the bank
• Being available to bear risk and absorb
losses
• Providing a base for further growth
• Giving confidence to the shareholders to
ensure the bank is managed in a safe and
sound manner
B. Key Prudential Issues
a. The 1988 Basel Accord ( the Accord, Bale Capital Accord) – 3
Contents:
1. Capital Structure ( classification)
1) Tier One (Core Capital) – T1
① Shareholder’s Equity
② Disclosed Reserves
③ Other Surplus
2) Tier Two ( Supplementary Capital) – T2
① Revaluation Reserves
② General Provision
③ Hidden Reserves
④ Subordinated term debt
⑤ Certain hybrid / equity instruments
B. Key Prudential Issues
a. The 1988 Basel Accord ( the Accord, Bale Capital Accord) – 3
Contents:

2. Risk Weights Distribution （ on- & off- balance sheet)

0; 10%; 20%; 50%; 100%
3 MCAR
Minimum Capital Requirement - MCR( MCR1 &
MCR2)

(core capital adequacy ratio & minimum capital adequacy ratio)

T1 ( Tier One)
RWA (Risk – weighted Assets)
MCR 1 >= 4%

T1 + T2
MCR 2 >= 8%
RWA
B. Key Prudential Issues

b. Basel II

• International Convergence of Capital

Measurement and Capital Standards
Issued in July 2006 as a revised
framework
– Three mutually reinforcing pillars
assessing capital adequacy
① MCR >= 8%
② Supervisory Review disclose requirement
③ Market Discipline
B. Key Prudential Issues

b. Basel II
T1 + T2
① MCR >= 8% MRC 2 >= 8%
RWA
i. T1= Common shares + non-cumulative
perpetual preferred shares + disclosed reserves
– goodwill
ii. T2 = undisclosed reserves + asset revaluation
reserves + general provisions + hybrid debt
capital instrument + subordinated term debt
iii. Tire 3 capital (T3): short-term subordinated term
debt bearing specified characteristic
B. Key Prudential Issues

b. Basel II

① MCR >= 8% Two Methodologies

• Standardized Approach (building block)

• Internal Models Approach
B. Key Prudential Issues

④ Liquidity

Equation ： short-term liquidity

Liquefiable Assets
Liquidity Ratio
Qualifying Liabilities

Liquefiable Gold; Cash; Reserves; A month due interest

Assets: receivable or loan

Qualifying Liabilities: Current deposit; One month deposit or

account payable
B. Key Prudential Issues

⑤ Asset Quality
• Definition:
– The most important factor in determining a bank’s
creditworthiness
– For a business, it can estimate its value, development
ability, and debt paying ability.
– Good or bad: represented by the differences between
its book value of the assets and realizable value or
further utilized potential value.
– It can be analyzed by its profitability, operation
capability, as well as asset structure.
B. Key Prudential Issues

⑤ Asset Quality

• Definition:
– For the bank, it is the credit asset quality.
– Classified by its recall possibility on the expected
loan principal and interest, and the final ratio got
from the undertaken classified statistic to findings
reflects the credit asset quality.
– The important measure Total indicators
Loans are:
NPLs <=5%
NPL Provision Coverage
B. Key Prudential Issues

⑤ Asset Quality
Loan Classification System:

Categor The The Effects of a Featur Note

ies degree of likelihood bank’s safety es of
risk of orderly and this
repayment soundness catego
ry
Pass(No Current in Pay in due Full payment
rmal) meeting time is in no of interest and
commiteme doubt principal
nts
Special Potential Adverse May result in Borrowe
Mention weakness economic or the rs’
market deterioration adverse
conditions of repayment operatin
g trends
Categories The degree of The likelihood Effects of a Features of this Note
risk of orderly bank’s safety category
repayment and
soundness
Substandard Well-defined Likelihood of Having a Current or
wakness; full collection of distinct expected
repayment may interest & potential for unprofitable
depend on principal may loss operations,
colateral or be in doubt inadequate debt
other credit risk service
mitigation coverage,
inadequate
liquidity, or
marginal
capitalization
Doubtful Having all the Collection or High
weakness the liquidation probability of
inherent in it in full is highly total or
questionable substantial
and loss, with
improbable pending events
Loss Basically, Little prospect As bankable Uncollectible and
worthless asset of collecting assets non- of so little value
either principal warranted
or interest
 3. Arrangements for ongoing banking
supervision
C. Methods of Ongoing Banking Supervision

1) Off-site Surveillance
2) On-site Examination
3) Supervision on a Consolidated Basis
 3. Arrangements for ongoing banking
supervision
1) Off-site Surveillance / Off-site Regulation

• Reported operating management, financial

statements and reports
• Analyze the operation situation, risk
management situation, and ethics and
compliance by using a technical method, so
as to find out the problems exists in banking
risk management.
 3. Arrangements for ongoing banking
supervision
2) On-site Examination

• Supervisors go to the financial institution

directly
• Institution and services observation and
risk judgment analysis
• Verify and check the problems or doubtful
points that found in off-site regulation
 C. Methods of Ongoing Banking Supervision

1) Off-site Surveillance
• Three Goals
• Information requirement
• Analyzing Tools (ratios)
• The Role of In-house Analysts
 C. Methods of Ongoing Banking Supervision

1) Off-site Surveillance

• Three Goals
① To identify banking facing problems or not
② To monitor problem banking institution
③ To asses patterns & trends in banking sector
 C. Methods of Ongoing Banking Supervision
1) Off-site Surveillance
• Information Requirement
1) Internal Requirement
① Regulatory reports
② Financial statements
③ Reports (monetary policy reports, weekly/ quarterly/ annual
reports)
2) External Requirement
① On-site information
② Market information Outer (public)
③ Analysis materials Internal (on-site examination
 C. Methods of Ongoing Banking Supervision
1) Off-site Surveillance

• Analyzing Tools (ratios)

① Capital adequacy measures :
Risk-based Capital
Leverage Ratio
② Asset quality indicators
③ Earnings measures
④ Liquidity measures
Loan-to-deposit Ratio or Loan-deposit Ratio
<=75%
 C. Methods of Ongoing Banking Supervision

2) On-site Examination & The role of External Auditors

a. The on-site examination process and focusing area

– Example: OCC (Office of the Comptroller of the Currency

b. Asset quality assessment

c. The use of external auditor

The auditor’s opinion helps establish

the credibility of the financial
statements
C. Methods of Ongoing Banking Supervision

2) On-site Examination & The role of External Auditors

Capital;
Capital;
Asset
AssetQuality;
Quality;
CAMELS Management;
Management;
Earnings;
Earnings;
Liquidity; Interest Rate
Liquidity; Exchange Rate
Sensitivity
SensitivitytotoMarket
MarketRisk
Risk Stock
Commodity Value

Risk
RiskManagement
Management
Operational
OperationalControls
Controls
ROCA
Compliance
Compliance
Asset
AssetQuality
Quality
 C. Methods of Ongoing Banking Supervision
2) On-site Examination & The role of External Auditors
b. Asset quality assessment
General guidelines for
total loan volume
Loan Policies & Process relative to bank assets
and capital

Evaluating the quality

Credit Review Process of individual loans

Adequacy loan Loss Reserve

C. Methods of Ongoing Banking Supervision
3) Supervision on a Consolidated Basis

• Three Models of Supervision

① Rigorous supervision
② Moderate regulation
③ Deregulation
Thank You