Structure, Goals and Functions of Bank Regulation

Structure, Goals and Functions of Bank Regulation
Partner in Building Corporate & Personal EQuity
EQuity Consulting
 Structure
 Goals and Functions
• Ensure the Safety and Soundness of Banks
• Provide an Efficient and Competitive Financial System (e.g., HK as fin. Center)
• Provide Monetary Stability
• Maintain the Integrity of the Payments System (B2C v. B2B)
• Protect Consumers from Abuses

Regulatory Structure: Supervision & Examination
EQuity Consulting
 Memorandum of Understanding
• Formal regulatory document
 Cease and Desist Order

• Legal document
• Has legal standing
Chartering a Bank
EQuity Consulting
 Chartering
• To ensure that banks will have
 the necessary capital and
 management expertise to ensure
• soundness and
• allow the bank to meet the public’s financial needs
©EQCC 3
National versus State Charter
EQuity Consulting
 All banks obtain FDIC deposit insurance as part of the chartering process
 National banks must join the Fed (Reserve Requirement Ratio)
• Primary regulator is the OCC (Office of Comptroller of Currency)
 State banks may join the Fed

• State banks are regulated by their state banking authority
 But unlikely to get approval without obtaining FDIC
• State banks also have a primary federal regulator
 The primary federal regulator of state banks that are members of the Fed is the Federal
Reserve
 The primary federal regulator of Non-Fed member state banks is the FDIC
New Charters
EQuity Consulting
Dual Banking System

 Office of the Comptroller of the
 State Banking Authorities
Currency (OCC)
• Charter state banks
• Charters national banks
 State Savings Authorities
 Office of Thrift Supervision (OTS)
• Charter state savings banks
• Charters federal savings banks and
savings associations
 National Credit Union
Administration (NCUA)  State Credit Union Authorities
• Charters federal credit unions • Charter state credit unions

OCC v. Fed
EQuity Consulting
 Office of the Comptroller of the Currency

• Charters and examines the books of federally chartered commercial banks and imposes
restrictions on the assets they can hold.
 Federal Reserve
• Examines the books of commercial banks that are members of the system, sets reserve
requirements.
 FDIC ?
©EQCC 6
The Hong Kong Monetary Authority (HKMA)
EQuity Consulting
 Established on 1 April 1993

 Merging the Office of the Exchange Fund with the Office of the Commissioner of
Banking
 Governed by the Exchange Fund Ordinance and the Banking Ordinance and it
reports to the Financial Secretary
©EQCC 7
Structure of HKMA
EQuity Consulting
 …financed by the Exchange Fund to

ensure a level of resource independence
appropriate to a central banking
institution.
 …reports to the FS, who is the
Controller of the Exchange Fund. In
this capacity, the Financial Secretary is
advised by the Exchange Fund
Advisory Committee (EFAC).
 Five specialised sub-committees report
and make recommendations to EFAC.
©EQCC
8
The role of HKMA
EQuity Consulting
Reference: An introduction to the Hong Kong Monetary Authority, Hong Kong Monetary Authority
©EQCC
9
Banking in HK
EQuity Consulting
 The principal function of the HKMA as banking supervisor is to promote the

general stability and effective working of the banking system in Hong Kong.
 The HKMA seeks to ensure that authorized institutions operate in an effective,
responsible, honest and business-like manner and to provide a measure of
protection to depositors. Its powers to meet these objectives come from the
Banking Ordinance.
• Three-tier banking system
• Deposit protection scheme (DPS)
©EQCC 10
Three-tier banking system
EQuity Consulting
©EQCC 11
Three-tier banking system
EQuity Consulting
Licensed banks may provide current and savings accounts; accept

deposits of any size and maturity from the public, pay or collect
cheques; and use the name “bank” without restriction. According to
the Deposit Protection Scheme Ordinance, only licensed banks can,
and are required to, join the Scheme as Members
Restricted many of which are engaged in wholesale and capital market

licence banks activities, may only take deposits from the public in amounts of
HK$500,000 or above without restriction on maturity
Deposit-taking are restricted to taking deposits of HK$100,000 or above with an

companies original term to maturity of at least three months. These companies
are mostly owned by, or otherwise associated with, banks and
engage in a range of specialised activities, including consumer and
trade finance, and securities business.
©EQCC 12
Licensing requirements for banks in HK
EQuity Consulting
 The HKMA - under the Banking Ordinance : grant or refuse an application for
authorization to operate a banking business or the business of taking deposits in
Hong Kong.
 All AIs are subject to the same authorization criteria except that:
• Cap Requirement (minimum)
 licensed banks (HK$300 million)
 restricted licence banks (HK$100 million) and
 deposit-taking companies (HK$25 million)
• only licensed banks are required to observe the minimum-size criteria (HK$3 billion customer
deposits and HK$4 billion total assets).
©EQCC 13
Licensing requirements for banks in HK
EQuity Consulting
 The other criteria specified in the Seventh Schedule to the Banking Ordinance
cover the internationally accepted principles of a prudent licensing system,
including:
• …an applicant incorporated outside Hong Kong…, whether the applicant is a bank
adequately supervised in its home country
• …”fit and proper” test for the chief executive, directors, controllers and executive officers of
the applicant
• the adequacy of the systems of control for appointment of senior executives, “managers”
under the Banking Ordinance
• the financial soundness of the applicant, w.r.t. capital, liquidity and asset quality
• the adequacy of internal controls and accounting systems
• whether the business of the applicant is, and will continue to be, carried out with integrity,
prudence and competence.
©EQCC 14
Structure, Goals and Functions of Bank Regulation
EQuity Consulting
 Structure
 Goals and Functions
• Ensure the Safety and Soundness of Banks
• Provide an Efficient and Competitive Financial System
• Provide Monetary Stability
• Maintain the Integrity of the Payments System
• Protect Consumers from Abuses
Risk Management of HKMA
EQuity Consulting
 Exercise: Major risks of banks as identified by regulators are…

• credit risk,
• interest rate risk,
• market risk,
• liquidity risk,
• operational risk,
• legal risk,
• reputation risk, and
• strategic risk
 … briefly describe each (no more than 20 words ea.)
©EQCC 16
Safe, Sound, Efficient & Competitive System
EQuity Consulting
 Supervision and Examination

• CAMELS
 Capital
 Asset Quality
 Management Quality
 Earnings Quality
 Liquidity
 Sensitivity to Market Risk
Risk Management of HKMA
EQuity Consulting
 Assessing CAMEL rating (since 2007)

• Capital adequacy (Basel II: at least 8%),
• Asset quality,
• Management,
• Earnings and
• Liquidity
• Also… Corporate governance, internal controls and other issues such as technology risk
management, electronic banking, securities and leveraged foreign exchange business, and the
prevention of money laundering
 Major risks
• credit risk, interest rate risk, market risk, liquidity risk, operational risk, legal risk, reputation
risk, strategic risk
©EQCC 18
Safe, Sound, Efficient & Competitive System
EQuity Consulting
 Shortcomings of Restrictive Bank Regulation

• Does not prevent bank failure
• Cannot eliminate economic risk
• Does not guarantee that bank management will make good decisions
Monetary Stability
EQuity Consulting
 The Federal Reserve System

• Fundamental Functions
 Conduct monetary policy
 Provide and maintain the payments system
 Supervise and regulate banking operations
• Organization
 Board of Governors
 12 Federal Reserve District Banks
Monetary Stability
EQuity Consulting
 The Federal Reserve System

• Monetary Policy Tools
 Open Market Operations
• Open market purchases (sales) increase (decrease) reserves & the money supply
 Discount Rate
• Decreasing (Increasing) the discount rate makes bank borrowing less (more) expensive, which leads to an
increase (decrease) in the money supply
 Reserve Requirements
• Decreasing (Increasing) reserve requirements increases (decreases) the money supply
Monetary Policy Tools: How it works
EQuity Consulting
 What policy is appropriate: Which target shall we follow?

• E.g., targets interest rate at 4%
 How to implement policy: Which action to take to reach the target

Monetary Stability & Banks
EQuity Consulting
 Commercial Banks and the Economy

• Banks are the primary conduit for monetary policy
• Banks are the primary source of credit for most small businesses and many individuals
Monetary stability
EQuity Consulting
 The HKD is officially linked to the US D at the rate of HK$7.8 to US$1.

• …a key in HK’s monetary system and in supporting HK as a leading international trading,
services and financial centre.
 Currency Board mechanism

• requires the MB to be fully backed by foreign reserves (and any change in the MB… fully
matched by a corresponding change in foreign reserves.)
• … i.e., the stability of the HKD is maintained through an automatic interest rate adjustment
mechanism, i.e., interest rates rather than the exchange rate adjust to the inflow or outflow of
funds.
©EQCC 24
The Linked Exchange Rate System
EQuity Consulting
Hong Kong-
dollar debt fully back the
securities issued banknotes
by the HKMA on issued by the
behalf of the note-issuing
Government banks
the sum of balances in the clearing accounts maintained by

commercial banks with the HKMA
©EQCC 25
EQuity Consulting
 Operation of Currency Board mechanism
©EQCC 26
EQuity Consulting
©EQCC
27
Monetary stability:
The EFAC Currency Board Sub-Committee
EQuity Consulting
 Terms of Reference:
1. To ensure that the operation of the Currency Board arrangements in Hong Kong is in accordance
with the policies determined by the Financial Secretary in consultation with the Exchange Fund
Advisory Committee.
2. To report to the Financial Secretary through the Exchange Fund Advisory Committee on the
operation of the Currency Board arrangements in Hong Kong.
3. To recommend, where appropriate, to the Financial Secretary through the Exchange Fund
Advisory Committee, measures to enhance the robustness and effectiveness of the Currency Board
arrangements in Hong Kong.
4. To ensure a high degree of transparency in the operation of the Currency Board arrangements in
Hong Kong through the publication of relevant information on the operation of such arrangements.
5. To promote a better understanding of the Currency Board arrangements in Hong Kong.
©EQCC 28
Consumer Protection US
EQuity Consulting
 Reg. B
• Equal Credit Opportunity
 Cannot discriminate on the basis of sex, race, marital status, religion, age, or national
origin.
 Reg. Z
• Truth-in-Lending
 Requires disclosure of:
• Effective interest rates, total interest paid, total of all payments
• Why credit was denied
Federal Deposit Insurance
EQuity Consulting
 Depositors are currently insured up to $100,000 per qualify account per insured
bank
• Original limit in 1933 was $5,000
 FDIC maintains the deposit insurance fund at 1.25% of insured deposits.

 Currently, the fund is “well-funded” and over 90% of banks pay no insurance
premium
Depository Institutions
EQuity Consulting
 Commercial Banks
• Specialize in short-term business credit
 Savings Institutions
• Specialize in real estate loans
• “Qualified Thrift Lender”
• Unitary Thrift Holding Company
 Credit Unions
• “Common Bond” requirement
Deposit protection in HK
EQuity Consulting
 Depositors in Hong Kong are protected by the Deposit Protection Scheme. The
Scheme was established in accordance with the Deposit Protection Scheme
Ordinance to provide protection up to HK$500,000 per depositor per bank. In
addition to protecting depositors, the Scheme helps maintain the stability of Hong
Kong’s banking system.
• Objectives:
 reduce the probability of failure by reducing the risk of rumour-driven runs;
 provide an orderly means of compensating depositors if a bank failure does occur; and
 reduce the fall-out effects of a bank failure.
©EQCC 32
Deposit protection in HK
EQuity Consulting
 all licensed banks, unless otherwise exempted by the Board, are required to participate
in the DPS as Scheme members;
 restricted licence banks and deposit-taking companies are not members of the DPS;
 the compensation limit is set at HK$500,000 per depositor per Scheme member;
 secured deposits are protected;
 Hong Kong dollar, Renminbi and foreign currency deposits are protected;
 a DPS Fund with a target fund size of 0.25% of the total amount of relevant deposits
will be built up through the collection of contributions from Scheme members; and
 differential contributions will be assessed based on the supervisory ratings of
individual Scheme members.
©EQCC 33
Banking stability
EQuity Consulting
 Deposit protection scheme

• Exclusions:
 structured deposits
 term deposits with a maturity exceeding 5 years
 deposits the repayment of which are secured on the assets of the Scheme member
 bearer instruments
 off-shore deposits
 deposits held for the account of the Exchange Fund
 deposits held by an excluded person
 financial products other than deposits
©EQCC 34
EQuity Consulting
©EQCC
35
Exercise
EQuity Consulting
 In addition to creating value for investors, banks are to serve key REGULATORY
goals and functions. If you were hired by a bank to serve as compliance officer
and interact with regulators, which aspect would you like to specialize in? Why?
©EQCC 36
Notes & Coins of Hong Kong
EQuity Consulting
 Note-issuing Banks
• The Hongkong and Shanghai Banking Corporation Limited,
• the Bank of China (Hong Kong) Limited and
• the Standard Chartered Bank (Hong Kong) Limited
 Printed by Hong Kong Note Printing Limited (HKNPL)
©EQCC 37

Structure, Goals and Functions of Bank Regulation

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Structure, Goals and Functions of Bank Regulation

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Structure, Goals and Functions of Bank Regulation

Partner in Building Corporate & Personal EQuity

• Protect Consumers from Abuses

 Cease and Desist Order

 State banks may join the Fed

Dual Banking System

• Charters federal credit unions • Charter state credit unions

 Office of the Comptroller of the Currency

 Established on 1 April 1993

 …financed by the Exchange Fund to

 The principal function of the HKMA as banking supervisor is to promote the

Licensed banks may provide current and savings accounts; accept

Restricted many of which are engaged in wholesale and capital market

Deposit-taking are restricted to taking deposits of HK$100,000 or above with an

 Exercise: Major risks of banks as identified by regulators are…

 … briefly describe each (no more than 20 words ea.)

 Supervision and Examination

 Assessing CAMEL rating (since 2007)

 Shortcomings of Restrictive Bank Regulation

 The Federal Reserve System

 The Federal Reserve System

 What policy is appropriate: Which target shall we follow?

 How to implement policy: Which action to take to reach the target

 Commercial Banks and the Economy

 The HKD is officially linked to the US D at the rate of HK$7.8 to US$1.

 Currency Board mechanism

the sum of balances in the clearing accounts maintained by

 Operation of Currency Board mechanism

 FDIC maintains the deposit insurance fund at 1.25% of insured deposits.

 Deposit protection scheme

 Printed by Hong Kong Note Printing Limited (HKNPL)

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