 Introduction

 Banking regulation
 Role of Central banks
 Rational of regulation/The theory of
regulation
 Types of regulation
 Functions of Central banks (see chapter two)
 The theory of regulation
 Most important function of FIs is to
assist in the transfer of funds from
surplus agents to deficit agents. In
assisting this process a financial
intermediary undertakes several
economic functions:
the provisions of a payments mechanism;
maturity transformations;
risk transformations;
liquidity provisions; and
reduction of transaction, information and
search costs.
 The financial sector play the following
role in the economy
 FI are responsible for enormous amount of
investors’ money
 They run the payment system upon which a
modern economy is crucially dependent
 The financial sector is the major employer and
can be a significant foreign exchange earner
for the country
 The financial sector is in charge with the
crucial role of allocating financial capital to its
most productive use
 The government, as agent of the public has
major interest in the operations of the FIs
 For these reasons, the government have
consistently intervened to regulate and
control the activities of FIs
1. Large portion of bank loans are either
originated by government agencies or carried
government guarantees
 EX : There are government loan programs for small
businesses, for housing, for exports, and for a host of
other worthy causes.
2. There are (were) Financial failures
everywhere:
 In 1990s crises in financial institutions have
rocked Chile, Hong Kong, Malaysia, and many
other economies.
 The world has not yet recovered from the
financial crises of 2008/2009.
 This crises resulted into the slow down of
world economy and were result of poor
government regulations
 The financial institutions lent money on projects that
could not generate adequate return-negative returns
were extremely high
 This shows that FIs failed to allocate resource to the
activities of highest return
3. The stock market is, first and foremost, a
forum in which individuals can exchange
risks.
 Itaffects the ability to raise capital, but in the
end, (unless is monitored) it is perhaps more a
gambling casino than a venue in which funds are
being raised to finance new ventures and expand
existing activities.
 A market is to fail if it cannot, by itself,
maintain all the requirements for a
competitive situation
 Financial market regulation is justified
because the market mechanisms of
competition and pricing could not manage
without help.
 Thefinancial crises of the world are believed to
be the result of market failures
 The competitive markets theories are
based on the premise that there is
perfect flow of information in the market
and every body has equal access to the
information.
 But in reality there is imperfect flow of
information.
 For example, investors (buyers of securities)
and the management of the firms (sellers) have
unequal opportunity to information about:
 Solvency of the FIs
 Financial and operating performance results
 Management and its philosophy
 Government intervention is rationalized
on the grounds of Market failure-that is,
left to itself the market would produce a
sub-optimal outcome.
 The following are some of the frequently
cited failures requiring intervention to
correct:
 The externalities problem
 The problem of asymmetric information
 The Principal-agent Problem
 The moral hazard problem
 The Financial system provides a payment
mechanism for the entire economy and FIs
play a pivotal role of linking both users and
lenders of funds.
 Thismeans that problem in the Financial sector
can potentially have a disastrous effect on the
entire economy.
 Asymmetric information means investors
and managers are subject to uneven access
to or uneven possession of information.
 The mgt and directors of a company as
well as FIs have more information than the
investors (suppliers of fund) on:
 Soundness of the company
 Its likely policies
 This could lead to problems such as insider-trading and
the concealment of relevant information from investors
 For
this reason the following regulations are
necessary:
 a law that prohibits insider trading
 Regulation on disclosure requirements
 Obliging companies to make public a great deal of
financial information to potential and actual investors
 Managers and directors are agents of shareholders
and investors (principals)
 There is potential problem that the directors and
managers could pursue their own interest at the
expense of the shareholders and investors.
 Forthis reason they are obliged to disclose information
on the financial performance of the company and are
subject to rules on their own dealings
 By moral hazard we mean that an
insurance against an event occurring will
make the event more likely to occur than
if the event was not insured against.
 For example, a deposit insurance protection
scheme will guarantee investors but a
deposit taking institution will get into
difficulty.
 This may encourage depositors to channel
more of their funds into risky FIs which are
more likely to run into problems and thereby
lead to a higher loss of deposit than the case
no deposit protection insurance policy exists.
 The government is responsible for the
following activities:
 Consumer/investor protection
 Ensuring bank solvency
 Improving macroeconomic financial stability
 Ensuring Competition
 Stimulating growth
 Improving the allocation of resources
 Example of Fraud:
 Deliberate manipulation of share prices
 The concealment of crucial information from investors
 The sale of inappropriate policies
 Insider trading
 The misuse of investors’ funds
1. Disclosure Regulation:
• This regulation requires issuers of securities
to make public a large amount of financial
information to actual and potential investors
• This reduces, if not to avoid problem of
information asymmetric and agency problems
2.Financial Activities Regulation
 This regulation restricts insider trading by insiders
who are corporate officers and others in positions
who know more about a firm’s prospects than general
public
 Insider trading is another problem posed by
asymmetric information
 This is b/s there may be possibility that members of
exchange may defraud the general investing public
3. Regulation of FIs.
 These regulation restricts FIs’ activities in the
vital areas of lending, borrowing, and funding
activities
 The idea of these restrictions is to ensure that
FIs do not take excess risks with investors’
funds and also limit potential conflicts of
interest
 For example in US and UK banks have long
been prohibited from holding significant stakes
in companies
 since this could result in distorted lending to such
companies should they get into financial difficulty.
4. Liquidity requirement
 Such regulations aim to ensure that unnecessary
problems do not arise due to insufficient
liquidity to meet depositor's demand.
 For this reason commercial banks are expected
(legally required) to maintain a prudent level of
cash reserve as a ratio of their deposit to meet
withdrawal demands known as the reserve ratio.
5. Capital Adequacy requirement (long run
solvency)
 Liquidityrequirements are essentially about
maintaining adequate short-term cash to meet
demand for deposit withdrawals.
 Solvency is ,however, a medium to long-term
concept concerning the ability of an institution
to meet its liabilities as they fall due
 The need to maintain sufficient capital to
ensure that the FI is regarded as a solvent and
remains so even if there are losses on its assets
can therefore serve a useful purpose.
6. Regulation of foreign Participants
 Such regulation limits the role foreign firms can
play in domestic markets and their ownership or
control of FIs.
7. Licensing regulations
 FI institutions should be licensed.
 This helps to prevent undesirable individuals
from running FIs and to ensure that FI does not
act recklessly with investors’ funds
 Because of the special role that CBs play in
the financial system, banks are regulated
and supervised by governments.
 The common regulations include:
a. Minimum Capital requirement for CBs
b. Capital Adequacy
c. Liquidity requirement
d. Asset Quality
e. Portfolio diversification
f. Ceiling imposed on interest rate payable on deposits
g. Geographical restriction on branch banks
h. Permissible activates for CBs
a. Minimum Capital requirement for CBs
 FI wanting to formalize must have a minimum
amount of equity capital to support their
activates
 Ethiopia
 The minimum paid up capital required to
obtain a banking business license shall be Birr
500 million (birr five hundred million), which
shall be fully paid in cash and deposited in a
bank in the name and to the account of the
bank under establishment(Directives No.
SBB/50/2011)
b. Capital Adequacy_ refers to the level of capital
in an organization that is available to cover its
risk
 All FI institutions are required to have a minimum
amount of capital relative to the value of their assets
 This means in the event of loss of assets, the
organization would have to sufficient funds of its own
(rather than borrowed from depositors) to cover the
loss.
 Capital adequacy ratios measure the amount of a bank's
capital in relation to the amount of its risk weighted
credit exposures.
 The risk weighting process takes into account, in a stylized
way, the relative riskiness of various types of credit
exposures that banks have, and incorporates the effect of
off-balance sheet contracts on credit risk.
 The higher the capital adequacy ratios a bank has, the
greater the level of unexpected losses it can absorb before
becoming insolvent. The Basle Capital Accord is an
international standard for the calculation of capital
adequacy ratios. The Accord recommends minimum capital
adequacy ratios that banks should meet.
 ETHIOPIA Banks are required to maintain minimum
total capital levels not less than 8% of risk weighted
assets(Directive No. SBB/24/99 Minimum Paid up Capital
to be maintained by Banks
c. Liquidity requirement
 Liquidity refers to the amount of available cash (or
near cash) relative to FIs demand for cash
 The level of liquidity requirement depends on the
stability of the market
In Ethiopia
"Current liabilities" shall mean the sum of demand
(current) deposits, savings deposits and time deposits and
similar liabilities with less than one-month maturity
period.
 Any licensed bank shall maintain liquid assets of
not less than 20% (twenty five percent) of its total
current liabilities(Directive No. SBB/45/2012)
 Current liabilities" shall mean the sum of demand
(current) deposits, savings deposits and time
deposits and similar liabilities with less than one-
month maturity period.
d. Asset Quality
 Asset quality refers the risk to earnings derived
from loans.
 It measures the degree of risk that some of the
loan portfolio will not be repaid.
 For this bank regulations limit the portfolio
that may be extended as unsecured loan.
 As per Directive No. SBB/43/ 2007) of National
Bank of Ethiopia, any bank should assure that
the Provisions for Loan Losses Account is
adequate to absorb potential losses in
accordance with the requirements laid out in
these directives; and
 All banks shall maintain Provisions for Loan
Losses Account which shall be created by
charges to provision expense in the income
statement and shall be maintained at a
level adequate to absorb potential losses in
the loans or advances portfolio;
 In determining the adequacy of the
Provisions for Loan Losses Account,
provisions may be attributed to individual
loans or advances or groups of loans or
advances as per the following schedule.
  
 Classification Category Minimum
Provision
“Pass” (fully Secured or protected by cash or 1 %
cash substitutes)
“Special Mention” (Past due 30 or more days 3%
but less than 90 days)
“Substandard”(Past due 90 or more days but 20%
less than 180 days)
“Doubtful” (Past due 180 or more days but 50%
less than 360 days)
“Loss” (Past due 360 or more days) 100%
 Nonperforming loan (NPL) ratios are calculated by dividing
nonperforming loans by total loans.
 Prudent financial practices require the maintenance of
nonperforming loans at five percent or below.
 Five percent nonperforming loan ratios are set to be
measure of asset quality for banks.
 Nonperforming Loan (NPL) ratios above five percent don’t
always lead to failures because banks keep capital
cushions and set aside reserves to absorb bad loans.
 Banks with higher ratios of equity to total assets could
better withstand such losses.
 Nonperforming loans can eat into a company’s earnings
and deplete cash, leaving banks below the minimum
capital level required by regulators.
e. Portfolio diversification
 Thisrefers to FIs’ need to ensure that they have
not concentrated their portfolio in one
geographic sector or one market segment
f. Ceiling imposed on interest rate payable on
deposits.
 No interest payable on demand account
 Countries impose ceiling on the maximum interest
rate that could be paid by banks on deposits other
than demand (checking) account.
g. Geographical restriction on branch banks
 Some federal or local states prevent large banks from
expanding geographically and thereby forcing out or
taking over smaller banking entities, possibly
threatening competition.
h. Permissible activities for commercial Banks
 Limitationscan be imposed on the areas of bank
investment.
 Example of Ethiopia (see directive no Directive
No. SBB/12/1996 and Directive No.
SBB/30/2002 )
1. No bank shall engage in insurance business but
may hold up to 20% in an insurance company
and up to a total of 10% of the banks equity
capital in such business.
2. Banks are prohibited from engaging directly in
non-banking businesses such as agriculture,
industry, and commerce.
3. A bank may hold shares in a non-banking
business only up to 20% of the company’s
share capital and total holdings in such
business shall not exceed10% of the bank’s
net worth.
4. A bank’s equity participation in another
bank shall be subject to prior authorization
by National Bank of Ethiopia.
5. No bank shall commit more than 20% of its
net worth in real estate acquisition and
development other than for own business
premises with out prior approval of the
National Bank of Ethiopia.
6. A bank may not invest more than 10 %(ten
percent) of its net worth in other securities.
7. The aggregate sum of all investments at any
one time (excluding investment in
government securities) may not exceed 50%
of the bank’s net worth, with out prior
approval by the National Bank of Ethiopia.
8. Dealing in securities shall be done by banks
only through a limited liability subsidiary
company wherein the holding of the bank
shall not exceed 10% (percent) of its equity
capital.
 ETHIOPIA
 Foreign nationals or organizations fully or
partially owned by foreign nationals may not
be allowed to open banks or branch offices
or subsidiaries of foreign banks in Ethiopia or
acquire the shares of Ethiopian banks.
1 Banks shall not extend loans to related parties on
preferential terms with respect to conditions,
interest rates and repayment periods other than the
terms and conditions normally applied to other
borrowers.

2 The aggregate sum of loans extended or

permitted to be outstanding directly or
indirectly to one related party at any one
time shall not exceed 15% of the total capital
of the bank.
3 The aggregate sum of loans extended or permitted to
be outstanding directly or indirectly to all related
parties at any one time shall not exceed 35% of the
total capital of the bank.
End of Chapter 5