Session:
FOURTEEN

MBF-705
LEGAL AND REGULATORY
ASPECTS OF BANKING
SUPERVISION
OSMAN BIN SAIF


Revision session 1


SECTION 1


Why and How Should Banks
Be Regulated?
•

•

The health of the economy and the
effectiveness of monetary policy depend
on a sound financial system.
Through supervising and regulating
financial institutions, the State Bank is
better able to make policy decisions.

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Why and How Should Banks
Be Regulated? (Contd.)
•

•

Bank supervision involves monitoring and
examining the condition of banks and their
compliance with laws and regulations.
If a bank under the State Bank’s
jurisdiction is found to have problems or
be noncompliant, the State Bank may use
its authority to request that the bank
correct the problems.
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Why and How Should Banks
Be Regulated? (Contd.)
•

Bank regulation includes issuing specific
regulations and guidelines to govern the
operations, activities and acquisitions of
banking organizations.

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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
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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
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loan – a bank’s primary source of
income.


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.
To measure the safety and soundness of a
bank, an examiner performs an on-site
examination review of the bank's
performance based on its management
and financial condition, and its compliance
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CAMELS
•

•

The Banking Supervisor/examiner uses
the CAMELS rating system to help
measure the safety and soundness of a
bank.
Each letter stands for one of the six
components of a bank’s condition:
–

capital adequacy,

–

asset quality,

–

management,

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What are Banking Regulations?
•

Bank Regulations are a form of

government regulations which subject
banks to certain requirements,
restrictions and guidelines.

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Key Objectives of Bank
Regulation
•

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.

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Bank
•

Operation
–

Take money as deposits on which they pay interests

–

Lend it to borrowers who use if for investment or consumption

–

Borrow money from other banks (inter bank market)

–


Make profit on the difference between interest paid and received

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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

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Criticality of Banking system
•

•

As bank provide credit and operate
payments- failure can have a more
damaging effect on the economy than the
collapse of other businesses
Hence need for more regulation by
government
–

Reserve requirement – holding a proportion of bank deposits at the
central bank (CRR)

–

Match a proportion of risky assets (i.e loans) with capital in form of
equity or retained earnings

•

Capital of internationally active banks15should


Investment Banks
•

•

•

Help firms raise money in the capital markets (equity and
bonds market)

Advise firms whether to finance themselves with debt or
equity

Underwrite such issues by agreeing often with other
banks in syndicate, to buy any unsold securities
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Institutional investors
•

At most basic , they are simply vast pools
of money

•


•

Institutional investors are
–

Pension funds

–

Mutual funds

–

Insurance companies

Dominate the securities( stocks, bonds)
market
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Banking CRISIS


Sub-prime mortgage – What’s
that?
•

Home loans made to borrowers with poor
credit ratings — a group generally defined

by FICO scores below 620 on a scale that
ranges from 300 to 850

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Sub-prime mortgage (Contd.)
•

FICO - a number that is based on a
statistical analysis of a person's credit
report, and is used to represent the
creditworthiness of that person.

(FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol
"FIC") that created the best-known and most widely used credit score model in the US.)

•

Creditworthiness—the likelihood that the
person will pay his or her debts.
Calculated by credit reporting agencies.
Ex. Equifax, Experian, and TransUnion
in
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Evolution of home mortgage
Home loan funding


1930s
Principal + interest payable over long term

Lender-Banks
•

•

Borrower-Individuals

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

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New Model of mortgage lending
Bought loan

Home loan funding

Cash

Securitization
fees

SPV
MBS


Cash

Transfer of credit & market risk

Lender-Banks
Principal + interest payable
over long term

Transfer of market risk

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New Model of mortgage lending
(Contd.)
•

Advantages
•

More liquidity in market

•

Risk spread out

•

Long term funding for mortgage lending


•

MBS- allows originators to earn fee income
from underwriting activities without exposure
to credit, market or liquidity risks as they see
the loans they make
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Further evolution
•

Big private players in this field were
–

Wells Frago

–

Lehman Brothers

–

Bear Stearns

–

JP Morgan

–


Goldman Sachs

–

Bank Of America

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Big assumptions
•

Belief that modern capital markets had become
so much more advanced than their
predecessors that banks would always be able
to trade debt securities. This encouraged banks
to keep lowering lending standards, since they
assumed they could sell the risk on.

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