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|Bank regulation and standards|
|Pillar 1: Regulatory capital|
|Pillar 2: Supervisory review|
|Pillar 3: Market disclosure|
|Business and Economics Portal|
|Part of a series on financial services|
Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. As regulation focusing on key actors in the financial markets, it forms one of the three components of financial law, the other two being case law and self-regulating market practices.
Given the interconnectedness of the banking industry and the reliance that the national (and global) economy hold on banks, it is important for regulatory agencies to maintain control over the standardized practices of these institutions. Another relevant example for the interconnectedness is that the law of financial industries or financial law focuses on the financial (banking), capital, and insurance markets.Supporters of such regulation often base their arguments on the "too big to fail" notion. This holds that many financial institutions (particularly investment banks with a commercial arm) hold too much control over the economy to fail without enormous consequences. This is the premise for government bailouts, in which government financial assistance is provided to banks or other financial institutions who appear to be on the brink of collapse. The belief is that without this aid, the crippled banks would not only become bankrupt, but would create rippling effects throughout the economy leading to systemic failure. Compliance with bank regulations is verified by personnel known as bank examiners.
The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common objectives are:
Banking regulations vary widely between jurisdictions.
Bank regulation is a complex process and generally consists of two components:
The first component, licensing, sets certain requirements for starting a new bank. Licensing provides the licence holders the right to own and to operate a bank. The licensing process is specific to the regulatory environment of the country and/or the state where the bank is located. Licensing involves an evaluation of the entity's intent and the ability to meet the regulatory guidelines governing the bank's operations, financial soundness, and managerial actions.The regulator supervises licensed banks for compliance with the requirements and responds to breaches of the requirements by obtaining undertakings, giving directions, imposing penalties or (ultimately) revoking the bank's license.
The second component, supervision, is an extension of the licence-granting process and consists of supervision of the bank's activities by a government regulatory body (usually the central bank or another independent governmental agency). Supervision ensures that the functioning of the bank complies with the regulatory guidelines and monitors for possible deviations from regulatory standards. Supervisory activities involve on-site inspection of the bank's records, operations and processes or evaluation of the reports submitted by the bank. Examples of bank supervisory bodies include the Federal Reserve System and the Federal Deposit Insurance Corporation in the United States, the Financial Conduct Authority and Prudential Regulation Authority in the United Kingdom, the Federal Financial Markets Service in the Russian Federation, the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) in Germany.
A national bank regulator imposes requirements on banks in order to promote the objectives of the regulator. Often, these requirements are closely tied to the level of risk exposure for a certain sector of the bank. The most important minimum requirement in banking regulation is maintaining minimum capital ratios.To some extent, U.S. banks have some leeway in determining who will supervise and regulate them.
The regulator requires banks to publicly disclose financial and other information and depositors and other creditors are able to use this information to assess the level of risk and to make investment decisions. As a result of this, the bank is subject to market discipline and the regulator can also use market pricing information as an indicator of the bank's financial health.
The capital requirement sets a framework on how banks must handle their capital in relation to their assets. Internationally, the Bank for International Settlements' Basel Committee on Banking Supervision influences each country's capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accords. The latest capital adequacy framework is commonly known as Basel III.This updated framework is intended to be more risk sensitive than the original one, but is also a lot more complex.
The reserve requirement sets the minimum reserves each bank must hold to demand deposits and banknotes. This type of regulation has lost the role it once had, as the emphasis has moved toward capital adequacy, and in many countries there is no minimum reserve ratio. The purpose of minimum reserve ratios is liquidity rather than safety. An example of a country with a contemporary minimum reserve ratio is Hong Kong, where banks are required to maintain 25% of their liabilities that are due on demand or within 1 month as qualifying liquefiable assets.
Reserve requirements have also been used in the past to control the stock of banknotes and/or bank deposits. Required reserves have at times been gold, central bank banknotes or deposits, and foreign currency.
Corporate governance requirements are intended to encourage the bank to be well managed, and is an indirect way of achieving other objectives. As many banks are relatively large, and with many divisions, it is important for management to maintain a close watch on all operations. Investors and clients will often hold higher management accountable for missteps, as these individuals are expected to be aware of all activities of the institution. Some of these requirements may include:
Among the most important regulations that are placed on banking institutions is the requirement for disclosure of the bank's finances. Particularly for banks that trade on the public market, in the US for example the Securities and Exchange Commission (SEC) requires management to prepare annual financial statements according to a financial reporting standard, have them audited, and to register or publish them. Often, these banks are even required to prepare more frequent financial disclosures, such as Quarterly Disclosure Statements. The Sarbanes–Oxley Act of 2002 outlines in detail the exact structure of the reports that the SEC requires.
In addition to preparing these statements, the SEC also stipulates that directors of the bank must attest to the accuracy of such financial disclosures. Thus, included in their annual reports must be a report of management on the company's internal control over financial reporting. The internal control report must include: a statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the company; management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year; a statement identifying the framework used by management to evaluate the effectiveness of the company's internal control over financial reporting; and a statement that the registered public accounting firm that audited the company's financial statements included in the annual report has issued an attestation report on management's assessment of the company's internal control over financial reporting. Under the new rules, a company is required to file the registered public accounting firm's attestation report as part of the annual report. Furthermore, the SEC added a requirement that management evaluate any change in the company's internal control over financial reporting that occurred during a fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting.
Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and to disclose it to investors and prospective investors. Also, banks may be required to maintain a minimum credit rating. These ratings are designed to provide color for prospective clients or investors regarding the relative risk that one assumes when engaging in business with the bank. The ratings reflect the tendencies of the bank to take on high risk endeavors, in addition to the likelihood of succeeding in such deals or initiatives. The rating agencies that banks are most strictly governed by, referred to as the "Big Three" are the Fitch Group, Standard and Poor's and Moody's. These agencies hold the most influence over how banks (and all public companies) are viewed by those engaged in the public market. In recent years, following the Great Recession, many economists have argued that these agencies face a serious conflict of interest in their core business model.Clients pay these agencies to rate their company based on their relative riskiness in the market. The question then is, to whom is the agency providing its service: the company or the market?
European financial economics experts – notably the World Pensions Council (WPC) have argued that European powers such as France and Germany pushed dogmatically and naively for the adoption of the "Basel II recommendations", adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD). In essence, they forced European banks, and, more importantly, the European Central Bank itself, to rely more than ever on the standardized assessments of "credit risk" marketed aggressively by two US credit rating agencies – Moody's and S&P, thus using public policy and ultimately taxpayers' money to strengthen anti-competitive duopolistic practices akin to exclusive dealing. Ironically, European governments have abdicated most of their regulatory authority in favor of a non-European, highly deregulated, private cartel.
Banks may be restricted from having imprudently large exposures to individual counterparties or groups of connected counterparties. Such limitation may be expressed as a proportion of the bank's assets or equity, and different limits may apply based on the security held and/or the credit rating of the counterparty. Restricting disproportionate exposure to high-risk investment prevents financial institutions from placing equity holders' (as well as the firm's) capital at an unnecessary risk.
In the US in response to the Great depression of the 1930s, President Franklin D. Roosevelt's under the New Deal enacted the Securities Act of 1933 and the Glass–Steagall Act (GSA), setting up a pervasive regulatory scheme for the public offering of securities and generally prohibiting commercial banks from underwriting and dealing in those securities. GSA prohibited affiliations between banks (which means bank-chartered depository institutions, that is, financial institutions that hold federally insured consumer deposits) and securities firms (which are commonly referred to as “investment banks” even though they are not technically banks and do not hold federally insured consumer deposits); further restrictions on bank affiliations with non-banking firms were enacted in Bank Holding Company Act of 1956 (BHCA) and its subsequent amendments, eliminating the possibility that companies owning banks would be permitted to take ownership or controlling interest in insurance companies, manufacturing companies, real estate companies, securities firms, or any other non-banking company. As a result, distinct regulatory systems developed in the United States for regulating banks, on the one hand, and securities firms on the other.
Among the reasons for maintaining close regulation of banking institutions is the aforementioned concern over the global repercussions that could result from a bank's failure; the idea that these bulge bracket banks are "too big to fail".The objective of federal agencies is to avoid situations in which the government must decide whether to support a struggling bank or to let it fail. The issue, as many argue, is that providing aid to crippled banks creates a situation of moral hazard. The general premise is that while the government may have prevented a financial catastrophe for the time being, they have reinforced confidence for high risk taking and provided an invisible safety net. This can lead to a vicious cycle, wherein banks take risks, fail, receive a bailout, and then continue to take risks once again.
Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the stability and integrity of the financial system. This may be handled by either a government or non-government organization. Financial regulation has also influenced the structure of banking sectors by increasing the variety of financial products available. Financial regulation forms one of three legal categories which constitutes the content of financial law, the other two being market practices and case law.
Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events, differ from the expected losses". This definition, adopted by the European Solvency II Directive for insurers, is a variation from that adopted in the Basel II regulations for banks. In October 2014, the Basel Committee on Banking Supervision proposed a revision to its operational risk capital framework that sets out a new standardized approach to replace the basic indicator approach and the standardized approach for calculating operational risk capital.
Basel II is the second of the Basel Accords,, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
A capital requirement is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds not a use of funds.
In general, compliance means conforming to a rule, such as a specification, policy, standard or law. Regulatory compliance describes the goal that organizations aspire to achieve in their efforts to ensure that they are aware of and take steps to comply with relevant laws, policies, and regulations. Due to the increasing number of regulations and need for operational transparency, organizations are increasingly adopting the use of consolidated and harmonized sets of compliance controls. This approach is used to ensure that all necessary governance requirements can be met without the unnecessary duplication of effort and activity from resources.
The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1974. The committee expanded its membership in 2009 and then again in 2014. In 2019, the BCBS has 45 members from 28 Jurisdictions, consisting of Central Banks and authorities with responsibility of banking regulation. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Committee frames guidelines and standards in different areas – some of the better known among them are the international standards on capital adequacy, the Core Principles for Effective Banking Supervision and the Concordat on cross-border banking supervision. The Committee's Secretariat is located at the Bank for International Settlements (BIS) in Basel, Switzerland. The Bank for International Settlements (BIS) hosts and supports a number of international institutions engaged in standard setting and financial stability, one of which is BCBS. Yet like the other committees, BCBS has its own governance arrangements, reporting lines and agendas, guided by the central bank governors of the Group of Ten (G10) countries.
The Office of the Superintendent of Financial Institutions is an independent agency of the Government of Canada reporting to the Minister of Finance created "to contribute to public confidence in the Canadian financial system". It is the sole regulator of banks, and the primary regulator of insurance companies, trust companies, loan companies and pension plans in Canada.
The Capital Requirements Directives (CRD) for the financial services industry have introduced a supervisory framework in the European Union which reflects the Basel II and Basel III rules on capital measurement and capital standards.
The Solvency II Directive is a Directive in European Union law that codifies and harmonises the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency.
Bank regulation in the United States is highly fragmented compared with other G10 countries, where most countries have only one bank regulator. In the U.S., banking is regulated at both the federal and state level. Depending on the type of charter a banking organization has and on its organizational structure, it may be subject to numerous federal and state banking regulations. Apart from the bank regulatory agencies the U.S. maintains separate securities, commodities, and insurance regulatory agencies at the federal and state level, unlike Japan and the United Kingdom. Bank examiners are generally employed to supervise banks and to ensure compliance with regulations.
A bank is a financial institution that accepts deposits and recurring accounts from the people and creates Demand Deposit. Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial stability of a country, banks are highly regulated in most countries. Most nations have institutionalized a system known as fractional reserve banking under which banks hold liquid assets equal to only a portion of their current liabilities. In addition to other regulations intended to ensure liquidity, banks are generally subject to minimum capital requirements based on an international set of capital standards, known as the Basel Accords.
The Dodd–Frank Wall Street Reform and Consumer Protection Act is a United States federal law that was enacted on July 21, 2010. The law overhauled financial regulation in the aftermath of the Great Recession, and it made changes affecting all federal financial regulatory agencies and almost every part of the nation's financial services industry.
Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole. In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective.
Basel III is a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk. This third installment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
The European Banking Authority (EBA) is a regulatory agency of the European Union headquartered in Paris. Its activities include conducting stress tests on European banks to increase transparency in the European financial system and identifying weaknesses in banks' capital structures. The EBA was established on 1 January 2011, upon which date it inherited all of the tasks and responsibilities of the Committee of European Banking Supervisors (CEBS). After the United Kingdom withdrawal from the European Union referendum the agency has relocated to Paris.
A systemically important financial institution (SIFI) or systemically important bank (SIB) is a bank, insurance company, or other financial institution whose failure might trigger a financial crisis. They are colloquially referred to as "too big to fail".
Wall Street and the Financial Crisis: Anatomy of a Financial Collapse is a report on the financial crisis of 2007–2008 issued on April 13, 2011 by the United States Senate Permanent Subcommittee on Investigations. The 639-page report was issued under the chairmanship of Senators Carl Levin and Tom Coburn, and is colloquially known as the Levin-Coburn Report. After conducting "over 150 interviews and depositions, consulting with dozens of government, academic, and private sector experts" found that "the crisis was not a natural disaster, but the result of high risk, complex financial products, undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." In an interview, Senator Levin noted that "The overwhelming evidence is that those institutions deceived their clients and deceived the public, and they were aided and abetted by deferential regulators and credit ratings agencies who had conflicts of interest." By the end of their two-year investigation, the staff amassed 56 million pages of memos, documents, prospectuses and e-mails. The report, which contains 2,800 footnotes and references thousands of internal documents focused on four major areas of concern regarding the failure of the financial system: high risk mortgage lending, failure of regulators to stop such practices, inflated credit ratings, and abuses of the system by investment banks. The Report also issued several recommendations for future action regarding each of these categories.
Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB) approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.
Basel IV is a contested term for the changes agreed in 2016 and 2017 to the international banking standards known as the Basel Accords. Regulators argue that these changes are simply completing the Basel III reforms, agreed in principle in 2010–11, although most of the Basel III reforms were agreed in detail at that time. The Basel Committee (BCBS) itself calls them simply "finalised reforms" and the UK Government has called them "Basel 3.1". Critics of the reform, in particular those from the banking industry, argue that Basel IV require a significant increase in capital and should be treated as a distinct round of reforms.
The Capital Requirements Regulation(EU) No. 575/2013 is an EU law that aims to decrease the likelihood that banks go insolvent. With the Credit Institutions Directive 2013 the Capital Requirements Regulation 2013 reflects Basel III rules on capital measurement and capital standards.