Global Bank Regulation

Principles and Policies

Heidi Mandanis Schooner, Michael W. Taylor

• Publisher: Academic Press
• Year: 2009
• ISBN:
  9780080925806
• Topic: Economia
• Subtopic: Settore bancario

Global Bank Regulation: Principles and Policies covers the global regulation of financial institutions. It integrates theories, history, and policy debates, thereby providing a strategic approach to understanding global policy principles and banking. The book features definitions of the policy principles of capital regularization, the main justifications for prudent regulation of banks, the characteristics of tools used regulate firms that operate across all time zones, and a discussion regarding the 2007-2009 financial crises and the generation of international standards of financial institution regulation. The first four chapters of the book offer justification for the strict regulation of banks and discuss the importance of financial safety. The next chapters describe in greater detail the main policy networks and standard setting bodies responsible for policy development. They also provide information about bank licensing requirements, leading jurisdictions, and bank ownership and affiliations. The last three chapters of the book present a thorough examination of bank capital regulation, which is one of the most important areas in international banking. The text aims to provide information to all economics students, as well as non-experts and experts interested in the history, policy development, and theory of international banking regulation.

• Defines the over-arching policy principles of capital regulation
• Explores main justifications for the prudent regulation of banks
• Discusses the 2007-2009 financial crisis and the next generation of international standards of financial institution regulation
• Examines tools for ensuring the adequate supervision of a firm that operates across all time zones

Chapter 1

The Changing Nature of Banks

Banks provide the lifeblood of a modern economy. They take funds from firms and individuals with surplus savings and allocate them to other firms and individuals who need to borrow. Other types of financial intermediaries also perform this economic function, but banks are distinguished by their promise to return savers’ funds at any time, or on demand. Before we examine the justification for bank regulation, it is essential that we understand the nature of banks’ activities and why the combination of activities renders banks potentially special. We will also look at the ways in which the activities of banks have changed, often quite dramatically, in the past two or three decades.

Definitions

Banks are middlemen, or, more technically, financial intermediaries. Banks borrow money from their customers (by accepting deposits) and invest that borrowed money in loans and other types of financial instruments. In this way, a bank intermediates its customers’ investment in the bank’s portfolio of loans.¹ Most legal definitions of a bank attempt to capture this aspect of their activities.

In 1899, the United States Supreme Court, in Auten v. United States National Bank of New York, considered the definition of a bank:

A bank … is an institution, usually incorporated with power to issue its promissory notes intended to circulate as money (known as bank notes); or to receive the money of others on general deposit, to form a joint fund that shall be used by the institution, for its own benefit, for one or more of the purposes of making temporary loans and discounts; of dealing in notes, foreign and domestic bills of exchange, coin, bullion, credits, and the remission of money; or with both these powers, and with the privileges, in addition to these basic powers, of receiving special deposits and making collections for the holders of negotiable paper, if the institution sees fit to engage in such business.²

No statute defined a bank in English law for a long period. Common law courts developed various definitions. The most prominent was the definition developed by Diplock LJ in the 1966 case of United Dominions Trust v. Kirkwood:

What I think is common to all modern definitions and essential to the carrying on of the business of banking is that the banker should accept from his customers loans of money on deposit, that is to say, loans for an indefinite period upon running account, repayable as to the whole or any part thereof upon demand by the customer. …³

The concept of deposit-taking as the core activity of banks was subsequently incorporated in the first statutory definition in English law, in the Banking Act 1979, and has continued in its successor statutes. For example, the Financial Services and Markets Act 2000 in the United Kingdom provides that bank means a UK institution which has permission under Part 4 of the Financial Services and Markets Act 2000 to carry on the regulated activity of accepting deposits.

European Union law takes a more extensive view of the functions of a bank. EU law refers to a credit institution rather than a bank, and such an institution is permitted to engage in a range of 14 activities specified in Annex I to the Credit Institutions Directive (2006/48/EC). The first two activities in the list of 14 are deposit taking and lending.

EU law has been very influential in the banking statutes adopted by countries of the former Soviet Union and Eastern Europe, many of which have enacted these statutes only since the mid-1990s. For example, the Republic of Armenia’s banking statutes provide a comprehensive list of bank activities, and the first two provide that “banks … may: a. accept demand and term deposits; [and] b. provide commercial and consumer credits…”⁴ In the Republic of Albania, bank activity is defined as “the receipt of monetary deposits or other repayable funds from the public, and the grant of credits or the investment for its own account, as well as the issue of payments in the form of electronic money.”⁵

Japan’s Banking Act defines banking business as “any of the following acts: (i) Both acceptance of deposits or Installment Savings, and loans of funds or discounting of bills and notes; or Conducting of exchange transactions.”⁶ In Qatar, the banking business is defined as “acceptance of deposits for use in banking operations, such as discounting, purchase or sale of negotiable instruments, granting loans, trading in foreign exchange and precious metals…”⁷ Australia’s Banking Act includes the following definition of banking business: “both taking money on deposit (otherwise than as part-payment for identified goods or services) and making advances of money.”⁸

From all these various definitions, some common themes emerge. Banks take deposits and lend out depositors’ funds in the form of loans and advances. This forms the traditional model of banking.

Money, Credit Creation, and Fractional Reserve Banking

While many other firms also serve as financial intermediaries (insurance companies, mutual funds), banks are a special type of financial intermediary because their liabilities (i.e., deposits) comprise a large part of the supply of money in a modern economy. We are often accustomed to think of money in terms of physical objects like metallic coins or paper notes. In fact, however, deposits at banks form by far the greatest part of the total stock of money, and debts are settled and payments made by transfers between accounts held at banks.⁹

This was not always true. Historically, payments evolved from a barter system to one that replaced it with the exchange of precious metal coins. Barter was inefficient because it required what economists call a double coincidence of wants. For example, if a farmer has two bushels of wheat and wants to exchange them for a new pair of shoes, the farmer must find a shoemaker who wants exactly that amount of wheat. Currencies based on coins struck from precious metals avoided the need for this double coincidence of wants. With the creation of currency, the shoemaker could take the farmer’s coins in exchange for his shoes and then use the coins to buy whatever he wanted. Since not all metal coins were of equal value, a market for exchanging one type of metal coin against another developed. The people who operated this market and who calculated exchange rates between metal coins (much like the current exchange rate between the dollar and the euro or yen) were known as money changers. The word bank derives from the Italian banca, the word for the wooden bench the money changers used to display their coins. Since the money changers needed vaults and safes to store their precious coins and bullion, it was but a short step to allow other merchants to use the same vault for the safekeeping of their coins and bullion.

What began as a safe-keeping service for other merchants evolved over time into a payments service. Instead of transporting large quantities of precious metal from one town to another, bankers offered merchants the possibility of making payments with a bill of exchange, i.e., a document demanding payment, drawn on the hoard of coins in their vaults. The bill of exchange transferred the ownership of the precious coins from one merchant to another without any coins leaving the money changer’s safekeeping. The bills of exchange began to circulate, transferred from one party to the next, and they were rarely presented to the money changer for final payment in gold. In consequence, with the rise of banks in the late seventeenth and early eighteenth centuries, a new form of money began to emerge: paper money in the form of notes issued by banks. By the mid-nineteenth century in England, paper money had become one of the main payment instruments in business transactions.

In the course of time, checking accounts replaced bank notes. Increasingly, checks became the payment instrument of choice, with payments between two parties involving a transfer across the ledger (balance sheet) of either a single bank or, if the parties held accounts at different banks, across the ledger (balance sheet) of a third bank at which both the other banks maintained accounts. Party A merely issued an instruction to his bank to debit his account and to credit the account of party B. Sophisticated clearing and payments systems have developed since, culminating in the demateralization of money in which payments increasingly take the form of electronic deductions direct from bank accounts (e.g., debit cards, Internet bill payment facilities, and the like).¹⁰ Note that banks remain essential to the payment system despite the demateralization of money, since virtually all modern payment mechanisms involve a credit and debit against deposit accounts held with a bank.

The emergence of bank deposits as the main form of money transfer in modern financial systems is not surprising. Bank deposits are a form of demandable debt, in that the bank contracts to pay a fixed sum of money on demand of the customer. Demandable debt instruments possess many of the characteristics of a good medium of exchange. Their face value is easily ascertained; they are divisible; they can be structured so that ownership is easily transferable; and those who accept them have few worries about losses. These factors make demandable debt a very good substitute for coins or paper money as a medium of exchange.

A second special feature of the banking business also emerged from the business of the money changers. When notes issued by the money changers began to circulate freely, they quickly realized that the notes would rarely be presented for final settlement in precious metal. This enabled the money changers to lend more money than they actually held in their vaults by issuing bank notes of a greater value. For example, if the money changer had vault coins worth $100, he could issue bank notes worth, perhaps, $300 or $400, secure in the knowledge that the holders of the notes would rarely ask for payment in coin or bullion. This allowed the money changers to create $300 or $400 out of only $100.

Modern banks also create money. To understand how, consider a country in which there is only one bank. Customer A deposits $100 in cash with the bank. Just like the money changers, the bank assumes that on any given day Customer A will likely withdraw only $10 of that deposit. So, the bank is able to lend the remaining $90 to Customer B. Customer B deposits the proceeds of the loan, i.e., the $90, into the bank. Again, the bank assumes that Customer B will likely withdraw only 10% of the $90 deposit. Therefore, the bank sets aside $9 in reserves and lends $81 to Customer C. This process can continue until the original $100 cash deposit will serve as the basis for $900 in loans.

Banks operate on the basis of fractional reserves described here. Banks hold, in the form of reserves, only a fraction of the deposits that they receive from their customers. Banks are able to maintain fractional reserves as long as depositors’ withdrawals (their demand for liquidity) are stable and predictable. Banks need not keep piles of cash in their vaults equal to their total deposits because not all depositors will withdraw the full amount of their deposits on the same day. So, the bank that received the cash deposit of $100 knows from past experience that the depositor is likely to demand a cash withdrawal of only $10 on any given day. This knowledge enables the bank to operate with a fractional reserve of 10%. The lower the fractional reserve, the greater the bank’s ability to lend more money (consider the impact if a bank decided it could operate with a 5% reserve instead of one of 10%).

Central banks emerged out of fractional reserve banking. Central banks served as the banks’ bank, acting as custodian for the reserves of other banks. Initially, the banks that acted as custodians for the other banks’ reserves were commercial banks that were regarded by other banks as being particularly sound and low risk. The Bank of England, for example, began as a commercial bank but evolved into the custodian of the English banking system’s reserves owing to its reputation for prudence and its implicit support from the government. Over time, the banks that held the banking system’s reserves ceased to perform any commercial activities of their own, and other banks became their only clients. This was the pattern followed by the earliest central banks, such as the Swedish Riksbank (the oldest central bank in the world), the Bank of England, and the Banque de France. In countries in which one commercial bank did not naturally evolve into a central bank, they were established under statute, as was the case with the Federal Reserve (1913). Many central banks established in this way are still known as reserve banks (for example, the Reserve Bank of Australia or the South African Reserve Bank). Central banks assumed responsibility for controlling the growth of money and credit in the economy and, thus, the rate of inflation.

In the modern financial system, central banks operate through three main monetary policy tools: reserve requirements, open market operations, and the discount rate.

Depository institutions are required, by statute or by the central bank, to maintain a fraction of certain liabilities (usually certain categories of deposit) in reserve in specified assets (usually deposits) with the central bank. These are required reserves. The central bank can adjust reserve requirements by changing reserve ratios, the liabilities to which the ratios apply, or both. In countries where the banking system relies heavily on deposits for its funding, changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit through the multiplier process we described previously.

Historically, reserve requirements served as the main instrument of monetary policy. In recent decades, reserve requirements have fallen out of favor in many advanced economies, although they are still widely used in the emerging markets. As discussed later in this chapter, banks no longer rely as heavily on deposits as a source of funding their operations. Thus, the shift toward a market-based system of finance undermined the effectiveness of required reserves as a monetary policy tool.

Open market operations are the central bank’s purchase or sale of bonds in the open market. When the central bank purchases securities through government securities dealers, the account balances of the dealers are credited with this amount. Thus, the total amount of funds at the dealer’s banks increases by the value of securities purchased by the central bank. This will permit an increase in the money supply. An open market purchase leads to an increase of deposits in commercial banks’ accounts and hence to a growth of the money supply or the monetary base. By contrast, an open market sale leads to a reduction of deposits and reserves in commercial banks’ accounts and hence a decline in the money supply. Change...

Table of contents

• Cover image
• Title page
• Table of Contents
• Dedications
• Acknowledgments
• Copyright
• Introduction: The Global Financial System and the Problems of Regulation
• Chapter 1. The Changing Nature of Banks
• Chapter 2. Panics, Bank Runs, and Coordination Problems
• Chapter 3. Collapsing Dominos and Asset Price Spirals
• Chapter 4. The Financial Safety Net and Moral Hazard
• Chapter 5. Sources of Financial Regulation
• Chapter 6. Bank Licensing and Corporate Governance
• Chapter 7. Banks in Corporate Groups: Ownership and Affiliation
• Chapter 8. The Rationale for Bank Capital Regulation
• Chapter 9. The New Capital Adequacy Framework: Basel II and Credit Risk
• Chapter 10. The New Capital Adequacy Framework: Basel II and Other Risks
• Chapter 11. Direct Limits on Banks’ Risk Taking
• Chapter 12. Consolidated Supervision and Financial Conglomerates
• Chapter 13. Anti-Money Laundering
• Chapter 14. Bank Insolvency
• Chapter 15. Institutional Structures of Regulation
• Chapter 16. Regulation After the Global Financial Crisis
• Appendix. Introduction to Regulation and Market Failure
• Index