“ALWAYS TWO THERE

ARE, NO MORE, NO

LESS”

Ukrainian Banking Forum October 2014

A bank is a financial intermediary

High leverage Mismatched assets and liabilities

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The nature of banking-inherent instability

The business of banking has a number of attributes which have thepotential to generate instability.

(a) High gearing (or “leverage”) results from banks’ financialintermediation between depositors and borrowers; by comparisonwith the generality of industrial and commercial companies, abank’s capital is small in relation to the size of its balance sheet.Therefore, any loss can have a profound effect on the bank’sviability.

(b) Typically, the term structures of assets and liabilities arefundamentally mismatched, with assets tending to have a longermaturity than liabilities - again a virtually inevitable consequenceof the role of the banks as intermediaries.

(c) Flowing from these observations, a bank’s solvency depends onits ability to retain the confidence of both its depositors and thefinancial markets or institutions on which it may rely for funding.

(d) Sometimes, the lack of transparency in published financialstatements hinders, or even defeats, counterparties’ efforts atrational analysis of a bank’s strengths and weaknesses; banks’balance sheets and off-balance sheet positions can change morerapidly than industrial and commercial companies’, andcustomers’ knowledge of their banks is inevitably imperfect.

Wider considerations

Although, as noted above, the focus of supervision is the individualbank, with the aim of limiting the risk to depositors, the safety andsoundness of the banking system as a whole is so critical to the properfunctioning of the economy, that supervisors must also be concernedabout the possible wider, “systemic” implications of problems or failuresin individual banks.

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BASIC PRINCIPLES OF BANKING SUPERVISION

1 Why supervise banks?

Banks and their activities are generally subject to much closerofficial supervision than other kinds of businesses; what is it about theirrole and nature which justifies this?

The role of banks

The economic and financial life of a country depends on banks inthree important respects.

(a) They occupy a central place in the payments mechanism forhouseholds, government and business.

(b) They accept deposits, which are widely regarded as “money”;which are expected to be repaid in full, either on demand or attheir due term; and which constitute part of society’s financialassets.

(c) Banks in market economies play a major role in the allocation offinancial resources, intermediating between depositors of surplusfunds and would-be borrowers, on the basis of active judgementsas to the latter’s ability to repay. This is in marked contrast topractice under conditions of central planning, where banks wouldtypically act merely as passive conduits for the distribution offunds, without the necessity to make credit decisions.

The primary justification for banking supervision is to limit the riskof loss to depositors, and by so doing to maintain public confidence inbanks. And while supervision naturally focusses on the individual bank,supervisors must also be alert to the possibility that problems in oneinstitution may have wider, systemic repercussions on others, or on theintegrity of the payments system.

Banking supervision

1. Capital adequacy

2. Liquidity

3. Asset quality

4. Risk concentration

5. Management/Shareholders

6. System of controls

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The conventional supervisory response is to limit exposures to singlecounterparties, or groups of counterparties, to the equivalent of someproportion of the bank’s capital base; the European Union, for example,imposes a limit of 25 percent. In addition, the total of all the bank’s largeexposures (in the EU case, any exceeding 10 percent of capital) isconstrained to a multiple of capital base.

Two aspects of the control of large exposures merit particularmention. First, the banks may face practical difficulties in identifyingthose exposures which should be aggregated and treated as one for thispurpose, because linkages between borrowers may not always be obvious.Larger banks may face an additional problem in collating data onexposures throughout their entire networks.

Secondly, there is the question of exposures to parties related to thebank itself. Such parties will include shareholders, directors and theirassociates as well as subsidiary and affiliated companies of the bank.There will be concerns that such exposures may be entered into on termsmore favourable than other customers receive, not least when industrial orcommercial undertakings own the bank. For this reason, it is commonpractice to subject the totality of exposures to related parties to the samelimit as a single exposure to an unrelated one.

Risk concentration may figure as a concern in other aspects of abank’s business than its assets. For example:

(a) Funding, if individual deposits are large and volatile, or if fundscome from a narrow range of sources.

(b) Profits, if income derives from a small number of transactions oractivities, as opposed to showing diversification.

(c) Product range, if over-specialisation occurs.

(d) Type of collateral, if a high proportion of loans are made againsta particular kind of collateral, a reduction in the value of whichcould impact on many otherwise unrelated borrowers.

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(e) Operational risk - the risk of a failure in the bank’s procedures orcontrols, whether from external causes or as a result of error orfraud within the institution.

(f) Ownership/management risk - the risk that shareholders, directorsor senior management might be unfit for their respective roles, oractually dishonest.

Any banking risk is heightened if it appears in concentrated form -for example through large exposures to single or related counterparties,industrial sectors, countries or currencies.

4 Key prudential issues

Capital adequacy

A bank’s capital is required as a cushion to absorb losses, whichshould be borne by shareholders rather than depositors, and to finance theinfrastructure of the business. The importance of capital adequacy isindicated by the development of an internationally accepted measure bythe Basle Committee on Banking Supervision1 in 1988, based on what isknow as the “risk asset” approach.

This approach defines the elements of capital for supervisorypurposes, allocates weights to different broad categories of asset (eggovernment securities, loans to banks, customer advances) and expressescapital as a percentage of total risk-weighted assets. A simplifiedcalculation is given in Appendix 1. A minimum result of 8 per cent is

1 The Committee consists of senior representatives of bank supervisory authorities and centralbanks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands,Sweden, Switzerland, United Kingdom and the United States.

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principle be identical; examples include reconciliation of nostroaccount statements with the bank’s own records, and of dealers’profit and position figures with those generated in the backoffice.

(c) Segregation of duties (perhaps the oldest and most fundamentalcontrol in banking) limits the scope for staff fraud by makingsuccessive steps in a process the responsibility of differentindividuals or departments; a key example is the completeseparation of dealing activities from the supporting confirmationand settlement tasks performed in the back office.

The role of an internal audit department is clearly an importantaspect of systems and controls. Supervisors will expect it to have clearand appropriate terms of reference, independence from line management,a direct reporting line to the board and to be adequately resourced.

5 Basis for an effective supervisory system

An effective supervisory system rests on: legislation relating tobanking and its supervision; the supervisory regime itself; and anappropriate legal and accounting environment.

It should be noted that various parts of the financial sector, otherthan banks, may also be subject to supervisory regulation of one form oranother. Attention may therefore need to be given to possible overlaps orgaps in regulation; to questions of consistency and fairness across thefinancial sector; and to the justification for any gradations of treatment asbetween different classes of institution. This Handbook is, however,concerned only with the supervision of banks, so does not address thoseother issues, important though they are.

Banking legislation

Legislation must first define which institutions are to be regarded as“banks”. One approach is to define a bank in terms of taking deposits

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authority to levy administrative fines on institutions which itjudges to have breached its requirements.

(d) Provision for the supervisory authority to exercise consolidatedsupervision over the world-wide activities of banks incorporatedin its jurisdiction has become increasingly important with theinternationalisation of banking. This is so because, following theissuance of minimum standards by the Basle Committee onBanking Supervision in 1992, supervisors in a growing numberof countries will refuse to licence branches or subsidiarycompanies of banks incorporated in countries whose supervisoryauthorities are not capable of performing supervision on aconsolidated basis.

The supervisory regime

It is for national consideration whether licensing and supervisionshould be entrusted to the central bank or to some other agency. In eitherevent, it is most important that the supervisory authority be independent ofpolitical or other outside pressure, so that its decisions can be made onobjective supervisory grounds. It is equally important that there shouldbe a mechanism by which the supervisory authority is accountable togovernment or parliament for the discharge of its duties. Precise questionsconcerning the statutory position of the supervisor and the balancebetween independence and accountability are, however, beyond the scopeof this Handbook.

Within the statutory criteria, licensing procedures should be rigorousand carefully applied; supervisors everywhere are conscious that tolicence in haste can be to regret at leisure. Licensing decisions, andequally those to remove or restrict a licence, should be made in aframework which pays due regard to natural justice and provides for thoseaffected to have the right to comment on, and appeal against, adversedecisions.

Historically, some countries have favoured on-site examination asthe core of their supervisory approach, while others have preferred toemploy off-site surveillance. A growing consensus holds that a

“It always seemed to me that success in business and in life should result from your impact on the people you touch - whether you enriched their lives or diminished them.”

While bad profits don’t show up on the books, they are easy to recognize. They are profits earned at the expense of the customer relationship.

“ALWAYS TWO THERE

ARE, NO MORE, NO

LESS”