Wesleyan University – Philippines

Mabini Extension, Cabanatuan City

College of Business and Accountancy

GOVERNMENT’S
ROLE IN
BANKING
Submitted by:
Diane Clarisse P. Angeles
Aira Lynne F. Caparas
Submitted to:
Prof. Manuel Castillo
GOVERNMENT’S ROLE IN BANKING

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.

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. 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 that 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.

Objectives of Bank Regulation

The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most
common objectives are:

 prudential — to reduce the level of risk to which bank creditors are exposed (i.e. to
protect depositors)
 Systemic risk reduction — to reduce the risk of disruption resulting from adverse trading
conditions for banks causing multiple or major bank failures.
 to 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
 It may also include rules about treating customers fairly and having corporate social
responsibility.
General Principles of Bank Regulation

Licensing and Supervision

Banks usually require a banking license from a national bank regulator before they are
permitted to carry on a banking business, whether within the jurisdiction or as an offshore bank.
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.

Minimum Requirements

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.

Market Discipline

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.

Instruments and Requirements of Bank Regulation

Capital Requirement

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.

Reserve Requirement

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

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, 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.

Financial Reporting and Disclosure Requirements

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.
Credit Rating Requirement

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.

Large Exposures Restrictions

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.

Activity and Affiliation Restrictions

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.

WHY DOES THE GOVERNMENT REGULATE BANKS?

 to reduce the externalities caused by bank problems

 to keep banks small
 to prevent bank runs

 Bank run – a situation in which many depositors go to a bank at the same time to
withdraw their money.

 Contagion – the spread of a bank run from one bank to another.

• to ensure that payments flow through the banking system efficiently

 Payment system – refers to the mechanisms by which cash, checks and electronic
payments flow from buyers to sellers.

 to stabilize the money supply

Government regulation affects the financial services industry in many ways, but the specific
impact depends on the nature of the regulation. Increased regulation typically means a higher
workload for people in financial services, because it takes time and effort to adapt business
practices to ensure that the new regulations are being followed correctly.

While the increased time and workload resulting from government regulation can be detrimental
to individual financial or credit services companies in the short term, government regulations
can also benefit the financial services industry as a whole in the long term.

Government regulation has also been used in the past to save businesses that would otherwise
not survive. The Troubled Asset Relief Program was run by the United States Treasury and
gave it the authority to inject billions of dollars into the U.S. financial system to stabilize it in the
wake of the 2007 and 2008 financial crisis. This type of government intervention is typically
frowned upon in the U.S., but the extreme nature of the crisis required quick and strong action
to prevent a complete financial collapse.
The government plays the role of moderator between brokerage firms and consumers. Too
much regulation can stifle innovation and drive up costs, while too little can lead to
mismanagement, corruption and collapse. This makes it difficult to determine the exact impact
that a government regulation will have in the financial services sector, but that impact is typically
far-reaching and long-lasting.

HOW DOES GOVERNMENT REGULATION ACHIEVE ITS GOALS?

• Supervise banks to reduce externalities

• Restricts merger and bank activities to keep banks small
• Provides a federal safety net to prevent bank runs
• Offers services to ensure efficient payments
• Requires banks to hold reserves to control the money supply

GLASS-STEAGALL ACT

The Glass-Steagall Act is a law that prevented banks from using depositors' funds for risky
investments, such as the stock market. It was also known as the Banking Act of 1933 (48 Stat.
162). It gave power to the Federal Reserve to regulate retail banks. It also prohibited bank sales
of securities. It created the Federal Deposit Insurance Corporation (FDIC).

Glass-Steagall separated investment banking from retail banking.

Investment banks organize the initial sales of stocks, called an Initial Public Offering. They
facilitate mergers and acquisitions. Many of them operated their own hedge funds. Retail banks
take deposits, manage checking accounts and make loans.

PURPOSE OF GLASS-STEAGALL ACT

Glass-Steagall was enacted as an emergency response to the failure of nearly 5,000 banks
during the Great Depression. In 1933, all U.S. banks closed for four days. When they reopened,
they only gave depositors 10 cents for each dollar. Where did the money go? Many banks had
invested in the stock market, which crashed in 1929.
When depositors' found out, they all rushed to their banks to withdraw their deposits.

Even sound banks usually only keep one tenth of the deposits on hand. They will lend out the
rest because they know that normally that's all they need to keep on hand to keep their
depositors' happy. However, in a bank run, they must quickly find the cash.Today, we don't
have to worry about bank runs because the FDIC insures all deposits.

Since people know they will get their money back, they don't panic and create a bank run.

 Dual Banking System - is the system of banking that exists in the United States in which
state banks and national banks are chartered and supervised at different levels. Under the
dual banking system, national banks are chartered and regulated under federal law and
standards, and supervised by a federal agency. State banks are chartered and regulated
under state laws and standards, which includes supervision by a state supervisor.

 Charter - a document, issued by a sovereign or state, outlining the conditions under which a
corporation, colony, city, or other corporate body is organized, and defining its rights and
privileges.
 State Bank - A state bank is generally a financial institution that is chartered by a state. It
differs from a reserve bank in that it does not necessarily control monetary policy (indeed,
the state in question may have no legal capacity to create monetary policy), but instead
usually offers only retail and commercial services.
 National Bank – a commercial bank that is chartered under the federal government and is a
member of the Federal Reserve System.

DEPOSIT INSURANCE

Banks are allowed (and usually encouraged) to lend or invest most of the money deposited with
them instead of safe-keeping the full amounts (see fractional-reserve banking). If many of a
bank's borrowers fail to repay their loans when due, the bank's creditors, including its
depositors, risk loss. Because they rely on customer deposits that can be withdrawn on little or
no notice, banks in financial trouble are prone to bank runs, where depositors seek to withdraw
funds quickly ahead of a possible bank insolvency. Because banking institution failures have the
potential to trigger a broad spectrum of harmful events, including economic recessions, policy
makers maintain deposit insurance schemes to protect depositors and to give them comfort that
their funds are not at risk.
Deposit insurance was formed to protect small unit banks in the United States when branching
regulations existed. Banks were restricted by location thus did not reap the benefits coming from
economies of scale, namely pooling and netting. To protect local banks in poorer states, the
federal government created deposit insurance.

Many national deposit insurers are members of the International Association of Deposit

Insurers (IADI), an international organization established to contribute to the stability of financial
systems by promoting international cooperation and to encourage wide international contact
among deposit insurers and other interested parties.

PHILIPPINE DEPOSIT INSURANCE CORPORATION

 What is the
Philippine Deposit Insurance Corporation (PDIC)?

PDIC is a government instrumentality created in 1963 by virtue of Republic Act 3591 to insure
the deposits of all banks which are entitled to the benefits of insurance. The latest amendments
to RA 3591 are contained in RA 10846 signed into law on May 23, 2016. RA 10846 empowered
PDIC with stronger authorities to protect the depositing public and promote financial stability.
The new law also includes important provisions to ensure that the PDIC remains financially and
institutionally strong to fulfill its mandate under its Charter.

The PDIC now has the authority to help depositors have quicker access to their insured
deposits should their bank close; resolve problem banks while still open; hasten the liquidation
process for closed banks; and mete out stiffer sanctions and penalties against those who
engage in unsafe and unsound banking practices.

The PDIC is an attached agency of the Department of Finance.

 What is PDIC’s maximum deposit insurance coverage?

Effective June 1, 2009, the maximum deposit insurance coverage is P500,000 per depositor. All
deposit accounts by a depositor in a closed bank maintained in the same right and capacity
shall be added together.

Under R.A. No. 9576, the PDIC may propose to adjust the MDIC, subject to the approval of the
President of the Philippines, in case of a condition that threatens the monetary and financial
stability of the banking system that may have systemic consequences.
 CAMELS Rating System

The CAMELS rating system is a recognized international rating system that bank supervisory
authorities use in order to rate financial institutions according to six factors represented by the
acronym "CAMELS." Supervisory authorities assign each bank a score on a scale, and a rating
of one is considered the best and the rating of five is considered the worst for each factor.

1. Capital Adequacy: The capital adequacy measures the bank’s capacity to handle the
losses and meet all its obligations towards the customers without ceasing its operations.This
can be met only on the basis of an amount and the quality of capital, a bank can access. A ratio
of Capital to Risk Weighted Assets determines the bank’s capital adequacy.
2. Asset Quality: An asset represents all the assets of the bank, Viz. Current and fixed,
loans, investments, real estates and all the off-balance sheet transactions. Through this
indicator, the performance of an asset can be evaluated. The ratio of Gross Non-Performing
Loans to Gross Advances is one of the criteria to evaluate the effectiveness of credit
decisions made by the bankers.
3. Management Quality: The board of directors and top-level managers are the key
persons who are responsible for the successful functioning of the banking operations. Through
this parameter, the effectiveness of the management is checked out such as, how well they
respond to the changing market conditions, how well the duties and responsibilities are
delegated, how well the compensation policies and job descriptions are designed, etc.
4. Earnings: Income from all the operations, non-traditional and extraordinary sources
constitute the earnings of a bank. Through this parameter, the bank’s efficiency is checked with
respect to its capital adequacy to cover all the potential losses and the ability to pay off the
dividends. Return on Assets Ratio measures the earnings of the banks.
5. Liquidity: The bank’s ability to convert assets into cash is called as liquidity. The ratio
of Cash maintained by Banks and Balance with the Central Bank to Total
Assets determines the liquidity of the bank.
6. Sensitivity to Market Risk: Through this parameter, the bank’s sensitivity towards the
changing market conditions is checked, i.e. how adverse changes in the interest rates, foreign
exchange rates, commodity prices, fixed assets will affect the bank and its operations.

COMMUNITY REINVESTMENT ACT

The Community Reinvestment Act is intended to encourage depository institutions to help meet
the credit needs of the communities in which they operate, including low- and moderate-income
neighborhoods, consistent with safe and sound operations.

REDLINING

Redlining is the practice of denying services, either directly or through selectively raising prices,
to residents of certain areas based on the racial or ethnic composition of those areas. While the
best known examples of redlining have involved denial of financial services such
as banking or insurance other services such as health care or even supermarkets have been
denied to residents (or in the case of retail businesses like supermarkets, simply located
impractically far away from said residents) to result in a redlining effect.