Bank regulation

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 factors 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.

Objectives

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

Banking regulations vary widely between jurisdictions.

Licensing and supervision

Bank regulation is a complex process and generally consists of two components:
* licensing, and
* supervision.
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.

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

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, 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:
* to be a body corporate (i.e. not an individual, a partnership, trust or other unincorporated entity)
* to be incorporated locally, and/or to be incorporated under as a particular type of body corporate, rather than being incorporated in a foreign jurisdiction
* to have a minimum number of directors
* to have an organizational structure that includes various offices and officers, e.g. corporate secretary, treasurer/CFO, auditor, Asset Liability Management Committee, Privacy Officer, Compliance Officer etc. Also the officers for those offices may need to be approved persons, or from an approved class of persons
* to have a constitution or articles of association that is approved, or contains or does not contain particular clauses, e.g. clauses that enable directors to act other than in the best interests of the company (e.g. in the interests of a parent company) may not be allowed.