Chapter Two Banking Background

Who is in charge of the banks? Germany: Federal Supervisory Authority (BaFin) France: Banking Commission Switzerland: Federal Banking Commission Japan: Financial Services Agency U.S.: Federal Reserve, individual states, FDIC, OCC and S&L Association U.K.: Up until 2012 the Financial Services Authority (FSA) but now the Bank of England’s Financial Conduct and Prudential Regulatory Authorities. China: the People’s Bank of China India: Reserve Bank of India

Types of Bank Central Bank Commercial Bank Merchant/investment banks Savings banks Cooperative banks Mortgage banks Giro banks and national savings banks Credit unions Islamic banks

Types of Bank (cont.) Commercial banks are in the classic business of taking deposits and lending money, it includes retail banking and wholesale banking In many European countries (France, Germany, Italy, Austria, the Netherlands and Spain), there are banks that do not have outside shareholders but are ‘mutually’ owned in some way. These are the savings banks and cooperative banks

Types of Bank (cont.) The term clearing bank is applied to the banks most involved in the system for clearing cheques. They will be the large domestic banks who are heavily into retail banking State or public bank refers to banks owned by the state that are not central banks but carry out some public sector activity. State-owned post offices or national savings banks, for example

A Bank’s Balance Sheet Three Key Sources: Shareholders’ equity plus additions from retained profit Deposits (the largest figure) Borrowings (for example a bond issue).

A Bank’s Balance Sheet (cont.) Banks list assets (i.e.; what its money is spent on) in descending order of liquidity: Cash Balances at the central bank Money at call and short notice Bank and trade bills of exchange Treasury bills Securities Advances to customers Premises and equipment.

A Bank’s Balance Sheet (cont.) Its liabilities (i.e.; where its money comes from) would be: Ordinary share capital Other share capital Reserves Retained profits Provisions against losses Bond issues Customers’ deposits Other borrowing Trade creditors Tax.

Summary Balance Sheet ASSETS LIABILITIES Cash Shareholders’ funds Money market funds Deposits Other securities Borrowings Lending

The Creation of Credit Banks’ credit creation has several implications: 1. A reminder that banking depends on confidence 2. Governments and central banks will want to control it in view of the implications for inflation and imports 3. Banks will need internal controls called ‘liquidity ratios’ 4. An external control enforced by bank supervisors called ‘capital ratio’ is required.

Capital Ratio Regulation The G10 nations, together with Luxembourg, set up the Committee on Banking Regulations and Supervisory Practices to draw up uniform rules. The committee meets at Basel in Switzerland under the auspices of the Bank for International Settlements (BIS), and is known as the Basel committee

Capital Ratio Regulation (cont.) The ‘best’ capital is called ‘tier 1’ and must be at least half the necessary figure. It consists of: Shareholders’ equity Retained profits Noncumulative perpetual preference shares ‘Tier 2’ capital is the remainder and would include: Cumulative perpetual preference shares Revaluation reserves Undisclosed reserves Subordinated term debt with maturity in excess of five years The minimum capital ratio itself is 8% and applied from 1 January 1993

Risk weighting example Assets Value Risk Risk weighted $m weighting % value ($m) Cash 50 0 — T-bills Mortgages Loans 1, ,000 Total 1,650 1,260 Tier 1 required capital must be 4% × $1,260m = $50.4m Tier 2 required capital must be 8% × $1,260m = $100.8m

Capital Ratio Regulation (cont.) Basel II updates: The use of credit ratings The use of banks’ internal statistical models The EU’s Capital Adequacy Directive (CAD) Two possibilities to meet the new requirements: Find more capital Reduce assets