MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF Session: FIFTEEN

Revision session 2

BASEL II 3

Basel II Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. 4

Basel II (Contd.) Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. 5

Basel II (Contd.) In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. 6

The accord in operation Basel II uses a "three pillars" concept – – minimum capital requirements (addressing risk), – supervisory review and – market discipline. 7

Basel II and the global financial crisis The role of Basel II, both before and after the global financial crisis, has been discussed widely. While some argue that the crisis demonstrated weaknesses in the framework, others have criticized it for actually increasing the effect of the crisis. 8

Basel II and the global financial crisis (Contd.) In essence, they forced private banks, central banks, and bank regulators to rely more on assessments of credit risk by private rating agencies. Thus, part of the regulatory authority was abdicated in favor of private rating agencies 9

Policy goals of Regulation It is commonly understood that financial regulation should be designed to achieve certain key policy goals, including: (a) safety and soundness of financial institutions, (b) mitigation of systemic risk, 10

Policy goals of Regulation (Contd.) (c) fairness and efficiency of markets, and (d) the protection of customers and investors. 11

SECTION 3

The Four Approaches to Financial Supervision While no two jurisdictions regulate financial institutions and markets in exactly the same manner, the current models of financial supervision adopted worldwide can, as already noted, be divided into four categories: (a) the Institutional Approach, (b) the Functional Approach, (c) the Integrated Approach, and (d) the Twin Peaks Approach. 13

1. The Institutional Approach The Institutional Approach is one of the classical forms of financial regulatory oversight. It is a legal-entity-driven approach. 14

CASE-Example-China (Contd.) Under the previous regulatory structure, all financial supervision was consolidated within the People’s Bank of China, which is China’s central bank. Through a series of reforms over the past 25 years, China has moved to an Institutional Approach, where the banking, securities, and insurance sectors are supervised by separate agencies. 15

2. The Functional Approach Under the Functional Approach, supervisory oversight is determined by the business that is being transacted by the entity, without regard to its legal status. Each type of business may have its own functional regulator. 16

CASE-Example-France France also has a regulatory oversight model that can best be described as a Functional Approach, although, like Italy, there is some allocation of functions that closely resembles the Twin Peaks Approach. Financial services oversight was reformed in France in 2003 with the goal of improving efficiency of the regulatory system. 17

3. The Integrated Approach Under the Integrated Approach, there is a single universal regulator that conducts both safety and soundness oversight and conduct-of- business regulation for all the sectors of the financial services business. 18

3. The Integrated Approach (Contd.) This model has gained increased popularity over the past decade. It is sometimes referred to as the “FSA model” because the most visible and complete manifestation is the Financial Services Authority (FSA) in the United Kingdom. 19

CASE-Example-The United Kingdom A jurisdiction that exhibits the key facets of the Integrated Approach to regulation is the United Kingdom (U.K.). The impetus for the move to the Integrated Approach was the recognition that major financial firms had developed into more integrated full-service businesses in the U.K. and elsewhere in the 1990s. 20

CASE-Example-The United Kingdom (Contd.) The FSA regulates and supervises almost all financial services businesses in the U.K., including banking, securities, and insurance, on a prudential basis and as regards conduct- of-business activities. 21

CASE-Example-The United Kingdom (Contd.) Thus, the FSA is responsible for both safety and soundness of financial institutions and conduct- of-business regulation. 22

4. The Twin Peaks Approach The Twin Peaks Approach is based on the principle of regulation by objective and refers to a separation of regulatory functions between two regulators: one that performs the safety and soundness supervision function and the other that focuses on conduct-of- business regulation. 23

4. The Twin Peaks Approach (Contd.) Under this approach, there is also generally a split between wholesale and retail activity and oversight of retail activity by the conduct-of- business regulator. This is also viewed by some as supervision by objective. 24

CASE-Example-Australia Since 1997, following a review of its system of financial services regulation, Australia has organized its oversight responsibilities under a Twin Peaks Approach that separates prudential regulatory oversight from conduct- of-business regulation. 25

CASE-Example-Australia (Contd.) The Australian Prudential Regulatory Authority (APRA) regulates deposit-taking institutions, which include banks, building societies, credit unions, and insurance companies and large superannuation (retirement pension) funds. 26

CASE-Example-Australia (Contd.) APRA is responsible for dealing with institutions that are unable to meet their obligations, and it does this in close cooperation with the Reserve Bank of Australia (RBA), the Australian central bank, which is available to provide liquidity support if necessary. 27

Over-regulation While the economic rationale of financial regulation is well-established there is, nevertheless, an ever-present potential to overregulate and in the process impose avoidable costs on the system and on the suppliers and consumers of financial services. 28

Over-regulation (Contd.) There is almost an inherent tendency towards over-regulation because regulatory and supervisory services are not provided through a market process but are imposed externally. The consumer has no choice with respect to the amount of regulation he/she is prepared to pay for. This means that regulation has a cost but not a price. In which case consumers will rationally perceive regulation to be a free good and hence will over-demand it. 29

Over-regulation (Contd.) If this is coupled with a risk-averse regulator (who is blamed when there are regulatory failures but not praised when there are not), it is almost inevitable that over-regulation will emerge as it will be both over-demanded and over-supplied. 30

Universal functions The basic functions performed by regulatory agencies are universal and cover ten main areas: 1.prudential regulation for the safety and soundness of financial institutions; 2.stability and integrity of the payments system; 31

Universal functions (Contd.) 3.prudential supervision of financial institutions; 4.conduct of business regulation (i.e. rules about how firms conduct business with their customers); 5.conduct of business supervision; 6.safety net arrangements such as deposit insurance and the lender-of-last-resort role performed by the central bank; 7.liquidity assistance for systemic stability, i.e. liquidity assistance for solvent institutions; 32

Universal functions (Contd.) 8.the handling of insolvent institutions; 9.crisis resolution, and 10.issues related to market integrity. 33

Role of the central bank While it is universally agreed that the central bank has a major responsibility for maintaining systemic stability, the definition and legal authority for this is often blurred. Financial stability usually refers to the risks to the financial system as a whole and the integrity of the payments system. 34

Role of the central bank (Contd.) Irrespective of what role, if any, is assigned to the central bank with respect to the prudential regulation and supervision of financial institutions, it is universally the case that the central bank is the agency responsible for – the stability of the payments system, – liquidity assistance to markets and – solvent institutions, and – systemic stability. 35

Governance Structure of State Bank of Pakistan

The governance framework of State Bank of Pakistan (SBP) is specified in the State Bank of Pakistan Act, 1956 amended at times to make it more autonomous. The Act provides for an independent Central Board of Directors and empowers it with general superintendence and direction of affairs and business of the Bank.

Governance Structure of State Bank of Pakistan (Contd.) The governor is the chairperson of the Central Board and manages the affairs of the Bank on its behalf. Except for the governor, all directors of the Central Board are non-executive.

Governance Structure of State Bank of Pakistan (Contd.) The committees constituted by the Central Board comprises of non-executive directors and representatives from the management. They carry out comprehensive review and analysis of the various proposals before these are taken to the Central Board.

Governance Structure of State Bank of Pakistan (Contd.) There are also some management committees to deliberate upon the issues before taking any decision on them, including Corporate Management Team (CMT) which is the apex management committee.

Central Board of Directors The Central Board of Directors consists of the governor, secretary finance and seven non- executive directors, including one director from each province, nominated by the federal government ensuring representation from Agriculture, Banking and Industrial sectors.

Corporate Secretary Corporate secretary plays a key role to ensure timely provision of relevant information to all the directors for review before meetings. Corporate secretary also records important discussions and all decision taken by the Central Board for compliance.

Committees of the Central Board The Central Board has constituted five specific committees comprising directors and representatives from the management to carry out comprehensive review and analysis of various proposals before these are taken up by the Central Board. The composition and functions of various committees are :

i) Committee on Audit (Contd.) The committee assists the Board in fulfilling its responsibilities relating to SBP’s financial statements, auditing, accounting, reporting processes, the systems of internal controls and corporate governance. The committee meet at-least five to six times during the year.

ii) Committee on Investment (Contd.) The purpose of the committee is to assist the Board in performing its responsibilities of investing and managing foreign exchange reserves. The mandate of the committee includes recommending, for Board’s approval, the strategy and policy for investment of the foreign exchange reserves and approving operational guidelines.

ii) Committee on Investment (Contd.) Similarly, the committee performs reviews on continued appropriateness of the approved investment policy and its benchmarks and guidelines. The committee meets as and when required.

iii) Committee on Building Projects (Contd.) The committee provides assistance to the Board in fulfilling its responsibilities relating to monetary approvals for construction of Bank’s buildings, their maintenance and matters pertaining to acquisition/disposal of assets.

iii) Committee on Building Projects (Contd.) The committee is also empowered to approve projects up to a limit of Rs. 50 million and, in case of projects involving a total cost of more than Rs.50 million, the committee’s recommendations are placed before the Board for approval.

iv) Committee on Human Resources (Contd.) The committee assists the Board in management of human resources. It reviews all the proposals requiring the approval of the Central Board regarding revision, modification or interpretation of HR policies and accordingly submits its recommendation to the Board.

v) Committee on Monetary and Credit Policies (Contd.) The committee assists the Board in carrying out its responsibilities relating to monetary and credit policies especially review of Monetary Policy Statements before approval by the Board.

Management Structure Governor: The governor, being the chief executive officer, directs and controls all affairs of the Bank.

Management Structure (Contd.) Heads of Clusters: After restructuring and reorganization of State Bank of Pakistan, four separate clusters were formed, which are: 1.Banking Cluster 2.Monetary Policy & Research Cluster 3.Financial Market & Reserve Management Cluster 4.Corporate Services Cluster

Management Structure (Contd.) Each of these clusters is headed either by a deputy governor or an executive director/adviser, who is in-charge of the management of day-to-day affairs.

Management Structure (Contd.) In addition to the office of the corporate secretary, following specialized offices are also reporting directly to the governor. 1.External Relations Department 2.General Counsel’s Office 3.Risk Management and Compliance Department 4.Internal Audit & Compliance Department

Other Major Management Committees: In addition to above discussed committees of the board, the following committees have been also established to further strengthen management of the Bank: 1.Monetary Policy Committee 2.Investment Committee 3.Banking Policy Committee 4.Business Continuation Plan Committee

SBP SUBSIDERIES 1.Banking Services Corporation 2.National Institute of Banking and Finance (NIBAF) The governor SBP is the chairperson of Boards of both the subsidiaries.

Core Functions of State Bank of Pakistan (Contd.) Under the State Bank of Pakistan Order 1948, the Bank was charged with the duty to "regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in Pakistan and generally to operate the currency and credit system of the country to its advantage". 57

Core Functions of State Bank of Pakistan (Contd.) The scope of the Bank’s operations was considerably widened in the State Bank of Pakistan Act 1956, which required the Bank to "regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to securing monetary stability and fuller utilization of the country’s productive resources". 58

Core Functions of State Bank of Pakistan (Contd.) The changes in the State Bank Act gave full and exclusive authority to the State Bank to regulate the banking sector, to conduct an independent monetary policy and to set limit on government borrowings from the State Bank of Pakistan. 59

Core Functions of State Bank of Pakistan (Contd.) Like a Central Bank in any developing country, State Bank of Pakistan performs both the traditional and developmental functions to achieve macro-economic goals. The traditional functions, which are generally performed by central banks almost all over the world, may be classified into two groups: 60

Classification of Core Functions (a) the primary functions including issue of notes, regulation and supervision of the financial system, bankers’ bank, lender of the last resort, banker to Government, and conduct of monetary policy, and 61

Classification of Core Functions (Contd.) (b) the secondary functions including the agency functions like management of public debt, management of foreign exchange, etc., and other functions like advising the government on policy matters and maintaining close relationships with international financial institutions. 62

Classification of Core Functions (Contd.) The non-traditional or promotional functions, performed by the State Bank include development of financial framework, institutionalization of savings and investment, provision of training facilities to bankers, and provision of credit to priority sectors. 63

Classification of Core Functions (Contd.) The State Bank also has been playing an active part in the process of islamization of the banking system. 64

Main Responsibilities of The State Bank The main functions and responsibilities of the State Bank can be broadly categorized as under. 1.Regulation of Liquidity 2.Ensuring the soundness of financial system 3.Exchange rate management and balance of payments 65

DEVELOPMENTAL ROLE OF STATE BANK The responsibility of a Central Bank in a developing country goes well beyond the regulatory duties of managing the monetary policy in order to achieve the macro-economic goals. This role covers not only the development of important components of monetary and capital markets but also to assist the process of economic growth and promote the fuller utilization of a country’s resources. 66

DEVELOPMENTAL ROLE OF STATE BANK (Contd.) The Bank’s participation in the development process has been in the form of rehabilitation of banking system in Pakistan, development of new financial institutions and debt instruments in order to promote financial intermediation, establishment of Development Financial Institutions (DFIs), directing the use of credit according to selected development priorities, providing subsidized credit, and development of the capital market. 67

THANK YOU