cb lecture ii iii

8/10/2019 Cb Lecture II III

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LBSIM

Commercial Banking

Lecture II III

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Banking in India

Two Big Current Challenges

Financial Inclusion: Not just a challenge but

also an opportunity

NPAsGross NPAs, Net NPAs, Slippage of

Restructured Assets

Another challenge relates to providing capital

to PSBs in the context of strained fiscal position

of the GOI and the move towards BASEL III


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Financial Inclusion

Before we go to the topic for the day, i.e. the

commercial banking sector in India in the

international context, let us talk about some

of the issues involved in financial inclusion,particularly in the historical context


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What is financial inclusion

Financial inclusion is the process of ensuring

access to appropriate financial products and

services needed by vulnerable groups such as

weaker sections and low-income groups at an

affordable cost in a fair and transparent

manner by mainstream institutional players


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Initiatives across the world

Initiatives for financial inclusion have come fromfinancial regulators, governments and the bankingindustry

The banking sector has taken a lead role in promotingfinancial inclusion

Legislative measures have been initiated in somecountries

For example, in the US, the Community ReinvestmentAct (1997) requires banks to offer credit throughouttheir entire area of operation and prohibits them fromtargeting only the rich neighbourhoods.


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India has for a long time, recognized the social and

economic imperatives for broader financial inclusion

Starting with the nationalization of banks, priority sector lending

requirements for banks, lead bank scheme, establishment of

regional rural banks (RRBs), service area approach, self- help

group-bank linkage programme, etc. multiple steps have been

taken by the Reserve Bank of India over the years to increaseaccess to the poorer segments of society.

It has encouraged expansion of bank branches, especially in rural

areas, resulting in more than ten-fold increase in branch network

from around 8,000 in 1969 to 111,778 as of December 2013 ,

spread across the length and breadth of the country, including40,245 urban (including 19039 in metropolitan centres), 29,909

semi-urban, and 41,624 rural branches


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Recent steps taken by RBI Opening of no-frills accounts

Relaxation on know - your- customer (KYC) norms Use of technology

Adoption of EBT (Electronic Benefits Transfer)

General Credit cards & Kisan Credit cards

Simplified branch authorization

Opening of branches in unbanked rural centres

Road map for providing banking services in unbankedvillages

Drawing up Financial inclusion plans of banks Engaging business correspondents (BCs) & Banking

Facilitators (BFs)


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Business Correspondents (BCs)

Under the 'Business Correspondent' Model, NGOs/ MFIs set up under

Societies/ Trust Acts, Societies registered under Mutually AidedCooperative Societies Acts or the Cooperative Societies Acts of States,

section 25 companies, registered NBFCs not accepting public deposits and

Post Offices may act as Business Correspondents.

In engaging such intermediaries as Business Correspondents, banks should

ensure that they are well established, enjoying good reputation and havingthe confidence of the local people. Banks may give wide publicity in the

locality about the intermediary engaged by them as Business

Correspondent and take measures to avoid being misrepresented.

In addition to activities listed under the Business Facilitator Model, the

scope of activities to be undertaken by the Business Correspondents willinclude (i) disbursal of small value credit, (ii) recovery of principal /

collection of interest (iii) collection of small value deposits (iv) sale of micro

insurance/ mutual fund products/ pension products/ other third party

products and (v) receipt and delivery of small value remittances/ other

payment instruments.


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Commercial Banks

The International Context


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Commercial Banks in US: An Introduction

Banking industry simultaneously consolidating anddiversifying

Traditional definition of banks blurred on account ofintroduction of new products and wave of mergers

Historically, a commercial bank accepted demand depositsand made commercial loans

Now these two products are offered by commercial banks aswell as savings banks, credit unions, companies, investmentbanks, finance companies, retailers, and pension funds

Changes in the regulatory and competitive environments have

essentially eliminated some of the erstwhile differencesbetween financial institutions

Today the real difference between an investment bank and acommercial bank is as to who the regulator is

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Historical Bank Regulation

Definition of Commercial BankAccept demand deposits (non interest

bearing checking accounts) and make

commercial loans.Glass Steagall Act of 1933 created 3

separate industries: Commercial

Banking, Investment Banking andInsurance, in order to separatecommerce from banking

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Historical Bank Regulation .. contd. Limitations on:

Geographic Scope: The McFadden Act of 1927had limited the geographic market of banking byallowing individual states to determine the extentto which a bank could branch within or outside its

home state Products and Services: The Bank Holding Act of

1956 specifically limited the scope of activities acompany could engage in if it owned a bank

Consequently, USA developed a banking systemwith a large number of small banks, with a limitedlist of products and services, and competingwithin a narrow geographic area


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Rationale for the Restrictions

The legal restrictions on branching and range

of permissible activities and products were

designed to promote a safe and sound

banking system


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Branching and Interstate Expansion

Until the passing of the Riegle-Neal Act in1994, branch banking was controlled by the

states, who limited branches to help retain

deposits in local communities and the

provide local bank ownership andmanagement

Branching restrictions had however created

a banking system in which there was nobank with a coast-to-coast presence until

the merger of Nations Bank and Bank of

America in 1998 15


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Financial Products and Services:

Major Providers functions until the late 70s

On the liabilities side:

Until the late 70s, Banks were the only firms

allowed to offer demand deposits (checking

accounts). While thrifts and credit unions also offered

savings accounts, they (along with banks)

were subjected to maximum interest ratesthey could pay on savings accounts

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Major Providers functions until the

late 70s contd. On the asset side:

Banks focused on commercial lending,

thrifts (savings and loan associations/mutual savings

banks) on mortgage lending, and

another set of thrifts (credit unions) on consumer loans

Regulations similarly limited the rates that the banks,

thrifts and credit unions could charge on their primary

loans Investment Banks like J P Morgan underwrote stocks &

bonds and provided brokerage services

Insurance companies underwrote insurance products


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Changes that came about from late 70s onwards

New products & technology allowed investment banks to

circumvent regulations restricting their banking activities In late 70s, Merrill Lynch, basically a securities brokerage

company, effectively created money market mutualfunds as an alternative to demand deposits. Customerscould write cheques against their balances and the

accounts paid interest. Money market funds grew rapidlydrawing funds from traditional banks

Various lending institutions opened Loan ProductionOffices across states but avoided bank regulation as they

did not accept demand deposits While such products were direct substitutes for banks

traditional product lines, banks were at that point oftime, not allowed to offer these.

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Changes that came about from late 70s onwards contd.

Exceptional returns from stock markets during

the 90s, made people move their money toequity MFs

While Investment Banks were regulated only by

the SEC and had few restrictions, Banks did nothave the freedom, given the Glass Steagall Actand the Bank Holding Company Act

Thus, the 80s and 90s saw a mass movement of

customers away from the banks to investmentcompanies


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Goals and Functions of Bank Regulation

Prior to the establishment of the Federal Reserve System in

US in 1913, the private banks operated free of closegovernment scrutiny.

The frequency of abuses and large number of failed banks

during the depression forced the federal government of the

US to redesign its regulatory framework, encompassingdeposit insurance and close supervision, to:

Ensure the Safety and Soundness of Banks

Provide an Efficient and Competitive Financial System

Provide Monetary Stability Maintain the Integrity of the Payments SystemFedwire, etc.

Protect Consumers from Abusesdisclosure of APR (annual

percentage rate) inc. fees

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What do the regulators focus on during their examinations?

The regulators assess the overall quality of a banks condition

according to CAMELS system The primary focus of the regulators is on asset quality,

management and market risk

The term CAMELS stands for:

Capital

Asset Quality

Management Quality

Earnings Quality

Liquidity

Sensitivity to Market Risk

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Banks Charters: Federal & State

Individual states as well as federal government issue

new bank, saving bank, and credit union charters

New Federal Charters (Various authorities)

Office of the Comptroller of the Currency

Charters national banks Office of Thrift Supervision

Charters federal savings and loan associations

National Credit Union Administration Charters federal credit unions

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Office of the Comptroller of the Currency

The OCC was established in 1863 as a bureau of the

U.S. Department of the Treasury The OCC is headed by the Comptroller, who is

appointed by the President

The Office of the Comptroller of the Currency (OCC)charters, regulates, and supervises all national banks

It also supervises the federal branches and agenciesof foreign banks

National bank examiners supervise domestic andinternational activities of national banks and performcorporate analyses


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New State Charters: Various Authorities

State Banking Authorities Charter state banks

State Savings Authorities

Charter state savings banks State Credit Union Authorities

Charter state credit unions

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National versus State Charter: Joining the Fed

National banks must join the Fed

Primary regulator is the Office of the Comptroller ofthe Currency (OCC), the authority which charters

national banks

State banks may join the Fed

The primary regulator of insured state banks that

are members of the Fed is the Federal Reserve

The regulator of insured Non-Fed member state

banks is the FDIC

Non-insured non-members are supervised by the

state banking authorities

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Besides being the insurer FDIC is also the receiver of

failed institutions

Federal Deposit Insurance

Depositors are currently insured up to $100,000 peraccount per insured bankwas temporarily hiked to$250,000, during the meltdown in the last decade

Original limit in 1933 was $5,000 FDIC maintains the deposit insurance fund at 1.25%

of insured deposits.

Currently, the fund is well-funded and over 90% of

banks pay no insurance premium Historically the regulators have not allowed large

institutions to fail so that uninsured depositors havereceived de facto 100% deposit insurance

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The Federal Reserve System

Fundamental Functions

Conduct monetary policy

Provide and maintain the payments

system Supervise and regulate banking

operations

Organization Board of Governors

12 Federal Reserve District Banks

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Federal Reserve Bank Regulations

Fed has issued regulations concerningmost aspects of banking business -

Regulation A to Z; AA, BB onwards

Equal credit opportunity, Truth inlending, truth in saving, Community

reinvestment, Fair credit reporting are

among the important regulations

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Feds Consumer Protection Regulations

Reg. B

Equal Credit Opportunity

Cannot discriminate on the basis of sex, race,

marital status, religion, age, or national origin.

Reg. Z Truth-in-Lending

Requires disclosure of:

Effective interest rates, total interest paid,total of all payments

Why credit was denied

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Federal Reserve System: Monetary Policy Tools

Open Market Operations/Change discount rate

Open market purchases (sales) increase(decrease) liquidity

Decreasing (Increasing) the discount rate(represents the interest rate that the banks

pay the Fed on their borrowings) makes bankborrowing less (more) expensive

Reserve Requirements

Decreasing (Increasing) reserverequirements increases (decreases) themoney supply

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Bank Holding Companies (BHC)

One-Bank Holding CompaniesMutli-Bank Holding Companies

A BHC is essentially a shell organization

that owns and manages subsidiaryfirms

Any organization that owns controlling

interest in one or more commercial

banks is a BHC

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Financial Holding Companies

Can engage in financial activities not

permitted in a bank or bank holding

company

Federal Reserve may not permit a bank

holding company to convert to a financial

holding company if the bank holding

company is not well capitalized, well

managed, or did not receive a satisfactoryrating on its most recent CRA exam (CRA

stands for Community Reinvestment Act)

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Mergers and Consolidations

Mergers must be approved, dependent on the

classification of the surviving bank

OCC approves national bank mergers

State member banks by the Federal Reserve

State non-member banks by the FDIC The community Reinvestment Act (CRA) passed

in 1977, prevents a bank from acquiring

another institution if the parent receives a poor

CRA evaluation, i.e. the bank is not doing

enough to insure that its credit and services are

available to all members of the defined

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Motivation for mergers and consolidation

Cut costs

Improve profitability

Increase competitiveposition

Cross-sell financial products& services

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Recent Trends in Federal Legislation & Regulation

Key Federal Legislations: 1994 - 2000 Riegle Neal Interstate Banking and

Branching Efficiency Act of 1994 (effectivelyallowed banks to locate offices anywhere inthe country/permitted adequatelycapitalized and managed bank holdingcompanies to acquire banks in any state-

unless the state legislature opted out)

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Key Federal Legislation: 19942000 contd.

Gramm-Leach-Bliley Act of 1999 opened up

the market between banking, investmentand insurance companies. It repealedGlass-Steagall Act and modified the BankHolding Company Act to create a newFinancial Holding Company authorized toengage in underwriting & selling insuranceand securities, conducting both commercial

& merchant banking, investing anddeveloping real estate and other activitiescomplementary to banking


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Key Federal Legislation: 20012010

USA Patriot Act of 2001 (anti money-laundering/terrorism)

Sarbanes-Oxley Act of 2002 (accountingreform and investor protection)

DoddFrank Wall Street Reform andConsumer Protection Act, July 2010(discussed later in detail)


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Deposit Insurance Reform issue

Too Big to FailShould $100,000 insurancelimit be permanently

increased?

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Fundamental Forces of Change

Deregulation/Re-regulation

Financial Innovation

Securitization (process of converting assets

into marketable securities)

Globalization

Advances in Technology(These are discussed in the next few slides)

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Securitization

A bank originates assets, combines them into pools and sells

them through pass-thro-certificates, which are secured by

interest and principal payments on the original assets

Residential mortgages and mortgage backed pass-thro-

certificates served as the prototype

The originating bank charges fees for making the loans. If it

services the loans, it collects interest and principal payments,

which it passes thro to the certificate holders less a fee

If the bank sells the certificates without recourse, it is

permitted to take the original assets off its books

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Impact of Nonbank Competition

General Finance Companies

Fund their loans by issuing commercial paper and

long-term bonds. Their cost of funds is higher

than a banks, but they charge higher rates.

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Competition for Payments Services

Credit Cards Debit Cards

Prepaid Cards

CHIPSa bank owned competitor to FEDWIRE

ACH: Automated Clearing Housean electronic

system for financial transactions in the US

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Deregulation and Re-regulation

Deregulation

Eliminating existing restrictions

Re-regulation

Implementing new restrictions on bankingactivities

The cycle continues

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Globalization and Technology

Globalization

Is the evolution of markets and institutions where

geographic boundaries do not restrict financial

transactions or competition

Advances in Technology Advances in technology increase the scope of the

global market place and competition

Do we not need global regulations?

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Dodd Frank Wall Street Reform and


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DoddFrank Wall Street Reform and

Consumer Protection Act, July 2010

The Act is categorized into sixteen titles

The stated aim of the legislation is to:

1. promote the financial stability of the United States

by improving accountability and transparency in the

financial system

2. end "too big to fail

3. protect the American taxpayer by ending bailouts

4. to protect consumers from abusive financial

services practices, and

5. serve other purposes


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Dodd-Frank Act . Contd.

The Act changes the existing regulatory structure, such as

creating a host of new agencies (while merging and removing

others) in an effort to streamline the regulatory process,

increasing oversight of specific institutions regarded as a

systemic risk, amending the Federal Reserve Act, promoting

transparency, and additional changes.

The Act establishes rigorous standards and supervision to

protect the economy and American consumers, investors and

businesses, ends taxpayer funded bailouts of financial

institutions, provides for an advanced warning system on thestability of the economy, creates rules on executive

compensation and corporate governance, and eliminates the

loopholes that led to the economic recession.


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The new agencies are either granted explicit power over a

particular aspect of financial regulation, or that power istransferred from an existing agency.

All of the new agencies, and some existing ones who are not

currently required to do so, are also compelled to report to

Congress on an annual (or biannual) basis, to present theresults of current plans and to explain future goals.

Important new agencies created include:

Financial Stability Oversight Council

Office of Financial Research, and Bureau of Consumer Financial Protection


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Of the existing agencies, changes are proposed ranging from new

powers to the transfer of powers in an effort to enhance the

regulatory system.

The institutions affected by these changes include most of the

regulatory agencies currently involved in monitoring the financial

system (FDIC, SEC, Comptroller of the Currency, Federal Reserve,the Securities Investor Protection Corporation, etc.), and the

elimination of the Office of Thrift Supervision

Certain Non-bank financial institutions and their subsidiaries will

be supervised by the Fed in the same manner and to the sameextent as if they were a bank holding company

Fi i l S bili & R h


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Financial Stability & Research

Title I of the Act outlines two new agencies tasked

with monitoring systemic risk and researching thestate of the economy and clarifies the

comprehensive supervision of bank holding

companies by the Federal Reserve

Title I creates the Financial Stability Oversight

Council (FSOC) and the Office of Financial Research

The two new offices are attached to the Treasury

Department, with the Treasury Secretary being Chairof the Council, and the Head of the Financial

Research Office being a Presidential appointment

with Senate confirmation.


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Financial Stability Oversight Council (FSOC)

The Council is tasked with identifying risks to the financial

stability of the United States, promoting market discipline, andresponding to emerging threats to the stability of the United

States financial markets

Specifically, there are three purposes assigned to the Council:

1. identify the risks to the financial stability of the United Statesfrom both financial and non-financial organizations

2. promote market discipline, by eliminating expectations that

the Government will shield them from losses in the event of

failure

3. respond to emerging threats to the stability of the US financial

system


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10 Voting members of FSOC

Secretary of the Treasury (chairs the Council)

Chairman of the Federal Reserve

Comptroller of the Currency

Director of the Bureau of Consumer Financial Protection

Chairperson of the SEC

Chairperson of the FDIC

Chairperson of Commodity Futures Trading Commission

Director of the Federal Housing Finance Agency

the Chairman of the National Credit Union AdministrationBoard

an independent member (with insurance expertise),

appointed by the President, with the advice and consent of

the Senate, for a term of 6 years

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