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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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Dodd-Frank Act . Contd.
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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Dodd-Frank Act . Contd.
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