BWBB2013

BANK MANAGEMENT

TOPIC 2
BANK REGULATIONS AND
COMPLIANCE

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 Why are Banks Regulated?

 Banks are the most highly regulated industry

 Highly regulated due to:
 The characteristic of banks
 The function they play in the economy

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 Bank Characteristics
 Highly leveraged
 Debt account for 90% of bank funding
 Main source of funds - deposits
 Opaque
 Asymmetry information problem is crucial in banking
 Inadequate or weak competition between banks
 Ability to create spill over or contagion effects to the other
industries and the whole economy

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 Bank Functions
 Intermediary functions between surplus unit and deficit unit
 Source of funding especially in the developing countries
 Payment systems
 Monitor and supervise firms and economic sectors

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 Objectives of Banks Regulation
1. Prevention of economic disruption
2. Guard against deposit insurance losses
3. Social goals

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 Prevention of Economic Disruption
 Reduce the risk of large-scale failures that would adversely affect
the level of economic activity

 To control the supply of money and credit in order to achieve a

nation’s broad economic goals

 The smooth functioning of the economy is dependent on the money

supply, the payments system, and an uninterrupted flow of credit

 Banks products such as checkable deposits, savings deposits

and time deposits are components of the money supply

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 Cont…
 Banks are the primary source of liquidity for other financial
institutions and are the “transmission belt” for the
implementation of monetary policy
 Thus, a safe and sound banking system is essential to a nation’s
monetary system and financial marketplace
 Systemic risk
 Failure in a bank would affect other banks and economy as a
whole

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 Guard Against Deposit Insurance Losses
 Bank – debtors
 Creditors – depositors and shareholders
 The largest number of creditors are small depositors
 Not capable of evaluating the financial condition of banks or
monitoring their actions
 Thus, it is in the public interest to protect small depositors
by having their deposits insured by a government agency

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 Cont…
 The deposit insurance agency represents the depositors
and the public’s interest to ensure that banks operate in
a sound fashion
 If bank failures are large enough to exhaust the deposit
insurance fund, the taxpayers will be called on to repay
depositors

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 Social Goals
 To promote an efficient and effective banking system that
finances economic growth, impartially allocates credit, and
meets the needs of the customers and communities that banks
serve
 To ensure equal opportunity and fairness in the public’s access
to credit and other vital financial services
 Banks cannot discriminate against borrowers on the basis of
race, gender, age, and other factors

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 Cont…
 Borrowers must be judged on the basis of their
creditworthiness, and banks must supply borrowers with
accurate information about the cost of borrowing
 To avoid concentrations of financial power in the hands of a
few individuals and institutions
 To provide the government with credit, tax revenues and
other services
 To help the priority sectors (housing, small business,
agriculture etc)

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 Cont…
 To avoid concentrations of financial power in the hands of
few individual and institutions
 To provide the government with credit, tax revenues and
other services
 To help sectors of the economy that have special credit needs
(such as SME, agriculture and other priority sector)

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 What Bank Regulators Do?
Four primary responsibilities:
1. Chartering
2. Regulating
3. Supervising
4. Examining

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 1. Chartering
 Regulator must determine whether the proposed bank :
 have adequate capital and proper management for its
respective market area
 take into account the needs and convenience of the
community, competition and other factors

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 2. Regulate
 Bank regulation – “the formulation and issuance by authorized
agencies of specific rules or regulations, under governing law for
the structure and conduct of banking”
 Bank supervision – concerned primarily with the safety and
soundness of individual banks, and involves general and continuous
oversight to assure that banks are operated prudently in accordance
with applicable statutes and regulations

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 3. Supervise
 Exercise by regulators to ensure that bankers comply with banking
regulations
 Bank examinations are one means of evaluating compliance
 Techniques to deal with banks not compliance with rules and
regulations:
 Memorandum of understanding (MOU)
 Detailing the changes that must occur to put the bank back in
good standing
 Cease and desist orders
 Prohibit the bank from continuing a particular course of
conduct
 Close the bank
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 In 1997, there was a shift towards a risk-based supervision
whereby more focus were given to areas of high risk which
threatened the soundness of the banking institutions.
 The risk-based supervision places emphasis on two main
elements;
 a dynamic off-site surveillance for early detection of
problems in the banking institutions
 an effective planning to customize on-site examinations to
suit the size, activities and risk profiles of the banking
institutions (Bank Negara Malaysia, 1999).

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 4. Examination
 Part of the supervisory process
 Two types of examination:
1. To determine the safety and soundness of the bank
 Commonly use the Uniform Financial Institutions
Rating System known as CAMELS
o Capital Adequacy
o Asset Quality
o Management
o Earnings
o Liquidity
o Sensitivity to market risk

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 Cont…
 Capital Adequacy
 Refers to amount of regulatory capital that banks are required to
maintain
 Asset Quality
 Reflects the risk associated with managing assets including the quality
of loans and investments
 Management
 Assesses to the capability of the board of directors and management’s
ability to measure, monitor and control risk

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 Cont…
 Earnings
 Indicates the profitability of the bank and sources of those earnings
taking risk into account
 Liquidity
 Represent the bank’s ability to meet its financial obligations when they
come due, and the needs of their customers (deposit withdrawals and
loans)
 Sensitivity to market risk
 Interest rates, foreign exchange, and the ability of the bank to manage
that risk

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 Cont…
2. To determine whether the bank is in compliance with all
relevant regulations and laws

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 Laws & Regulations in Malaysian Banking
The levels of Malaysian Banking System legislature can be
summarized as follows:
 Level 1: Central Bank of Malaysia Act 2009
 Level 2: Financial Services Act 2013 & Islamic Financial Services
Act 2013
 Level 3: Regulations, guidelines, notices and directions issued by
Bank Negara Malaysia (BNM)
Example: BNM Guidelines and Circulars
Foreign Exchange Administration (FEA) rules

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 Laws & Regulations in Malaysian Banking
 Level 4: Other Legislations and Regulations
Example: - Anti-Money Laundering and Counter Terrorism
Financing Act 2001
- Companies Act 1967
- National Land Code 1965
- Capital Market Regulations
- Malaysian Financial Reporting Standards
- Contracts Act 1950
- Hire Purchase Act 1967
- Personal Data Protection Act 2010, etc…
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 Laws & Regulations in Malaysian Banking
 The regulations of banking industry in Malaysia comprise:
1. The Financial Services Act 2013 (FSA 2013) & The Islamic Financial
Services Act 2013 (IFSA 2013); and
2. Supporting legislation such as the Companies Act 1965

 The Central of Malaysia – Bank Negara Malaysia (BNM) – is the

principal regulatory agency responsible for enforcing FSA 2013
and IFSA 2013.

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 FSA 2013 and IFSA 2013
 Financial Services Act 2013 (FSA) and Islamic Financial Services Act 2013
(IFSA) came into force on 30 June 2013.
 The FSA and IFSA is the culmination of efforts to modernize the laws that
govern the conduct and supervision of financial institutions in Malaysia.
 The FSA: to provide for the regulation and supervision of financial
institutions, payment systems and other relevant entities and the oversight
of the money market and foreign exchange market to promote financial
stability and for related, consequential or incidental matters
 The FSA amalgamates several separate laws to govern the financial sector
under a single legislative framework for the conventional financial sector,
namely,
BAFIA 1989,
Insurance Act 1996,
Payment Systems Act 2003, and
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Exchange Control Act 1953
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 FSA 2013 and IFSA 2013
 The IFSA has repealed the following laws:
Islamic Banking Act 1983
Takaful Act 1984
 One of the key features of both the FSA and IFSA is to provide
UNIFORM legislations for the governance and supervision of
financial institutions.
 One of the safeguards introduced by the FSA is the prohibitions
of deposit-taking by any person or organization except by parties
licensed under the Act.

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 FSA 2013
 Broadly, the FSA 2013 covers:
 Authorization and registration of authorized businesses,
registered businesses and representative offices.
 Prudential requirements, which specify, among other things, the
power of BNM to set standards on prudential matters, banking
compliance requirements and single counterparty exposure
limit.
 Rules related to the ownership, control and transfer of licensed
business.
 Business conduct and consumer protection standards.
 The money market and foreign exchange market.
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 FSA 2013
 Broadly, the FSA 2013 covers:
 Prohibited business conduct
 Secrecy and permitted disclosures relating to customer
information in financial institutions
 BNM’s powers of investigation, supervision and control of
financial services business.

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 Key Features of the New Legislation:
 Greater clarity and transparency in the implementation
and administration of the law. Clearly defined regulatory
objectives and accountability of Bank Negara Malaysia in
pursuing its principal object to safeguard financial
stability, transparent triggers for the exercise of Bank
Negara Malaysia's powers and functions under the law,
and transparent assessment criteria for authorizing
institutions to carry on regulated financial business, and
for shareholder suitability;

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 Key Features of the New Legislation:
 A clear focus on Shariah compliance and governance in
the Islamic financial sector. In particular, the IFSA
provides a comprehensive legal framework that is fully
consistent with Shariah in all aspects of regulation and
supervision, from licensing to the winding-up of an
institution;

 Provisions for differentiated regulatory requirements

that reflect the nature of financial intermediation
activities and their risks to the overall financial system;

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 Cont
 Provisions to regulate financial holding companies and
non-regulated entities to take account of systemic risks
that can emerge from the interaction between regulated
and unregulated institutions, activities and markets. The
Minister of Finance may subject an institution that
engages in financial intermediation activities to ongoing
regulation and supervision by Bank Negara Malaysia if it
poses or is likely to pose a risk to overall financial
stability;

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 Cont
 Strengthened business conduct and consumer
protection requirements to promote consumer
confidence in the use of financial services and products;

 Strengthened provisions for effective and early

enforcement and supervisory intervention

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 BNM General Guidelines for Financial Institutions
 BNM/GP1 (Revised): Guidelines on Corporate Governance for
Licensed Institutions
 BNM/GP2: Guidelines on Submission of Annual Accounts has
been superseded by:
BNM GP/8 (Revised): Guidelines on Financial
Reporting for Licensed Institutions.
 BNM/GP3: Guidelines on the Suspension of Interest on Non-
Performing Loans and Provision for Bad and Doubtful Debts

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 BNM General Guidelines for Financial Institutions
 BNM/GP4: Guidelines on Staff Training Fund
 BNM/GP5: Guidelines on the Credit Limit to a Single
Customer
 Guidelines on Credit Transactions and Exposures with
Connected Parties (replaced BNM/GP6: Guidelines on
Prohibition of Loans to Directors, Staff and their Interested
Corporations)
 BNM/GP7: Guidelines on the Code of Conduct of Directors,
Officers and Employees in the Banking Industry

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 BNM General Guidelines for Financial Institutions

 BNM/GP8 (Revised): Guidelines on Financial Reporting for

Licensed Institutions
 UPW/GP1: Standard Guidelines on Anti-Money Laundering
and Counter Financing of Terrorism
(Replaces BNM/GP9: Guidelines on Money
Laundering and “Know Your Customer Policy”)
 GP10: Guidelines on Minimum Audit Standards for Internal
Auditors of Financial Institutions
 BNM/GP11: Guidelines on Consumer Protection on Electronic
Fund Transfers
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 Instruments of Monetary Control
1. Money Market Operations
 Can be conducted either through
 borrowing or lending by BNM in the interbank
market or
 the usual open market operations, which are
transacted mainly via the sale and purchase of
government securities and other papers either
directly or through repurchase agreements

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 Cont…

 The scope for an active open market operations has been constrained
by the limited availability of the Government papers (Government
securities, Treasury bills and Government Investment Issues)
 With the limited supply of papers, the role of open market
operations has been largely used for providing discount window
facility to the banking institutions as a last resort in times of liquidity
needs

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 Cont…
2. Statutory Reserve Requirement (SRR)
 One of the oldest monetary instruments for BNM
 Is a monetary policy instrument available to BNM for
purposes of liquidity management
 Also served as an instrument to deal with
fundamental changes
 Banking institutions are required to maintain a certain
percentage of their reserves with BNM in the form of
cash reserves

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  SRR continues to remain an effective monetary policy
instrument in Malaysia
 This is attributed to several factors:
 Disintermediation of funds away from the banking system is
not pervasive
 Total deposits placed with the banking system accounted
for about 87% of deposits placed with the financial
system
 High share of bank loans (82%) of the total financial
system
 SRR is imposed solely for monetary purposes, and not for
income to either the Government or BNM

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3. Centralization of deposits with Bank Negara Malaysia
 In order to ensure that the Government does not
accumulate its deposits unnecessarily with the banking
institutions, Bank Negara Malaysia has required the
Government and Employees Provident Fund (EPF) to
deposits certain percentage of their cash in Bank Negara
Malaysia.
 Bank Negara Malaysia will manage the Government’s
money, consistent with the desired interest rate level and
underlying excess liquidity conditions.

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  During a tight liquidity situation, Bank Negara Malaysia will
recycle this money into the banking system as a temporary
measure to stabilize the banking institutions ensure
consistency in operations of the Government and the EPF
with monetary stance.

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 4. Selective credit and administrative measures
 BNM influences the credit situation of the country
through several policies on bank lending.
 Guidelines on lending are such as lending to priority
sectors (i.e., small and medium business sector,
agriculture sector, manufacturing sector etc), hire-
purchase guidelines on motor vehicles and guidelines
on credit cards spending.
 If implemented over a protracted period, may affect
efficient allocation of resources

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 Limitations of Regulations
1. Moral hazard
 the safety net arrangements provided by the central banks
creates moral hazard behavior among banking institutions
 The safety net arrangements such as deposit insurance
systems and lender-of-last-resort facilities which was
intended to protect the interests of banks’ customers,
banking system and the economy as a whole cause the
banks’ customers to take for granted on the safety of their
money in the banks.
 the safety net arrangements induce opportunistic and self-
serving behavior

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 2. Agency capture
Banking regulations can create the problems of agency
capture;
 a situation where the regulatory process is captured by
banks and other financial institutions to be used in their
own interest rather than the interest of the banks’
customers.
 For example, there are arguments that the Basle Capital
Accord has had too much input from banking sector
participants and large banks in particular.

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 3. Costs of compliance
 as banking institutions have to comply with all rules and
regulations imposed on them, it would create an additional
cost for the banks.
 however, banks would not bear the cost of compliance alone
but would pass on to bank customers which would result in
higher costs of banking services and possibly less
intermediation business.
 the costs of compliance to the regulations may act as a
barrier to entry to the market and this may create a
monopoly position in the banking industry.

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 Impact of bank regulation on the banking
institutions
Positive impacts of banking regulations on the banking
institutions
1. Increase bank performance
 Tight regulations on bank entry, restrictions on bank
activities and regulations that inhibit the freedom of
bankers to conduct their business boost the banks’ net
interest margin
 Banking regulations increase banks’ performance by
reducing corruptions and increase the banks’ cost
efficiency
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 2. Reduce bank risk taking
 Bank regulations are designed to curb excessive risk taking
by the banking institutions and, thereby reduce the prospect
of credit, liquidity and solvency problems
3. Good corporate governance
 Banking regulations would increase accountability,
transparency and skill level of the management of the
banking institutions.
 The bank management will be under greater scrutiny, thus
would have to focus more on improving their efficiency and
competitiveness.

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 Negative impacts of banking regulations to the banking
institutions
1. Reduce competition among banks
 Banking regulations limit competition in the banking
industry as all banking activities, investments, services
offered or take over and acquisition need to have an
approval from the regulator
2. Reduce innovations in banking products
 Specialization in banking activities (i.e., commercial
banking – conduct retail banking activities; investment
banking – wholesale banking activities) products (i.e., only
commercial banks can offer current account to bank
customers) and services reduce innovations among the
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banking institutions.