Chapter Two

Banking Backgroun

d

Who is in charge of the banks?Germany: Federal Supervisory Authority (BaFin)France: Banking CommissionSwitzerland: Federal Banking Commission Japan: Financial Services AgencyU.S.: Federal Reserve, individual states, FDIC,

OCC and S&L AssociationU.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 ChinaIndia: Reserve Bank of India

Types of BankCentral BankCommercial BankMerchant/investment banksSavings banksCooperative banksMortgage banksGiro banks and national savings banksCredit unionsIslamic 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 SheetThree 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:CashBalances at the central bankMoney at call and short noticeBank and trade bills of exchangeTreasury billsSecuritiesAdvances to customersPremises and equipment.

A Bank’s Balance Sheet (cont.)Its liabilities (i.e.; where its money comes from)

would be:Ordinary share capitalOther share capitalReservesRetained profitsProvisions against lossesBond issuesCustomers’ depositsOther borrowingTrade creditorsTax.

Summary Balance SheetASSETS LIABILITIES

Cash Shareholders’ funds

Money market funds DepositsOther securities BorrowingsLending

The Creation of CreditBanks’ credit creation has several

implications:1. A reminder that banking depends on confidence2. Governments and central banks will want to control it in view of the implications for inflation and imports3. Banks will need internal controls called ‘liquidity ratios’4. An external control enforced by bank supervisors called ‘capital ratio’ is required.

Capital Ratio RegulationThe 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’ equityRetained profitsNoncumulative perpetual preference shares

‘Tier 2’ capital is the remainder and would include:Cumulative perpetual preference sharesRevaluation reservesUndisclosed reservesSubordinated term debt with maturity in excess of five

years

The minimum capital ratio itself is 8% and applied from 1 January 1993

Risk weighting exampleAssets Value Risk Risk weighted

$m weighting % value ($m)Cash 50 0 —T-bills 100 10 10Mortgages 500 50 250Loans 1,000 100 1,000Total 1,650 1,260

Tier 1 required capital must be 4% × $1,260m = $50.4mTier 2 required capital must be 8% × $1,260m =

$100.8m

Capital Ratio Regulation (cont.)Basel II updates:

The use of credit ratingsThe use of banks’ internal statistical models The EU’s Capital Adequacy Directive (CAD)

Two possibilities to meet the new requirements:Find more capitalReduce assets