Financial Regulation and

Supervision
Course Leader: Fahad Fahim

Course Learning
Outcome

At the end of this course the students should be

able to understand:

What is financial regulation and supervision

Why financial regulation is important

What different techniques do the regulators use to

save the financial system

Implications of Basel II on Commercial Banks

Application of Basel II on a Banks balance sheet

Allocation of economic capital to different business

units

The Foundation IRB and Advanced IRB Approaches

Various issues in implementation of the new accord

Reading List

Core text book:

Economic Capital Allocation with Basel II Dimitris N.

Chorafas

State Bank of Pakistans Guideline on Minimum

Capital Requirement

Financial Markets and Institutions, Mishkin & Eakins

Articles from Financial Services Authority (FSA)

website (www.fsa.gov.uk)

Any other reading material provided to you through

discussion board

Assessment

Students will be assessed on combination of

term project, mid term exams and final
exam as follows
Term Project

20%

Mid Term Exam

30%

Discussion and Class participation 10%

Final Exam

40%

Project will be group based

Communication

All the communication will be done through

yahoo group

Those of you who are not member of the

group please follow the link
groups.yahoo.com/group/rmiobm and join

If someone wants to get his/her individual

queries answered, write me on
fahimfahad@hotmail.com

Class Timings and

Structure

Routine classes will be on every Saturday

from 1400hrs till 1700hrs

There will be two sessions of approximately

75 minutes each with a 30 minutes break in
between

First session will be class lecture while

second session will be a workshop

Course Pre-Requisites

Clear understanding of a commercial bank

balance sheet

Good concepts of financial accounting

Can do attitude

Hard work and commitment will be your key

to success

Introduction to Financial System and

Commercial Banking
Week 1
Learning Objectives

To develop your knowledge of the terminology and definitions of modern banking and
financial markets

To develop your knowledge and understanding of financial intermediation

To develop your ability to appraise critically the relationship between banking and
financial markets and the factors driving developments affecting national and global
banking and financial markets

To develop a commands of the key definitions and terminology vital to the development
of understanding of banking and financial markets

To develop and explore your understanding of the operations and activities of the main
categories of banking institutions

To explore the distinctive nature, operations and risks of retail and commercial banking

Explain the significance of the provision of payments services by commercial banks

What is Financial
System
A financial system is an interconnected
set of different types of financial
intermediary institutions, brokers and
financial markets, dealing in funds,
securities and risk.

The Financial System

and the Economy

Modern economies can not function without a

financial system.

The more advanced the economy the more

developed its financial system.

Underdevelopment of a countrys financial

system is one of the factors explaining
differences in income levels between
countries.

The Purpose of the

Financial System

To facilitate payments within the economy

To encourage optimal savings and

consumption
decisions

To promote the productive use of funds by

business and government

To facilitate and promote cross-border trade

and financial flows

To facilitate the effective distribution and

management of risk.

The Nature of the

Financial System
What is a financial intermediary, (FI)?

An economic agent specializing

in the activities of buying and
selling (at the same time)
financial
contracts
and
services.

The Nature of the

Financial System
What is a financial market (FM)?

An organized arrangement for the

pricing and trading of funds,
securities and risk.
A financial market is defined by
its participants, and what is traded
as well as its location.

The Nature of the

Financial System

The National Financial System

Domestic Financial

Domestic Financial

Markets, FMs

Intermediaries, FIs

Global

Financial

Markets

Foreign
Exchange

Markets, FOREX

Eurocurrency

Markets

The Essentials of a
Financial System
The essential functions of a financial system are a set
of institutions, markets and arrangements for
providing the following:

A payments system

Liquidity

Monitoring and disciplining users of funds

Aggregating and allocating savings

Pricing and redistributing risk

The Range of Financial

Institutions and
Markets
Funds Management Organisations
Commercial Investment Savings
Investment
Banks
Banks
Institutions
Institutions
Payments
System +
Retail
Financial
Services

Corporate
Finance +
Securities
Trading

Retail
Savings +
Mortgages

Insurance

Pensions

Institutions

Institutions

Other

Major users of Domestic

and Global Financial
Markets

Money Markets
Capital Markets: Bond, Equity
Foreign Exchange Markets
Financial Derivatives Markets
All of the above are dependent on the payments system for their effective
operation

The Fundamental
Nature of the Financial
System

Financial systems are arrangements for trading

information and overcoming incomplete or
unverified information relating to transactions in
funds, securities and risk.

Financial institutions and markets exist because

of UNCERTAINTY and RISK.

They are arrangements for overcoming the

problems created by incomplete information and
the costs of undertaking financial transactions in
an uncertain environment.

The Fundamental
Nature of the Financial
System
The fundamental information problems relating to
financial transactions involve:

Honesty

investors preferences

borrowers preferences

uncertainty

Direct Financial
Transactions
In the absence of financial markets and intermediaries
society would suffer from low levels of savings and
productive investment because of the risks involved in
direct financial transactions between people. People
would either not save or save in the form of cash or
gold, that they kept at home, rather than lending to
others for productive use.
Households

Funds

lend
from

Firms
borrow

savings
households
Promise of payment
=
RISK

The Financial System

Financial
Intermediation
FINANCIAL INTERMEDIATION:
financial intermediaries are financial institutions that stand
between
the suppliers of funds ( surplus units/investors) and the users of
funds ( deficit units/borrowers).

They exist to overcome the problems created for both savers and
borrowers by the absence of complete information in an economy.
Incomplete information creates risk and the avoidance of risk
implies high transactions costs for individual savers and borrowers
if they deal directly with each other.

The Financial System

Financial
Intermediation

The Financial System

Financial
Intermediation
The economic benefits of financial intermediaries
derive
from:

aggregation of funds

maturity transformation

risk pooling

risk reduction

economies of scale leading to lower transactions

costs

The Financial System

Financial Markets
The alternative way of lending and borrowing is through financial
markets.
In a world of perfect information, and thus the ability to deal only
with those in whom you had perfect trust, virtually all financial
transactions would take place through financial markets. In such
an
ideal world financial intermediaries would not exist as people
would deal directly in all their saving, investing and borrowing
activities and avoid the cost of the middleman.

The Financial System and Economic

Growth and Development
Modern economies can not function without a financial
system.
An efficient financial system is essential for a high rate
of savings, investment and economic growth.
A characteristic of less developed, low income
economies, is that they have incomplete and seriously
inefficient financial systems.

Factors Determining The Nature And Speed

Of The Evolution Of The Modern Financial
System
What factors explain the main differences between the
structures of the financial systems in different
countries?
What factors determine the dynamics of financial
system evolution?
What determines the balance between FIs and FMs?

Factors Determining The Nature And Speed

Of The Evolution Of The Modern Financial
System
1. legal system. Its transparency and effectiveness of its
operation,
especially with respect to commercial contracts
2. regulatory system and philosophy of regulation.
( Nature of
the competitive process in the financial system)
3. Stage of economic development and level and
distribution
of wealth
4. Technology lower costs of information collecting and
processing
One of the factors governing the degree of innovation in the
financial system and for creating tension regarding regulatory
arrangements
5. The accounting framework, its transparency and

Commercial Banking

Types of Banking

In some countries, such as Germany, some banks undertake

both commercial and investment banking within an
integrated organization. This type of banking is termed
'universal banking'.

In some countries, commercial banks also operate as

insurance companies. This type of banking is termed
'bancassurance'.

Pure investment banks are distinguished from all other types

of bank by their lack of a branch network, and the fact that
they do not provide directly payments services.

In many developed countries today traditional commercial

banks have expanded their activities to include some
investment banking and insurance activities so that the
distinction between different types of banks is blurred.

Commercial Bank
Definitions:
Commercial banking refers to the provision of retail and
wholesale banking services to individuals and
companies. Commercial banks typically have a large
retail customer base and branch network, and do not
participate directly in the provision of investment
banking services.

Commercial Bank
Balance Sheet
Structure
TYPICAL COMMERCIAL BANK BALANCE SHEET
STRUCTURE
ASSETS

LIABILITIES

Cash
Shareholders funds
(capital)
Balances with other banks
Deposits
Investments
Market borrowings
Lending
---------------------------------------------------------------------------------------------Off Balance Sheet
Fees
Guarantees (Contingent
Claims)

The Model of the Bank

Production Process

Commercial Banking
Risk Exposure
The two main categories of risk faced in commercial banking
are:
1. Liquidity Risk = the holding of assets with longer maturity
than
deposit liabilities ( consequence of
maturity
transformation). A bank should always
have the
funds to meet liabilities when they fall
due.
2. Asset Risk = the risk that the value of a banks assets will
fall and
be less than its liabilities.

Payment System
A banking system can not function without a
mechanism or system for dealing with the inter-bank
payments resulting from the provision of payments
services for bank customers.

Payments systems have evolved over time, and

arrangements differ between countries. A key factor
affecting payments system design is the value of the
transactions involved. The key distinction is between
large value transfer systems (LVTS) and small value
transfer systems (SVTS). Virtually all banks are involved
in LVTS and such systems always include the central
bank.

Payment System
Governments and Central Banks are interested in:
1. Reliability and Safety, especially for LVTs, since the
rest of the financial system depends on the payments
system functioning effectively. That is, NBFI's and
financial markets can not function without an effective
payments system.
2. Efficiency since this affects costs the competitiveness
of the rest of the economy.
For these reasons Central Banks are promoting
electronic payments systems and real time gross
settlement arrangements.

Payment System
Commercial banks are also interested in the same two factors
1. Reliability and safety
2. Cost
Cash, cheque and electronic payments systems and services are
expensive to provide and traditionally banks in developed
countries cross
subsidized any loss making payments services from their net
interest
margin on funds in and loans made.
Increased competition for deposits and loans means that the net
interest
margin has been reduced in many countries and retail banks can
no longer
afford to cross subsidize payments services to the same extent.
For this reason, especially for SVTs, commercial banks are

Payment Services and the

Profitability of the Commercial Bank
Traditionally commercial banks made the bulk of their
profits from their net interest margin = the difference
between their cost of funds and their loans and
investments. Low or zero interest chequing accounts,
( payments services), provided a significant source of
cheap funds that could be lent out at profit. Until the
1980s in many OECD countries the profits were
sufficient to cover the cost of providing free payments
services and yield a sizeable return on capital.

Payment Services and the

Profitability of the Commercial Bank
The situation regarding the profitability of the provision
of payments services - chequing accounts has
changed in in many countries with deregulated banking
markets. Today commercial banks are faced with lower
interest margins due to increased competition from new
competitors and reduced monopoly profits from
provision of payments services.
Commercial banks have responded in several ways,
including new or increased involvement in investment
and private banking, if permitted. Fee income is now the
important source of profit. For example, in the UK,
commercial banks now generate more than 50% of their
income from fees.

The Modern Theory of Why

Commercial Banks Exist
Commercial Banks differ from all other financial intermediaries in
offering
a unique service:
Depositors can withdraw their funds in full as cash, or transfer by
order
without restriction, and are always guaranteed the full nominal
value of
their deposits.
This creates a liquidity management problem for commercial
banks and
the constraints this imposes on their balance sheet structure
appears to
reduce their profitability.

The Modern Theory of Why

Commercial Banks Exist
The modern theory of commercial banking explains the special nature
of the current or chequing account bank contract and the existence of
commercial banks offering this contract in terms of the following
factors:

Asymmetric Information ( the 'Lemons problem' )

Adverse Selection

Moral Hazard

Inside Information

Monitoring Costs

Enforcement Costs

Are Commercial Banks

Special?
Commercial Banks are special for the following reasons:

They provide the economy with its main form of payments

services

They have a special relationship with the central bank

They have inside information on customers that enables them

to select and monitor borrowers

A crisis affecting commercial banks can lead to collapse of the

economy's financial system and a major economic crisis AND
SO

THEY ARE SUBJECT TO MORE REGULATION AND SUPERVISION

THAN OTHER FINANCIAL INSTITUTIONS

Regulation of Financial
System

The financial system is among the most

heavily regulated sectors through out the
world

The government regulates the financial

system for three main reasons:

To increase the information available to the

investors

To ensure the soundness of the financial

system

To improve control of monetary policy

Increased information
available to the
investors

The regulators around the world emphasizes

on more disclosures to avoid:

Asymmetric information

Moral Hazard

Adverse Selection

Ensuring the
Soundness of Financial
Intermediaries

Asymmetric Information can lead to financial panic

Financial Panic can ultimately create a chaos among

the investor and flight to quality

To avoid such situation, the regulators normally

takes following six steps;

Restrictions on entry

Disclosure

Restrictions on Assets and Activities

Deposit Insurance

Limits on Competition

Restrictions on interest rates

Improving Control of
Monetary Policy

Because banks plays such an important role

in countrys economy, much regulations of
these financial intermediaries is intended to
improve the control over money supply

The regulators for this purpose may use the

following techniques:

Cash Reserves Requirement

Liquidity Reserves Requirements

Discount Rate