Banking and Financial Institutions 2024-2025 Handouts PDF

HANDOUTS FOR MAJOR EXAMINATION 2024-2025 FMGT55 – BANKING AND FINANCIAL INSTITUTIONS BANK REGULATIONS Bank Regulation – is a form of government regulation that subjects banks to certain requirements, restrictions, and guide...

HANDOUTS FOR MAJOR EXAMINATION 2024-2025 FMGT55 – BANKING AND FINANCIAL INSTITUTIONS BANK REGULATIONS Bank Regulation – is a form of government regulation that subjects banks to certain requirements, restrictions, and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. Objectives of Bank Regulations: 1. Prudential – to reduce the level of risk to which bank creditors are exposed (i.e., to protect depositors). It is an adjective meaning involving or showing care and forethought, especially in business. 2. Systemic Risk Reduction – to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures. 3. Avoid misuse of banks – to reduce the risk of banks being used for criminal purposes, e.g., laundering the proceeds of crime. Money laundering is the illegal process of making large amounts of money generated by criminal activity, such as drug trafficking or terrorist funding, appear to have come from a legitimate source. 4. Protect banking confidentiality 5. Credit Allocation – to direct credit to favored sectors Areas of Banking Banking regulations can vary widely across nations and jurisdictions. Some of these are: 1. Minimum requirements like maintaining minimum capital ratios 2. Supervisory review by providing directions and ensuring compliance 3. Market discipline through transparency and financial disclosure requirements 4. Reserve requirement prescribing minimum reserves to ensure liquidity 5. Corporate governance to encourage close watch on all operational aspects 6. Financial reporting and disclosure requirements to ensure accuracy and reliability 7. Credit rating requirement to provide an estimation of relative risk dealing with the bank Office of the Comptroller of the Currency (OCC) - charters, regulates, and supervises nationally chartered banks. One of the oldest federal agencies. Its main purpose is to have a safe financial system ensuring to provide a fair and transparent services and complying with the rules and regulations of the banks. Federal Deposit Insurance Corporation (FDIC) - created by the Glass-Steagall Act of 1933 to provide insurance on deposits to guarantee the safety of funds kept by depositors at banks. They prevent the run on the bank it is where customers rushed to withdraw their money immediately because of possible the bank is on the verge of failing or closing. Office of Thrift Supervision (OTS) - examines federal and many state-chartered thrift institutions, which include savings banks and savings and loan associations. It is responsible for the safety of the depositors on the thrift bank by auditing and inspections to the banks. Banking Crisis - Any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. A situation when a country’s corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time. Basel Accord This is a set of agreements for broad supervisory standards which was established in 1988, and also provided a capital measurement for banks developed by the Basel Committee on Banking Supervision (BCBS) which constitutes a series of recommendations on banking and financial regulation set forth by the Basel Committee on Banking Supervision which was later strengthened by Basel I, II and III. Basel I – The Basic Capital Accord It was first published in 1988. The Basel 1 agreement contains three layers which provide the following: Definition of equity capital which differentiated between core capital and supplementary capital Thus the global tracking of the equity capital was standardized for the first time. Determination of risk weights of bank assets (RWA) – determining the risk weights of bank assets according to their presumed credit risk, assets could be classified in one of five first classes starting from 0% which is equal to zero risk going up to a hundred percent which means high-risk. The sum of this risk weights was labeled riskweighted assets (RWA) from then on. Definition of a capital adequacy indicator- respectively the minimum requirements the banks had to maintain between capital and assets weighted by risk level. Depending on the calculation method the minimum value this indicator must be at least 8% when it expresses the total capital ratio which is tier 1 + tier 2 + tier 3 / all-risk weighted assets. This means that banks with international presents have to withhold capital equal to 8% of their risk weighted assets while a minimum of 4% has to originate from the tier one. Tier 1 Capital composed of core capital which primarily consists of common stock and disclosed reserves. Tier 2 Capital It is designated as supplementary capital and is composed of items such as revaluation reserves, undisclosed reserves, hybrid instruments, and subordinated term debt. Tier 2 Capital It is designated as supplementary capital and is composed of items such as revaluation reserves, undisclosed reserves, hybrid instruments, and subordinated term debt. Basel II - The New Capital Framework Developed to be the refined and reformed version of Basel I Accord’s work, particularly in the areas of risk and capital, and first published in 2004. The Basel II accord was based on the three pillars approach implemented through minimum capital requirements, supervisory review process and market discipline. Basel III- Global Regulatory Framework This encourages banks to operate more prudently by enhancing their capability of absorbing incident that occurred from financial and economic stress by requiring them to keep a significantly greater capital base, boosting transparency, and improving liquidity. Asymmetric Information- lacks crucial information about another party, impacting decision-making. 1. Adverse Selection- Before transaction occurs. Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan. 2. Moral Hazard- After the transaction occurs. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back. FDIC rates the banks in the basis of six characteristics (CAMELS Ratings) 1. Capital Adequacy Regulators determine the capital ratio (capital divided by assets). If banks hold more capital, they can more easily absorb potential losses. 2. Asset Quality - The FDIC evaluates the quality of bank’s assets, including its loans and securities. 3. Management - The FDIC specifically rates the bank’s management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environment The FDIC also assesses the bank’s internal control systems. 4. Earnings - A commonly used profitability ratio to evaluate banks is Return on Assets (ROA), defined as EAT or Earnings after Taxes divided by assets. Earnings can also be compared to industry earnings. As earnings are the profit that a company produces in a specific period, usually defined as a quarter or a year while industry earnings are its after-tax net income.  5. Liquidity - is a measure of the cash and other assets banks have available to quickly pay bills and meet short-term business and financial obligations. 6. Sensitivity - Regulators assess the degree to which a bank might be exposed to adverse financial market conditions or the problems before transaction. Regulators place much emphasis on a bank's sensitivity to interest rate movements. Three levels of rehabilitation as stated in RA 7653 Sec 29-33 1. Conservatorship - One appointed if the bank is in the state of illiquidity or the bank fails or refuses to maintain a state of liquidity adequate to protect its depositors and creditors. The bank still has more assets than its liabilities, but its assets are not liquid or not in cash thus it cannot pay its obligation when it falls due. 2. Receivership - One appointed if the bank is already insolvent which means that its liabilities are greater than its assets. The Court has no authority to appoint a receiver for a bank if the latter will function as such under BSP law. The power to appoint belongs to BSP. 3. Liquidation - Acts of liquidation are those which constitute the conversion of the assets of the banking institution to money or the sale, assignment, or disposition of the same to creditors and other parties for the purpose of paying debts of such institution. Main Causes of Banking Crises Bank Runs - Many customers withdraw their deposits from a financial institution at the same time due to a loss of confidence in the banks. Contagion - It is the spread of an economic crisis from one market or region to another and can occur at both a domestic or international level. Great Depression - as a severe worldwide economic depression that took place mostly during the 1930s, beginning in the United States. BANK LOAN AND CREDIT FUNCTIONS 5 C's of Credit 1. Character - refers to credit history, which is a borrower's reputation or track record for repaying debts. This information appears on the borrower's credit reports. These reports contain detailed information about how much an applicant has borrowed in the past and whether they have repaid loans on time. 2. Capacity - measures the borrower's ability to repay a loan by comparing income against recurring debts and assessing the borrower's debt-to-income (DTI) ratio. 3. Capital - represents the overall pool of assets under the name of the borrower. Its an additional security in case of unforeseen circumstances or setbacks such as unemployment. 4. Conditions - refer to the specifics of any credit transaction, such as the principal amount or interest rate. 5. Collateral - It gives the lender the assurance that if the borrower defaults on the loan, the lender can get something back. Bank Loans - are one of the most common forms of finance for small and medium-sized enterprises. Repurchase agreement (Repo) - Is a short-term loan where both parties agree to the sale and future repurchase of assets within a specified contract period. The seller sells a security with a promise to buy it back at a specific date and at a price that includes an interest payment. Reverse Repo (RRP) - is an act of buying securities with the intention of returning— reselling—those same assets back in the future at a profit. Forms of Collateral 1. Properties Putting up your property as collateral is one of the most common decisions borrowers make. This includes real estate, personal assets, cars, motorcycles, and the likes. Real estate such as house or  lot parcel is ideal because it has high value with a low risk of depreciation. Beware though that payment defaults from your end could easily lead to the loss of your property. 2. Cash secured loan An individual can take a loan from the bank where he maintains active accounts, and in the event of a default, the bank can liquidate his accounts in order to recoup the borrowed money. 3. Inventory financing This involves an inventory that serves as the basis for the release of a loan. Should a default happen, the things listed in the inventory will be sold. 4. Invoice collateral Invoices are one of the types of collateral used by small businesses, wherein invoices that are still unpaid are used as collateral. 5. Blanket liens It is a legal claim allowing a lender to dispose of the assets of a business that is in default of its loan. REPUBLIC ACT No. 9510: AN ACT ESTABLISHING THE CREDIT INFORMATION SYSTEM AND FOR OTHER PURPOSES This Act is known as the “Credit Information System Act” Signed into law by President Gloria Macapagal Arroyo on October 31, 2008 The State recognizes the need to establish a comprehensive and centralized credit information system for the collection and dissemination of fair and accurate information relevant to, or arising from, credit and credit-related activities of all entities participating in the financial system. A credit information system will directly address the need for reliable credit information concerning the credit standing and track record of borrower. REPUBLIC ACT 3765: AN ACT TO REQUIRE THE DISCLOSURE OF FINANCE CHARGES IN CONNECTION WITH EXTENSIONS OF CREDIT. This Act known as the “Truth in Lending Act” This is declared to be the policy of the state to protect its citizens from the lack of awareness of the true cost of credit to customers by assuring full disclosure of such cost and other terms and conditions with a view of preventing the uninformed use of credit. The important aspect of the act concerns the information that must be disclosed to a borrower before extending credit such as APR, term of the loan and total costs to the borrower. BANK MANAGEMENT HOW DO FINANCIAL MARKETS FACILITATE THE BANK’S STRATEGY? To implement their strategy, commercial banks rely heavily on financial markets. They rely on the money markets to obtain funds, on the mortgage and bond markets to use some of their funds, and on the futures, options, and swaps markets to hedge their risk. FINANCIAL MARKET PARTICIPATION BY COMMERCIAL BANKS Money As banks offer deposits, they must compete with offer financial institutions in the money markets market along with the Treasury to obtain short-term funds. The serve households that wish to invest funds for short-term periods.  Mortgage Some banks offer mortgage loans on homes and commercial property and therefore markets provide financing in the mortgage market. Bond Commercial banks purchase bonds issued by corporations, the Treasury, and markets municipalities. Futures Commercial banks take positions in futures to hedge interest rate risk. markets Options Commercial banks take positions in options on futures to hedge interest rate risk. markets Swaps Commercial banks engage in interest rate swaps to hedge interest rate risk. markets BANK GOVERNANCE BY THE BOARD OF DIRECTORS A bank’s board of directors oversees the operations of the bank and attempts to ensure that managerial decisions are in the best interests of the shareholders. Some of the more important functions of bank directors are: Oversee policies for changing the capital structure including decisions to raise capital or to engage in stock purchases. Determine a compensation system for the bank's executives. Assess the bank's performance and ensure that corrective action is taken if the performance is weak because of poor management. Ensure proper disclosure of the bank's financial condition and performance to investors. Oversee growth strategies such as acquisitions. Balance sheet (aka statement of condition, statement of financial position) is a financial report that shows the value of a company's assets, liabilities, and owner's equity on a specific date, usually at the end of an accounting period, such as a quarter or a year. MANAGING LIQUIDITY Bank Liquidity - Liquidity for a bank means the ability to meet its financial obligations as they come due. Liquidity Management - The acquisition of sufficiently liquid assets to meet the bank's financial obligations to its depositors. Banks are often evaluated in their liquidity. Healthy banks tend to have easy access to liquidity. 4 WAYS OF MANAGING LIQUIDITY 1. Management of Liabilities Banks have access to various forms of borrowing, such as the federal funds market. The decision regarding how to obtain funds depends on the situation. If the need for funds is temporary, an increase in short-term liabilities (from the federal funds market) may be appropriate. If the need is permanent, however, then a policy for increasing deposits or selling liquid assets may be appropriate. 2. Management of Money Market Securities Because some assets are more marketable than others, the bank’s asset composition can affect its degree of liquidity. At an extreme, banks can  ensure sufficient liquidity by using most of their funds to purchase short-term Treasury securities or other money market securities. 3. Management of Loans Since the secondary market for loans has become active, banks can attempt to satisfy their liquidity needs with a higher proportion of loans while striving for higher profitability. However, loans are not as liquid as money market securities. Banks may be unable to sell their loans when economic conditions weaken, because many other banks may be attempting to sell loans as well, and very few financial institutions will be willing to purchase loans under those conditions. 4. Use of Securitization to Boost Liquidity The ability to securitize assets such as automobile and mortgage loans can enhance a bank’s liquidity position. The process of securitization commonly involves the sale of assets by the bank to a trustee, who issues securities that are collateralized by the assets. Interest Rate Risk Management Interest Rate Risk - is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates that might result in losses or returns of the financial institutions. Interest rate risk is the potential for investment losses that result from a change in interest rates. It exists in an interest- bearing asset, such as a loan or a bond, due to the possibility of a change in the asset's value resulting from the variability of interest rates. Methods Used to Reduce Interest Rate Risk 1. hedging approach 2. Floating-Rate Loans 3. Interest Rate Futures Contracts 4. Interest Rate Swaps 5. Interest Rate Caps Managing Credit Risk Credit Risk - is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligation. Credit Risk Management - is the practice of mitigating the losses by understanding the adequacy of a borrower’s capital loan loss reserves. Five Principles for Managing Credit Risk 1. Screening and Monitoring 2. Establishment of long-term relationships 3. Loan commitments 4. Collateral and Compensating balances. 5. Credit rationing MANAGING MARKET RISK Market risk - Refers to the risk that an investment may face due to fluctuations in the market. The risk that the investment value will decrease. It is also known as SYSTEMATIC RISK the term may also refer to a specific currency or commodity. MARKET RISK FACTORS 1. EQUITY RISK The risk that the share price will change. It is often referring to equity in companies through the purchase of stocks and does not commonly refer to the risk in paying into real estate or building equity property.  2. COMMODITY PRICE RISK This is a financial risk on an entity’s financial performance/profitability upon fluctuations in the prices of commodities that are out of the control of the entity since they are primarily driven by external market forces. 3. CURRENCY RISK Currency risk, commonly referred to as exchange rate risk, arises from the change in one price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits or losses. 4. INTEREST RATE RISK It is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed income assets like bonds rather than with equity investments. The interest rate is one of the primary drivers of a bond’s price. A hedge is a strategy to reduce the risk of adverse price movements in an asset. It can be used to minimize or offset the chance that your assets will lose value. It also limits your loss to a known amount if the asset indeed does lose value. THREE COMMON USE OF HEDGE ▪ Protect Profits ▪ Mitigate Losses ▪ Portfolio Protection Foreign Exchange Risk - risk imposed on a business’ financial performance by changes in currency exchange rates. These fluctuating exchange rates can damage a business’ profitability. Three types of foreign exchange risk 1. Transaction risk: This is the risk that a company faces when it's buying a product from a company located in another country. The price of the product will be denominated in the selling company's currency. If the selling company's currency were to appreciate versus the buying company's currency, then the company doing the buying will have to make a larger payment in its base currency to meet the contracted price. 2. Translation risk: A parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, must be translated back to the parent company's currency. 3. Economic risk: Also called forecast risk, refers to when a company’s market value is continuously impacted by an unavoidable exposure to currency fluctuations. BUSINESS APPLICATIONS IN BANKING eCOMMERCE/eBUSINESS PRACTICES IN THE PHILIPPINES E-Commerce - stands for Electronic Commerce, which implies the process of carrying out trading activities through electronic devices such as computers, laptops, tablets, mobiles, and other interconnected telecommunication networks. The other transaction between the buyer and seller is electronic interaction of the parties It also refers to transactions availed through money. E-commerce includes: Online Shopping Online Ticket Booking Online Banking  Online Hotel Booking Social Networking 4 Types of E-Commerce Activities in Philippines B2C (Business to Consumer) -When a person buys a product or services online. -When you purchase goods from the supermarket, that is an example of a Business-to-Consumer (B2C) transaction. B2B (Business to Business) -When E-Commerce Website orders from suppliers or sellers to deliver to customers. -The supermarket will also need to purchase goods from its suppliers. The business transaction that takes place on this end is what we would refer to as Business-to-Business (B2B). C2C (Consumer to Consumer) -When Consumers directly trade with one another. -E-Commerce is not limited to businesses. G2B G2C (Government to Business and Government to Consumer) -When the government transacts with business or consumers online. -Government has also embraced e-commerce to serve its constituents. eBusiness E-business expands to electronic Business which implies the online presence of the business firms. It is not restricted in interaction of customers and suppliers only, indeed it encompasses the interaction with different departments of employees within the organization. It includes e-Commerce and other business activities. Advantages and Disadvantages of eCommerce and eBusiness Advantages: All time processing. Time saving. Enhanced speed and accuracy of a product. Cost saving of the product. Reduces paperwork. fast dissipation of information. Disadvantages: Lack of customer awareness. It is not free. Security problems. Customer satisfaction problems. Data integrity problems. Web content index (WCI) - Parameter used to evaluate and assess websites of commercial banks. - It is essentially based on the load or content of the website as indicated by the kind or nature information or data provided by the bank on its website. Transaction Index - An index is a method to track the performance of a group of assets in a standardized way.  NON-BANK FINANCE NBFI - Non-Banking Financial Institution refers to companies that offer financial services, but do not hold banking licenses. These institutions are not allowed to take deposits from the public. Examples of NBFI: A. Insurance B. Pension Funds C. Finance Companies D. Mutual Funds E. Government Financial Intermediation F. Securities Market Operations Types of Services offered by a Non-bank Financial Institution: Risk-pooling Institutions Contractual Savings Institutions Market makers Specialized Sectoral Financiers Financial Service Providers Insurance - Is a contract represented by a policy, in which an individual or entity receives financial protection or reimbursement against losses from an insurance company. The company pool clients’ risks to make payment more affordable for the insured. Pension funds - investment pools that pay for employee retirement commitments. Funds are paid for by either employee, employers, or both. Corporations and all levels of government provide pensions. Finance company - is an organization that makes loans to individuals and businesses. Mutual Fund - is essentially a company that collects money from different investors and then allocates them in a variety of investment options like stocks, bonds, money market instruments, and others.