Bank Models & Prudential Requirements
The "prudential" requirements of a bank pertain to business practices that show discretion and sound judgment, in consideration of the risks that banks face. These are practices that are simply smart business, not necessarily required by regulations. The various banking models that are described represent common approaches to banking, which are not the only ways in which a bank can operate, but merely what seems to have worked thus far.
Bank Models
Bank models are generally based on specializations that have arisen by virtue of the way that banks do business and the kinds of client they serve. It is a survey of common types and is not comprehensive. It is also noted that few banks fall strictly into one model, and many blend various models.
Commercial Banks
In the present day, commercial banking is the norm. Their originations are in serving retailers and their suppliers, but they expanded to provide services to manufacturers and individuals. Commercial banks were the originators of checking to transfer funds between their customers and established clearinghouses to process checks and transfers of funds among banks. They are the typical "main street" banks that sprung up in most small communities.
Their typical services include holding funds (deposits) for their customers and enabling them to make withdrawals and pay by check and card, making loans to individuals and small businesses in the community, and serving as facilitators between their customers and money markets, including treasury securities and foreign exchange.
Mutual Banks and Building Societies
Mutual banks serve many of the same functions as commercial banks, the primary difference being in their organization: a mutual bank belongs to its depositors, who hold shares of ownership in the bank in proportion to their deposits. Instead of or in addition to interest on deposits, shareholders are entitled to a share of the bank's profits.
Some mutual banks are specialized around a specific practice or trade. For example, "building societies" were created to fund real estate development, lending to finance construction and to purchase property, though many have diversified to other lines of business when activity decreased in their initial line of business (e.g., many "farmers" banks provide loans and savings for non-agricultural purposes).
Investment Banks and Merchant Banks
These banks were established to finance industrial and retail operations: the building of a new factory or to finance a merchant shipping voyage. Investment banks do not offer the traditional retail banking services (maintaining accounts, issuing loans, etc.) but instead organize investment in commercial undertakings, particularly in the establishment of new corporations. The investment bank helps a company to originate and becomes the point of origin for the initial sale of shares, and may be reengaged by an existing corporation to manage a significant new issue of equities.
Rather than depositors, investment banks serve investors by selling securities, and generally broker the securities of other investment banks in addition to their own (stock brokering services, though a pure broker is not involved in creating new securities). Most individuals served by investment banks have substantial wealth to invest.
Brokerages and Trading Banks
Brokerages participate in the reselling of investments (whereas investment banks create securities) and are often focused on the investor, offering advice and planning services in addition to trading. Generally, these operations focus on the more common forms of investments (stocks and bonds) and sometimes branch into derivatives and commodities.
Private Banks
Private banks are established to provide services to high net worth individuals and families. A private bank may have only one client, though it is common for private banks to merge and serve several wealthy individuals or families. They are not open to new depositors and manage the wealth of their existing clients only.
Private banks can offer the same services as commercial ones (checking and savings accounts, time deposits, loans, foreign exchange, securities management, etc.) but are generally not interested in turning a profit from banking transactions (since it may be one person "loaning" to himself or members of a family borrowing from one another) and the revenue-generating activities they engage in are meant to preserve wealth against inflation rather than to create an income.
Islamic Banks
Islamic banks have been established to help Muslims engage in banking practices, which forbid the collection or payment of interest (Riba) and must avoid the investment of funds in any business activity that is contrary to the religious doctrine (such as businesses that sell alcohol or pork, gambling businesses, etc.).
Many of their practices mirror standard banking, but are documented in a way that is acceptable to religious practices. For example, a Muslim cannot borrow money at interest to purchase a house, nor can depositors charge interest for loaning him the money. But since there is no prohibition about selling goods at a profit, the Islamic bank can purchase the house for the client, resell it to him at a higher price, and allow him to pay for it in installments while he lives on the property. And depositors can participate as partners in the sale and receive a share of the profits (so it's not technically paying or collecting interest on a loan).
Not all Muslims are comfortable with these banks. Whether the banks are obeying Sharia law or finding sneaky ways to pretend to comply is a matter of opinion and religious faith, neither of which are subject to rational argumentation.
Development Banks
Development banks are common to areas that are undergoing industrialization and provide banking functions (primarily business financing) by very lax and often unprofitable terms. Development banks are often established by governments (who cover the losses with tax revenue) or nonprofit organizations (who cover losses with donations and grants).
The purpose of these banks is not to be successful or even sustainable as businesses, but to encourage economic development on the belief that the locale they serve will eventually become self-sustaining. When this occurs, a development bank will typically close down or transition itself into being a standard commercial bank.
Micro-Credit Banks
Micro-credit banks are similar to development banks in that they are established to contribute to economic development, but they function on a much smaller scale. A micro-credit bank may loan a small amount of money for a craftsman to purchase tools, to a farmer to buy piglets, to a weaver to purchase thread, etc. They generally serve the needs of a single individual whose need for money is short-term and for the purpose of small scale production. Because these banks finance rather poor and unsophisticated individuals, there is a great deal of effort helping them to plan and execute, instructing them in the basics of their trade, and the like.
By way of an example (Grameen Bank in Bengaldesh), the numbers look promising: these loans are made at 16% and have a 95% repayment rate. But because of the small sums and intensive oversight, it is doubtful that these banks operate at a profit, and more likely that they are mostly acts of charity. (EN: even this exemplary bank is supported by the Grameen Foundation, which solicits donations to "help the world's poorest people" to learn skills in hopes they may become self-sufficient.)
Cooperative Banks
Another banking institution in developing economies provides small-scale services in rural areas. These banks are established by individuals who have some common bond, such as working for the same employer, belonging to the same church or civic group, being in the same family or community, etc. These banks are essentially people helping others in the same community, and most of them are nonprofit organizations that require constant infusion of capital to remain solvent.
Dedicated Banks
The author mentions a "new banking genre" that has emerged for very narrow purposes, such as enabling cell-phone payments or offering pre-paid debit cards. As an emerging model, there is little standardization and a great deal of idiosyncrasy in their operations.
In some instances, they merely hold funds for their depositors and pay no interest, covering their operating expenses by charging fees or receiving income from merchants who accept payments. Some of them have sufficient capital to invest in short-term securities (treasury bills), though they may or may not share this income with their depositors.
Rationale, Objectives & Principles of Regulation
Banking operations began as entirely independent businesses, but are presently the most heavily regulated industry. This is the cumulative effect of centuries of government intrusion, usually at the demand of the public in the wake of some financial disaster caused by misconduct, or even suspicion that misconduct might occur.
While the ostensible purpose of regulation is to monitor interactions and ensure that individuals act responsibly and honor their commitments, the side-effects of regulation are to complicate and slow down the process, and to largely smother attempts to innovate or evolve the industry.
Rationale for Regulation
The financial sector plays a critical role in the modern economy, as daily life involves financial transactions, hence any malfunction in the system causes mayhem: nothing can be bought or sold except for cash-in-pocket until the payment systems are restored, payments cannot be processed, wages are not received, and virtually all commercial activity basically shuts down.
Hence, there is great interest in keeping the machinery running, and people look to their government to tend to this task because it is beyond the scope of any single company to address systemic issues. Even relatively small-scale issues, such as the malfunctioning of a single bank or the mishandling of a single transaction, are matters in which people look to their government to sort out. The author suggest six basic justifications for government intrusion into the financial system:
- Systemic Malfunction - Certain failures can affect multiple banks and financial intermediaries, and is well beyond the ability of any single firm to respond in a way that will restore the system to working order.
- Asymmetric Information - Certain people will have access to information that others do not, and can leverage this information to take advantage of the ignorance of others.
- Moral Hazard - People who handle others' money are entrusted to act on behalf of those who pay them, but often abuse the authority they have been given to serve their own interests to the detriment of their employers.
- Economies of Scale - The financial system operates most efficiently when transactions are aggregated rather than having multiple, redundant, incompatible, and idiosyncratic practices and systems
- Consumer Protection - Consumers seek the assistance of government in protecting their interests against being taken advantage of by their vendors and others who have greater knowledge and experience in financial matters.
- Supplier Protection - Those who provide money to the system seek government assistance in ensuring that their creditors repay them per the terms of the loan or investment agreement.
The Objectives of Regulation
The core objectives of regulation are to promote financial stability, ensure fairness in competition, and to protect the consumer.
By financial stability, the author means a serviceable credit facility that makes capital available to those who need it and at a price that does not fluctuate wildly. Individual banks and financial services organizations tend to their own stability and the central bank and regulatory agencies oversee the stability of the overall market.
Healthy competition means fair play among the suppliers in the market, such that no single organization has an advantage that enables them to exploit or control the others or to create artificial barriers to entry. Competition contributes to the health and stability of the financial system, and is necessary for the market to be responsive to changes in supply and demand.
Consumer protection includes shielding borrowers from unfair and fraudulent practices on the part of suppliers as well as protecting them against the failure of the system or any firm. Healthy competition does much to keep things fair for the consumer as well as suppliers, but there are many instances in which the misdeeds of one firm or one individual can be harmful to the consumer. Largely, his requires a judicial system to enforce (or nullify) agreements and a method of insuring funds on deposit.
The Principles of Regulation
The author provides a list of principles that support the three objectives:
- Efficiency - The manner in which the market is regulated should not be overly obstructive to the interaction of suppliers and customers. It is entirely possible for the cost and time of compliance with regulation exceeds the benefit gained by regulation.
- Stability - Regulators should understand that the market is a complex system and any change may cause instability that interferes with the ability of lenders and borrowers to find and interact with one another.
- Conflict Resolution - Regulation should prevent or resolve conflicts in a manner that is fair to all parties in order to avoid discouraging participation. Any firm or individual who feels they have been treated unfairly may simply leave the market, particularly if they expect similar treatment in future.
- Regulatory Structure - The structure of the regulatory system must not be obstructive. In general, it is preferable to have few (rather than many) regulatory agencies and mechanisms should be in place to prevent or resolve conflicting regulations.
- General Principles - There's a catch-all category at the end that speaks to various concerns: the cost of compliance should not be onerous and should be distributed equitably, regulatory arrangements must be flexible enough to accommodate unusual situations and permit innovation, there should be a clear purpose to having any regulation, and practitioners should have a voice in their own regulation.
Prudential Requirements
Regulation is only necessary where there is misconduct that is harmful to society, and it is unusual for government to meddle in private affairs where there are no problems (EN: this presumes a proper government that is not self-serving or corrupt). In the financial services industry, it can generally be seen that regulations are opposed in the wake of crises. Which is to say that regulation is unnecessary where individuals and organizations behave in a prudent manner. And so, the "prudential requirements" of banking are not regulations, but guidance for good behavior that, if followed, should make regulation unnecessary.
The basic ethics of banking are the same as it is for any commercial interaction: fairness among the parties involved. Legal intervention is required when a vendor has been unfair with a customer or a customer has been unfair with a vendor. The civil courts sort out specific disputes to repair the damage after the fact, and legislation follows when there is a rash of similar disputes to prevent them from occurring. Under a liberal government, legislation is always a step behind misconduct - meaning that misconduct must occur and recur before regulations are put into place.
In the financial services industry, there are three sets of recommendations to banks, referred to as the Basel Accords (Basel 1, 2, and 3 for those who need to be specific about exactly when an idea was introduced). These are essentially suggestions made by the Basel Committee of Banking Supervision, an international committee in which many of the world's governments and central banks participate. Participants voluntarily assent to comply with these non-binding agreements about the way things ought to be done, and many governments adopt their recommendations into their national laws and regulations.
There is various detail about the suggestions made in these conventions. (EN: I'm skipping it, as it seems very random and granular. There are likely better sources for a summary of the Basel Accords.)