Chapter Four

Regulation of Financial
System
Introduction
 The financial sector play the following role in the
economy
 FI are responsible for enormous amount of investors’
money
 They run the payment system upon which a modern
economy is crucially dependent
 The financial sector is the major employer and can be a
significant foreign exchange earner for the country.
 The financial sector is in charge with the crucial role of
allocating financial capital to its most productive use.
Introduction
 The government, as agent of the public has major
interest in the operations of the FIs
 For these reasons, the government have consistently
intervened to regulate and control the activities
of FIs
 Some Facts that induce regulation
1. Large portion of bank loans are either
originated by government agencies or carried
government guarantees
 EX : There are government loan programs for small
businesses, for housing, for exports, and for a host of other
worthy causes.
Some facts (Cont’d)
2. There are (were) Financial failures everywhere:
 In 1990s crises in financial institutions have rocked
Chile, Hong Kong, Malaysia, and many other
economies.
 This crises resulted into the slow down of world
economy and were result of poor government
regulations
 The financial institutions lent money on projects that
could not generate adequate return-negative returns were
extremely highly risky.
 This shows that FIs failed to allocate resource to the
activities of highest return
 Market Failure
 A market is to fail if it cannot, by itself,
maintain all the requirements for a competitive
situation.
 Financial market regulation is justified because
the market mechanisms of competition and
pricing could not manage without help.
 The financial crises of the world are believed to be
the result of market failures.
 Market Failure-Cont’d
 The competitive markets theories are based on the
premise that there is perfect flow of information in
the market.
 But in reality there is imperfect flow of information.
 For example, investors (buyers of securities) and the
management of the firms (sellers) have unequal opportunity
to information about:
 Solvency of the FIs
 Financial and operating performance results
 Management and its philosophy
 Government intervention is rationalized on the
grounds of Market failure-that is, left to itself the
market would produce a sub-optimal outcome.
 The following are some of the frequently cited

failures requiring intervention to correct (Keith p

434):
1. The externalities problem
2. The problem of asymmetric information
3. The moral hazard problem
 1. Rational- Externalities Problem
 It is a cost or benefit which affects a party who did
not choose to incur that cost or benefit.
 The Financial system provides a payment
mechanism for the entire economy and FIs play
a pivotal role of linking both users and lenders
of funds.
 This means that problem in the Financial sector can
potentially have a disastrous effect on the entire
economy.
2. Rational- Problem of Asymmetric Information
 The problem of asymmetric information

 The Principal-agent Problem(where one party, called an

agent, acts on behalf of another party, called the
principal.
 The agent usually has more information about his or her
actions or intentions than the principal does, because the
principal usually cannot completely monitor the agent.
 The agent may have an incentive to act inappropriately
(from the viewpoint of the principal) if the interests of
the agent and the principal are not aligned.)
 Rational- Problem of Asymmetric Information
 In the context of a corporate entity, asymmetric information
means investors and managers are subject to uneven access to or
uneven possession of information.
 The mgt and directors of a company as well as FIs have more
information than the investors (suppliers of fund) on:
 Soundness of the company
 Its likely policies
 This could lead to problems such as insider-trading (the
trading of a public company’s stock or
other securities(such as bonds or stock options) by
individuals with access to non-public information
about the company.
 In various countries, insider trading based on inside
information is illegal.
 This is because it is seen as unfair to other investors
who do not have access to the information. )and the
concealment of relevant information from investors
 Asymmetric information may lead to the principal and agent
problem.
 Managers and directors are agents of shareholders and investors
(principals).
 There is potential problem that the directors and managers
could pursue their own interest at the expense of the
shareholders and investors.
 For this reason the following regulations are necessary:

 Regulation on Obliging companies to make public a great

deal of financial information to potential and actual
investor( disclose information )on the financial
performance of the company and are subject to rules on
their own dealings
 3. Rational- The moral hazard Problem
 The moral hazard problem ( is a situation where a party
will have a tendency to take risks because the costs that
could result will not be felt by the party taking the risk.
 In other words, it is a tendency to be more willing
to take a risk, knowing that the potential costs or
burdens of taking such risk will be borne, in whole
or in part, by others.)
 By moral hazard we mean that an insurance against an
event occurring will make the event more likely to
occur than if the event was not insured against.
 For example, a deposit insurance protection
scheme will guarantee investors their funds but
a deposit taking institution will get into
difficulty.
 However, this may encourage depositors to
channel more of their funds into risky FIs
which are more likely to run into problems and
thereby lead to a higher loss of deposit than
the case no deposit protection insurance policy
exists.
Some facts (cont’d)..

3. The stock market is, first and foremost, a

forum in which individuals can exchange
risks.
 Itaffects the ability to raise capital, but in the
end, (unless is monitored) it is perhaps
more a gambling casino than a venue in which
funds are being raised to finance new ventures
and expand existing activities.
Objectives of Government Regulation

 The government is responsible for the following

activities:
 Consumer protection
 Ensuring bank solvency

 Improving macroeconomic stability

 Ensuring Competition

 Stimulating growth

 Improving the allocation of resources

Objectives of Government Regulation- Ctd

 Governments have many objectives when intervening

in the financial Markets.
 These include:
a. Promoting financial stability
b. To provide protection for investors against fraud or the
dissemination of misleading or inadequate information.
 Example of Fraud:
 Deliberate manipulation of share prices
 The concealment of crucial information from investors
 The sale of inappropriate policies
 Insider trading
 The misuse of investors’ funds
Objectives of Government Regulation- Ctd

c. Desire to promote fair and healthy competition to

ensure competitive price for consumers
d. To control the activities of FIs in order to exert
some degree of control over the level of economic
activities, particularly with respect to monetary
policy.
Types of Government Regulations (Fabozzi
,Keith)
1. Disclosure Regulation:
• This regulation requires issuers of securities to make
public a large amount of financial information to
actual and potential investors
• This reduces, if not to avoid problem of information
asymmetric and agency problems.
2.Financial Activities Regulation
 This regulation restricts insider trading by insiders who are
corporate officers and others in positions who know more about a
firm’s prospects than general public
 Insider trading is another problem posed by asymmetric information

 This is because there may be possibility that members of exchange

may be able, under certain circumstances, to cloud and defraud the
general investing public.
 These regulation restricts FIs’ activities in the vital areas of lending,
borrowing, and funding activities.
 The idea of these restrictions is to ensure that FIs do not take excess
risks with investors’ funds and also limit potential conflicts of
interest
 For example in US and UK banks have long been prohibited from
holding significant stakes in companies .
 since this could result in distorted lending to such companies should
they get into financial difficulty.
 Types of Regulation-Cont’d
3. Liquidity requirement
 Such regulations aim to ensure that unnecessary
problems do not arise due to insufficient liquidity to
meet depositor's demand.
 For this reason commercial banks are expected
(legally required) to maintain a prudent level of
cash reserve as a ratio of their deposit to meet
withdrawal demands known as the reserve ratio.
Types of Regulation-Cont’d
4. Capital Adequacy requirement (long run solvency)
 Liquidity requirements are essentially about
maintaining adequate short-term cash to meet
demand for deposit withdrawals.
 Solvency is ,however, a medium to long-term
concept concerning the ability of an institution
to meet its liabilities as they fall due.
 The need to maintain sufficient capital to ensure that
the FI is regarded as a solvent and remains so even if
there are losses on its assets can therefore serve a
useful purpose.
VI. Types of Regulation-Cont’d
5. Regulation of foreign Participants
 Such regulation limits the role foreigner firms can
play in domestic markets and their ownership or
control of FIs.
VI. Types of Regulation-Cont’d

6. Licensing regulations
 FI institutions should be licensed.
 This helps to prevent undesirable individuals
from running FIs and to ensure that FI does
not act recklessly with investors’ funds
VII. Regulation of the Commercial Banking sector (CBS)

 Because of the special role that CBs play in the financial

system, banks are regulated and supervised by governments.
 The common regulations include:
a. Minimum Capital requirement for CBs
b. Capital Adequacy
c. Liquidity requirement
d. Asset Quality
e. Portfolio diversification
f. Ceiling imposed on interest rate payable on deposits
g. Geographical restriction on branch banks
h. Permissible activities for CBs
CBs- Regulation (Cont’d)
A. Minimum Capital requirement for CBs
 FI wanting to formalize must have a minimum
amount of equity capital to support their activities
 Ethiopia
 The minimum paid up capital required to obtain a banking
business license shall be Birr 500 million (birr five hundred
million), which shall be fully paid in cash and deposited in a
bank in the name and to the account of the bank under
establishment(Directives No. SBB/50/2011)
CBs- Regulation (Cont’d)
B. Capital Adequacy
Refers to the level of capital in an organization
that is available to cover its risk
 All FI institutions are required to have a
minimum amount of capital relative to the
value of their assets
 This means in the event of loss of assets, the
organization would have to sufficient funds
of its own (rather than borrowed from
depositors) to cover the loss.
 Capital adequacy ratios measure the amount of a bank's capital
in relation to the amount of its risk weighted credit
exposures.
 Credit exposures arise when a bank lends money to a
customer, or buys a financial asset (e.g. a commercial bill
issued by a company or another bank), or has any other
arrangement with another party that requires that party to
pay money to the bank (e.g. under a foreign exchange
contract).
 A credit risk is a risk that the bank will not be able to recover the
money it is owed.
 The calculation of credit exposures recognizes and adjusts for
two factors:
1. On-balance sheet credit exposures differ in their degree of
riskiness (e.g. Government Stock compared to personal loans).
Capital adequacy ratio calculations recognize these differences
by requiring more capital to be held against more risky
exposures.
This is done by weighting credit exposures according to their degree of
riskiness.
2. Off-balance sheet contracts (e.g. guarantees, foreign exchange
and interest rate contracts) also carry credit risks.
 The risk weighting process takes into account, in a stylized way,
the relative riskiness of various types of credit exposures that
banks have, and incorporates the effect of off-balance sheet
contracts on credit risk. The higher the capital adequacy ratios a
bank has, the greater the level of unexpected losses it can absorb
before becoming insolvent. The Basle Capital Accord is an
international standard for the calculation of capital adequacy
ratios. The Accord recommends minimum capital adequacy
ratios that banks should meet (Reserve Bank of New Zealand,
2007).
 ETHIOPIA
Banks are required to maintain minimum total capital levels not less
than 8% of risk weighted assets(Directive No. SBB/24/99 Minimum Paid up
Capital to be maintained by Banks)
CBs- Regulation (Cont’d)
c. Liquidity requirement
 Liquidity refers to the amount of available cash
(or near cash) relative to FIs demand for cash
 The level of liquidity requirement depends on the
stability of the market
  In Ethiopia , "Current liabilities" shall mean the sum of
demand (current) deposits, savings deposits and time
deposits and similar liabilities with less than one-month
maturity period.
 Any licensed bank shall maintain liquid assets of not less than
25% (twenty five percent) of its total current liabilities(
Directive No. SBB/44/2008 )
 Current liabilities" shall mean the sum of demand (current)
deposits, savings deposits and time deposits and similar liabilities
with less than one-month maturity period.
D. Asset Quality
 Asset quality refers the risk to earnings and collectability
derived from loans.
 It measures the degree of risk that some of the loan portfolio
will not be repaid.
 For this bank regulations limit the portfolio that may be
extended as unsecured loan.
 As per Directive No. SBB/43/ 2007) of National Bank of
Ethiopia, any bank should assure that the Provisions for
Loan Losses Account is adequate to absorb potential losses
in accordance with the requirements laid out in these
directives; and
 All banks shall maintain Provisions for Loan Losses
Account which shall be created by charges to provision
expense in the income statement and shall be
maintained at a level adequate to absorb potential
losses in the loans or advances portfolio;
 In determining the adequacy of the Provisions for
Loan Losses Account, provisions may be attributed to
individual loans or advances or groups of loans or
advances as per the following schedule.
Classification Category Minimum Provision

“Pass”(fully Secured or protected by cash or cash substitutes) 1%

“Special Mention” (Past due 30 or more days but less than 90 days) 3%
“Substandard”(Past due 90 or more days but less than 180 days) 20%
“Doubtful” (Past due 180 or more days but less than 360 days) 50%
“Loss” (Past due 360 or more days) 100%
 Nonperforming loan (NPL) ratios are calculated by dividing nonperforming
loans by total loans.
 Prudent financial practices require the maintenance of nonperforming loans
at five percent or below.
 Five percent nonperforming loan ratios are set to be measure of asset quality
for banks.
 Nonperforming Loan (NPL) ratios above five percent don’t always lead to
failures because banks keep capital cushions and set aside reserves to absorb
bad loans.
 Banks with higher ratios of equity to total assets could better withstand such
losses.
 Nonperforming loans can eat into a company’s earnings and deplete cash,
leaving banks below the minimum capital level required by regulators.
CBs- Regulation (Cont’d)
E. Portfolio diversification
 This refers to FIs’ need to ensure that they have not
concentrated their portfolio in one geographic
sector or one market segment.
F. Ceiling imposed on interest rate payable on deposits.
 No interest payable on demand account

 Countries impose ceiling on the maximum interest

rate that could be paid by banks on deposits other
than demand (checking) account.
CBs- Regulation (Cont’d)
g. Geographical restriction on branch banks
 Some federal or local states prevent large banks from
expanding geographically and thereby forcing out or taking
over smaller banking entities, possibly threatening
competition.
h. Permissible activities for commercial Banks
 Limitations can be imposed on the areas of bank
investment.
 Example of Ethiopia (see directive no Directive No.
SBB/12/1996 and Directive No. SBB/30/2002 )
Directive No. SBB/12/1996: Limitation On Investment Of Banks

1. No bank shall engage in insurance business but may

hold up to 20% in an insurance company and up to a
total of 10% of the banks equity capital in such
business.
2. Banks are prohibited from engaging directly in non-
banking businesses such as agriculture, industry,
and commerce.
3. A bank may hold shares in a non-banking business only
up to 20% of the company’s share capital and total
holdings in such business shall not exceed10% of the
bank’s net worth.
4. A bank’s equity participation in another bank shall be
subject to prior authorization by National Bank of
Ethiopia.
5. No bank shall commit more than 20% of its net
worth in real estate acquisition and development
other than for own business premises with out prior
approval of the National Bank of Ethiopia.
6. A bank may not invest more than 10 %(ten percent)
of its net worth in other securities.
7. The aggregate sum of all investments at any one
time (excluding investment in government securities)
may not exceed 50% of the bank’s net worth, with
out prior approval by the National Bank of Ethiopia.
8. Dealing in securities shall be done by banks only
through a limited liability subsidiary company
wherein the holding of the bank shall not exceed
10% (percent) of its equity capital.
 ETHIOPIA
 Foreign nationals or organizations fully or partially
owned by foreign nationals may not be allowed to
open banks or branch offices or subsidiaries of
foreign banks in Ethiopia or acquire the shares of
Ethiopian banks.
Directive No. SBB/30/2002: Amendment of
Limitation on Loans to Related Parties

4.1 Banks shall not extend loans to related parties on preferential

terms with respect to conditions, interest rates and repayment
periods other than the terms and conditions normally applied to
other borrowers.

4.2 The aggregate sum of loans extended or permitted to be

outstanding directly or indirectly to one related party at any one
time shall not exceed 15% of the total capital of the bank.

4.3 The aggregate sum of loans extended or permitted to be

outstanding directly or indirectly to all related parties at any one
time shall not exceed 35% of the total capital of the bank.
END OF CHAPTER FOUR