Traditional Banking in the United States and Its Evolution as Bank Holding Companies

Abstract

In order to understand the context in which shadow banking has evolved, the chapter commences with a discussion of traditional banking. The historical background of banking in the USA is initially set forth, followed by discussion of the Dodd-Frank Act that arose as a result of the financial crisis of 2007–2009, including mention of the Volcker Rule and the Act’s requirements with respect to credit ratings agencies. Thereafter, the important development of bank holding companies created under the Bank Holding Act of 1956 is reviewed; this expanded substantially to meet global competition, The Dodd-Frank Act and the regulations promulgated thereunder provide extensive oversight, particularly with respect to banks that are very large and may pose a systemic threat to the financial stability of the United States.

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Appendices

Appendix 1: Iosco Code of Conduct for Credit Rating Agencies

Quality and Integrity. Among the indicia of quality and integrity are the following:

• The adoption, implementation, and enforcement of written procedures to ensure opinions are based on all known information;

• Rating methodologies that are rigorous, systematic, and be subjected to objective validation;

• Individuals performing the ratings are to be qualified with knowledge and experience in the particular financial instrument being rated;

• Avoidance of misrepresentations and maintenance of records for a reasonable period of time;

• Assessment whether it has adequate and qualified personnel to perform the ratings which are to be objectively conducted without bias and utilizing methodologies in a consistent manner; and

• Monitor and update opinions by regularly reviewing the issuer’s creditworthiness.

Independence and Avoidance of Conflicts of Interest. Among the recommendations are:

• A CRA should not forbear or refrain from taking a rating action based on the potential effect of the action on the CRA, an issuer, an investor, or other market participant;

• A CRA and its analysts should use care and professional judgment to maintain both the substance and appearance of independence and objectivity and be influenced only by factors relevant to the credit assessment;

• The credit rating a CRA assigns to an issuer or security should not be affected by the existence of or potential for a business relationship between the CRA and the issuer;

• A CRA should separate, operationally and legally, its credit rating business and CRA analysts from any other businesses of the CRA, including consulting businesses that may present a conflict of interest;

• A CRA and its analysts should use care and professional judgment to maintain both the substance and appearance of independence and objectivity and be influenced only by factors relevant to the credit assessment; and

• A CRA should separate, operationally and legally, its credit rating business and CRA analysts from any other businesses of the CRA, including consulting businesses that may present a conflict of interest.

Transparency and Timeliness of Ratings Disclosure. Among the recommendations are:

• A CRA should distribute in a timely manner its ratings decisions regarding the entities and securities it rates and publicly disclose its policies for distributing ratings, reports and updates;

• A CRA should indicate with each of its ratings when the rating was last updated and the CRA should disclose to the public, on a non-selective basis and free of charge, any rating regarding publicly issued securities, or public issuers themselves, as well as any subsequent decisions to discontinue such a rating, if the rating action is based in whole or in part on material non-public information;

• A CRA should publish sufficient information about its procedures, methodologies and assumptions (including financial statement adjustments that deviate materially from those contained in the issuer’s published financial statements and a description of the rating committee process, if applicable) so that outside parties can understand how a rating was arrived at by the CRA; and

• Where a CRA rates a structured finance product, it should provide investors and/or subscribers with sufficient information about its loss and cash-flow analysis so that an investor allowed to invest in the product can understand the basis for the CRA’s.

Treatment of Confidential Information. Among the recommendations are:

• A CRA should adopt procedures and mechanisms to protect the confidential nature of information shared with them by issuers under the terms of a confidentiality agreement or otherwise under a mutual understanding that the information is shared confidentially;

• Unless otherwise permitted by the confidentiality agreement and consistent with applicable laws or regulations, the CRA and its employees should not disclose confidential information in press releases, through research conferences, to future employers, or in conversations with investors, other issuers, other persons, or otherwise;

• A CRA should use confidential information only for purposes related to its rating activities or otherwise in accordance with any confidentiality agreements with the issuer;

• CRA employees should take all reasonable measures to protect all property and records belonging to or in possession of the CRA from fraud, theft or misuse. CRA employees should not selectively disclose any non-public information about rating opinions or possible future rating actions of the CRA, except to the issuer or its designated agents;

• CRA employees should not share confidential information entrusted to the CRA with employees of any affiliated entities that are not CRAs. CRA employees should not share confidential information within the CRA except on an “as needed” basis; and

• CRA employees should not use or share confidential information for the purpose of trading securities, or for any other purpose except the conduct of the CRA’s business.

Appendix 2: Basel III Core Principles for Effective Banking Supervision

1.2.1 Supervisory Powers, Responsibilities and Functions

• Principle 1 – Responsibilities , objectives and powers : An effective system of banking supervision has clear responsibilities and objectives for each authority involved in the supervision of banks and banking groups. A suitable legal framework for banking supervision is in place to provide each responsible authority with the necessary legal powers to authorise banks, conduct ongoing supervision, address compliance with laws and undertake timely corrective actions to address safety and soundness concerns.

• Principle 2 – Independence , accountability , resourcing and legal protection for supervisors : The supervisor possesses operational independence, transparent processes, sound governance, budgetary processes that do not undermine autonomy and adequate resources, and is accountable for the discharge of its duties and use of its resources. The legal framework for banking supervision includes legal protection for the supervisor.

• Principle 3 – Cooperation and collaboration : Laws, regulations or other arrangements provide a framework for cooperation and collaboration with relevant domestic authorities and foreign supervisors. These arrangements reflect the need to protect confidential information.

• Principle 4 – Permissible activities : The permissible activities of institutions that are licensed and subject to supervision as banks are clearly defined and the use of the word “bank” in names is controlled.

• Principle 5 – Licensing criteria : The licensing authority has the power to set criteria and reject applications for establishments that do not meet the criteria. At a minimum, the licensing process consists of an assessment of the ownership structure and governance (including the fitness and propriety of Board members and senior management) of the bank and its wider group, and its strategic and operating plan, internal controls, risk management and projected financial condition (including capital base). Where the proposed owner or parent organisation is a foreign bank, the prior consent of its home supervisor is obtained.

• Principle 6 – Transfer of significant ownership : The supervisor has the power to review, reject and impose prudential conditions on any proposals to transfer significant ownership or controlling interests held directly or indirectly in existing banks to other parties.

• Principle 7 – Major acquisitions : The supervisor has the power to approve or reject (or recommend to the responsible authority the approval or rejection of), and impose prudential conditions on, major acquisitions or investments by a bank, against prescribed criteria, including the establishment of cross-border operations, and to determine that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.

• Principle 8 – Supervisory approach : An effective system of banking supervision requires the supervisor to develop and maintain a forward-looking assessment of the risk profile of individual banks and banking groups, proportionate to their systemic importance; identify, assess and address risks emanating from banks and the banking system as a whole; have a framework in place for early intervention; and have plans in place, in partnership with other relevant authorities, to take action to resolve banks in an orderly manner if they become non-viable.

• Principle 9 – Supervisory techniques and tools : The supervisor uses an appropriate range of techniques and tools to implement the supervisory approach under the Core Principles for Effective Banking Supervision 11 and deploys supervisory resources on a proportionate basis, taking into account the risk profile and systemic importance of banks.

• Principle 10 – Supervisory reporting : The supervisor collects, reviews and analyses prudential reports and statistical returns from banks on both a solo and a consolidated basis, and independently verifies these reports through either on-site examinations or use of external experts.

• Principle 11 – Corrective and sanctioning powers of supervisors : The supervisor acts at an early stage to address unsafe and unsound practices or activities that could pose risks to banks or to the banking system. The supervisor has at its disposal an adequate range of supervisory tools to bring about timely corrective actions. This includes the ability to revoke the banking license or to recommend its revocation.

• Principle 12 – Consolidated supervision : An essential element of banking supervision is that the supervisor supervises the banking group on a consolidated basis, adequately monitoring and, as appropriate, applying prudential standards to all aspects of the business conducted by the banking group worldwide.

• Principle 13 – Home-host relationships : Home and host supervisors of cross-border banking groups share information and cooperate for effective supervision of the group and group entities, and effective handling of crisis situations. Supervisors require the local operations of foreign banks to be conducted to the same standards as those required of domestic banks.

1.2.2 Prudential Regulations and Requirements

• Principle 14 – Corporate governance : The supervisor determines that banks and banking groups have robust corporate governance policies and processes covering, for example, strategic direction, group and organisational structure, control environment, responsibilities of the banks’ Boards and senior management, and compensation. These policies and processes are commensurate with the risk profile and systemic importance of the bank.

• Principle 15 – Risk management process : The supervisor determines that banks have a comprehensive risk management process (including effective Board and senior management oversight) to identify, measure, evaluate, monitor, report and control or mitigate all material risks on a timely basis and to assess the adequacy of their capital and liquidity in relation to their risk profile and market and macroeconomic conditions. This extends to development and review of contingency arrangements (including robust and credible recovery plans where warranted) that take into account the specific circumstances of the bank. The risk management process is commensurate with the risk profile and systemic importance of the bank.

• Principle 16 – Capital adequacy : The supervisor sets prudent and appropriate capital adequacy requirements for banks that reflect the risks undertaken by, and presented by, a bank in the context of the markets and macroeconomic conditions in which it operates. The supervisor defines the components of capital, bearing in mind their ability to absorb losses. At least for internationally active banks, capital requirements are not less than the applicable Basel standards.

• Principle 17 – Credit risk : The supervisor determines that banks have an adequate credit risk management process that takes into account their risk appetite, risk profile and market and macroeconomic conditions. This includes prudent policies and processes to identify, measure, evaluate, monitor, report and control or mitigate credit risk (including counterparty credit risk) on a timely basis. The full credit lifecycle is covered including credit underwriting, credit evaluation, and the ongoing management of the bank’s loan and investment portfolios.

• Principle 18 – Problem assets , provisions and reserves : The supervisor determines that banks have adequate policies and processes for the early identification and management of problem assets, and the maintenance of adequate provisions and reserves.

• Principle 19 – Concentration risk and large exposure limits : The supervisor determines that banks have adequate policies and processes to identify, measure, evaluate, monitor, report and control or mitigate concentrations of risk on a timely basis. Supervisors set prudential limits to restrict bank exposures to single counterparties or groups of connected counterparties.

• Principle 20 – Transactions with related parties : In order to prevent abuses arising in transactions with related parties and to address the risk of conflict of interest, the supervisor requires banks to enter into any transactions with related parties on an arm’s length basis; to monitor these transactions; to take appropriate steps to control or mitigate the risks; and to write off exposures to related parties in accordance with standard policies and processes.

• Principle 21 – Country and transfer risks : The supervisor determines that banks have adequate policies and processes to identify, measure, evaluate, monitor, report and control or mitigate country risk and transfer risk in their international lending and investment activities on a timely basis.

• Principle 22 – Market risks : The supervisor determines that banks have an adequate market risk management process that takes into account their risk appetite, risk profile, and market and macroeconomic conditions and the risk of a significant deterioration in market liquidity. This includes prudent policies and processes to identify, measure, evaluate, monitor, report and control or mitigate market risks on a timely basis.

• Principle 23 – Interest rate risk in the banking book : The supervisor determines that banks have adequate systems to identify, measure, evaluate, monitor, report and control or mitigate interest rate risk in the banking book on a timely basis. These systems take into account the bank’s risk appetite, risk profile and market and macroeconomic conditions.

• Principle 24 – Liquidity risk : The supervisor sets prudent and appropriate liquidity requirements (which can include either quantitative or qualitative requirements or both) for banks that reflect the liquidity needs of the bank. The supervisor determines that banks have a strategy that enables prudent management of liquidity risk and compliance with liquidity requirements. The strategy takes into account the bank’s risk profile as well as market and macroeconomic conditions and includes prudent policies and processes, consistent with the bank’s risk appetite, to identify, measure, evaluate, monitor, report and control or mitigate liquidity risk over an appropriate set of time horizons. At least for internationally active banks, liquidity requirements are not lower than the applicable Basel standards.

• Principle 25 – Operational risk : The supervisor determines that banks have an adequate operational risk management framework that takes into account their risk appetite, risk profile and market and macroeconomic conditions. This includes prudent policies and processes to identify, assess, evaluate, monitor, report and control or mitigate operational risk on a timely basis.

• Principle 26 – Internal control and audit : The supervisor determines that banks have adequate internal control frameworks to establish and maintain a properly controlled operating environment for the conduct of their business taking into account their risk profile. These include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding the bank’s assets; and appropriate independent internal audit and compliance functions to test adherence to these controls as well as applicable laws and regulations.

• Principle 27 – Financial reporting and external audit : The supervisor determines that banks and banking groups maintain adequate and reliable records, prepare financial statements in accordance with accounting policies and practices that are widely accepted internationally and annually publish information that fairly reflects their financial condition and performance and bears an independent external auditor’s opinion. The supervisor also determines that banks and parent companies of banking groups have adequate governance and oversight of the external audit function.

• Principle 28 – Disclosure and transparency : The supervisor determines that banks and banking groups regularly publish information on a consolidated and, where appropriate, solo basis that is easily accessible and fairly reflects their financial condition, performance, risk exposures, risk management strategies and corporate governance policies and processes.

• Principle 29 – Abuse of financial services : The supervisor determines that banks have adequate policies and processes, including strict customer due diligence rules to promote high ethical and professional standards in the financial sector and prevent the bank from being used, intentionally or unintentionally, for criminal activities.