Bank Regulation, Risk Management, and Compliance

Theory, Practice, and Key Problem Areas

Alexander Dill

• Publisher: Informa Law from Routledge
• Year: 2019
• ISBN:
  9781000702736
• Edition: 1
• Topic: Law
• Subtopic: Law Theory & Practice
• Index: Law

Bank Regulation, Risk Management, and Compliance is a concise yet comprehensive treatment of the primary areas of US banking regulation – micro-prudential, macroprudential, financial consumer protection, and AML/CFT regulation – and their associated risk management and compliance systems. The book's focus is the US, but its prolific use of standards published by the Basel Committee on Banking Supervision and frequent comparisons with UK and EU versions of US regulation offer a broad perspective on global bank regulation and expectations for internal governance.

The book establishes a conceptual framework that helps readers to understand bank regulators' expectations for the risk management and compliance functions. Informed by the author's experience at a major credit rating agency in helping to design and implement a ratings compliance system, it explains how the banking business model, through credit extension and credit intermediation, creates the principal risks that regulation is designed to mitigate: credit, interest rate, market, and operational risk, and, more broadly, systemic risk. The book covers, in a single volume, the four areas of bank regulation and supervision and the associated regulatory expectations and firms' governance systems. Readers desiring to study the subject in a unified manner have needed to separately consult specialized treatments of their areas of interest, resulting in a fragmented grasp of the subject matter. Banking regulation has a cohesive unity due in large part to national authorities' agreement to follow global standards and to the homogenizing effects of the integrated global financial markets.

The book is designed for legal, risk, and compliance banking professionals; students in law, business, and other finance-related graduate programs; and finance professionals generally who want a reference book on bank regulation, risk management, and compliance. It can serve both as a primer for entry-level finance professionals and as a reference guide for seasoned risk and compliance officials, senior management, and regulators and other policymakers. Although the book's focus is bank regulation, its coverage of corporate governance, risk management, compliance, and management of conflicts of interest in financial institutions has broad application in other financial services sectors.

Chapter 6 of this book is freely available as a downloadable Open Access PDF at http://www.taylorfrancis.com under a Creative Commons Attribution-Non Commercial-No Derivatives (CC-BY-NC-ND) 4.0 license.

Part I

Foundations

Chapter 1

The banking business model and rise of the financial conglomerate

Banking is now, and has always been, a risky business. The key to success in operating a bank and in supervising a banking system is management of risk.¹

1 George Kaufman and others, Perspectives on Safe & Sound Banking: Past, Present, and Future (MIT Press: 1986) xiii.

1.1 Introductory overview

Banks² play a central role in the world’s economies yet have one of the most fragile of business models. These two factors alone explain why these firms have been at the center of many financial crises throughout history in the US and abroad. However, an additional factor is the size and complexity of many banking firms. Policymakers’ fear that their potential failure in the global financial crisis of 2007–09 (GFC) would cause a catastrophic disruption of the financial system led them to make unprecedented bailouts of several financial conglomerates. These three factors together explain why banking today is one of the most highly regulated industries in the US.³ Moreover, they help to explain why national authorities have looked increasingly to these firms’ corporate governance systems and risk management and compliance functions as central to the effective management of the risks inherent in the banking business.

2 In this chapter the term ‘bank’ refers to all types of depository institutions: commercial banks, savings banks, savings and loan associations, and credit unions, unless the context otherwise requires. In the US, only these entities have legal authority to accept deposits and therefore function as banking organizations. ‘Bank’ also refers to bank holding companies, which are separately identified as the context requires.

3 Banking is the most regulated industry in the US with the possible exception of the companies that manufacture and use nuclear material. Jonathan Macey and Maureen O’Hara, ‘Bank corporate governance: a proposal for the post-crisis world’, FRBNY Economic Policy Review (August 2016) 94.

Managing these risks is the core concern of both bank management and a bank’s regulator, but each comes to it from a very different set of incentives. Banks will manage the risks of their business model to preserve their franchise and enhance shareholder value. Regulators across the developed world also consider franchise value important but have the additional mission of mitigating the moral hazard introduced by the government safety net, which can lead banks to take excessive risks. Moreover, banks have the additional incentive to grow ever larger, more complex, and more leveraged to take advantage of the federal safety net, making them ‘TBTF’, further undermining financial system stability.

National authorities seek to achieve three fundamental objectives in financial regulation: (1) the safety and soundness of individual financial institutions (micro-prudential regulation); (2) protection of investors and consumers of financial products through fair and transparent conduct of business (conduct regulation); and (3) stability of the financial system (macro-prudential regulation). In pursuit of these objectives, banking agencies have issued a wide array of regulations, exercised supervisory oversight, and provided guidance on their regulatory expectations for effective risk management and compliance systems.

This chapter and the following two chapters provide the foundation for understanding the role of corporate governance and the control functions in the four primary areas of bank regulation covered in this book.⁴ This chapter highlights banks’ central role in the economy and the key risks of their business that cause banks to be so highly regulated. For each of these economic functions and risks, it indicates the corresponding area of bank regulation. It then turns to the factors contributing to the emergence of large, complex bank holding companies (BHCs) that were at the center of the GFC and are a primary focus of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010⁵ (Dodd-Frank). Chapter 2 examines the regulatory and supervisory framework and sources of risk management and compliance expectations for banking institutions. Chapter 3 provides an overview of basic corporate governance principles and the unique features of bank and BHC corporate governance, followed by an in-depth discussion of the bank compliance and risk management functions. Where relevant, the discussion places these subjects in an international context, specifically relating to the UK and the EU.

4 These are micro- and macro-prudential, consumer protection, and anti-money laundering and terrorist financing regulation, the subjects of Chapters 4–5, 6–8, 9–10, respectively.

5 Pub. L. No. 111–203, 124 Stat. 1376, 1871 (2010).

1.2 Factors that cause banks to be so highly regulated

Several factors have caused banking to be one of the most heavily regulated industries worldwide. First, banks globally play a central role in the economy, in extending credit, in linking long-term borrowers with short-term savers through liquidity transformation, and in ensuring a smoothly functioning payments system. Second, risks inherent in the banking business model have caused policymakers to impose intrusive, intensive, and ongoing oversight over banking organizations. These risks make it imperative for regulators to closely monitor banks’ financial condition and corporate governance system. Third, and relatedly, banks enjoy a government safety net due to federal insurance of deposit accounts, the liquidity backstop at the Federal Reserve System’s⁶ (Federal Reserve) discount window, and its role as lender of last resort in safeguarding the stability of the nation’s financial system. Finally, the GFC has had a profound impact on the bank regulatory framework. Previous financial crises have led to enhanced regulation and supervision, but the scale and scope of the legislation and rulemaking following the GFC, and the resulting changes demanded of firms’ corporate governance and control functions, through both private and regulatory initiatives, have been unprecedented. These factors, in turn, have fundamentally shaped banking’s risk management and compliance systems.

6 The Federal Reserve, which consists of 12 Federal Reserve Banks, was established in 1913. The Federal Reserve Board (FRB) supervises the Federal Reserve and issues rules governing the banks subject to its jurisdiction.

The following four subsections discuss each of these factors in turn. With minor variations, all four apply to the banking sector globally.⁷

7 In Europe, the banks play an even more critical role as financiers of businesses. In the US, the capital markets have increasingly provided the primary source of funds for business investment.

1.2.1 Intensity of regulation a function of banks’ central role in the economy

Banks’ central role in the economy is perhaps the most critical reason for the scope and intensity of banking regulation and the demands the government places on the risk management and compliance functions. This economic role of the banking industry occurs in three primary areas: (1) extension of credit, (2) acting as intermediary in funneling savers’ short-term deposits to borrowers in the form of long-term, illiquid loans, and (3) operating the nation’s payments system.

1.2.1.1 Banks’ role in the extension of credit

Banks serve as engines of the economy by extending credit to individuals and to businesses, some $10 trillion annually in the US alone, expanding consumers’ access to necessities and providing funds to businesses and governmental agencies for capital investments, purchasing inventory, and hiring workers. Banks are vital to the general health of the overall US economy. In addition, banks’ extension of credit is the essential link in the FRB’s monetary policy by serving as the main transmission mechanism through which it implements this policy.⁸

8 The FRB conducts monetary policy, whose dual mandate consists of price stability and economic growth, in part by adopting a target short-term interest rate by vote of the Federal Open Market Committee (FOMC). Traditionally, the FRBNY would implement the policy through purchases or sales of Treasury securities through primary dealers that transact directly with banks, increasing or decreasing reserves in banks’ Federal Reserve accounts, decreasing and increasing the target rate respectively by affecting demand for reserves, and thus the interest rate. This short-term interest rate affects banks’ propensity to lend in the broader economy. This mechanism broke down after the financial crisis due to the enormous amount of excess reserves that resulted from the FRB’s quantitative easing policy. Thus, the FOMC, among o...