Law of international banking

Regulation of Banks

Banks are an important aspect of any modern economy. They provide financing for commercial businesses, access to payment systems and a variety of financial services for the economy as a whole. The integral role that banks play in the national economy is demonstrated by the need for and practice of banking regulation and as part of the lessons learnt from the recent global financial crisis, provides a government safety net to compensate depositors when banks fail thus providing depositor protection.[footnoteRef:1] One of the main reasons why banking regulation is vital is because of systemic risks; the risk that financial difficulties at one or more banks spill over to a large number of other banks or the financial system as a whole. Systemic risks were traditionally bank -- based. Bank regulators traditionally focused on systemic risk in the banking sector while securities regulators traditionally focused on investor protection and market practices however recent crisis shows that systemic risk can arise from a general drying up of liquidity in capital markets. Other goals of banking regulation are to ensure the stability and soundness of the financial system and the safeguard of confidence and trust. Economists tend to share a different view in that they argue that regulation is only necessary in the presence of market failure or deficiency. This paper will examine the function of banking in society, the difference in commercial "deposit-oriented" versus investment banks, the role of government regulation and how the regulation of these entities shape their behaviors and their customers. [1: Allen, F. And Douglas, G. 2000. Comparing Financial Systems. MIT Press: Cambridge. MA.]

Functions of a Bank

The Canadian-American economist John Kenneth Galbraith once wrote, "The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. While the question of what a bank does and what function it serves in society may seem elementary, the answer can be quite complex as suggested by Galbraith. Understanding what banking is all about will help this paper to illustrate the role of banks and their regulation better. A bank is a financial institution where an individual can deposit money. Banks provide a system for easily transferring money from one person or business to another. Using banks and the many services they offer saves an incredible amount of time, and ensures that the funds of micro as well as macroeconomic agents "pass hands" in a legal and structured manner. There are also other financial institutions that operate like banks.

The functioning of a bank is among the more complicated of corporate operations. Since banking involves dealing directly with money, governments in most countries regulate this sector rather stringently. The regulation in most industrialized countries has traditionally been very strict. The multiplicity of policy and regulations that a bank has to work with makes its operations even more complicated, sometimes bordering on illogical. This section attempts to give an overview of the functions in as simple manner as possible. An excellent definition of banking comes from the Banking Regulation Act of India, 1949 which defines Banking as "accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdraw able by cheques, draft, order or otherwise." Deriving from this definition and viewed solely from the point-of-view of the customers, Banks essentially perform the following functions: 1. Accepting Deposits from public/others (Deposits); 2. Lending money to public (Loans); 3. Transferring money from one place to another (Remittances); 4. Credit Creation; 5. Acting as trustees; 6. Keeping valuables in safe custody and 7. Investment Decisions.[footnoteRef:2] [2: Allen, F. And Douglas, G. 2000.]

In addition to providing a safe custodian of money, banks also loan money to businesses and consumers. A large portion of a bank's business is lending. How do banks get the money they loan? The money comes from depositors who intend to save a portion of their wealth. Banks acting as intermediaries use these deposits as loans to prospective borrowers. The objective of commercial banks like any other organization is profit maximization. This profit generally originates from the interest differential between borrowers and lenders. In the present day, however, the banking operation has extended much beyond simple lending exercise. So there are other different channels of profit ensuing from other investment programs as well. However, it should be mentioned in this context that the entire deposit held by a bank cannot be given as loans as the Central Bank retains a portion of this money in the form of cash-reserve for unforeseen circumstances.[footnoteRef:3] [3: Caprio, G. And Honohan, P. 2001. Finance for Growth: Policy Choices in a Volatile World. World Bank: Washington, DC.]

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by whatever national government. This amount can be held either in cash on hand or in the bank's reserve account. To understand the importance of this on the national economy, an example is useful. When a bank gets a deposit of $100, assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.[footnoteRef:4] [4: Allen, F. And Douglas, G. 2000.]

Types of Banks

While regulation has changed the businesses in which commercial and investment banks may now participate, the core aspects of these different businesses remain intact. In other words, the difference between how a typical investment bank and a typical commercial operate bank can be simplified: A commercial bank takes deposits for checking and savings accounts from consumers while an investment bank raise capital by acting as an intermediary between sellers and buyers of stocks and bonds.

Commercial banks

A commercial bank may legally take deposits for checking and savings accounts from consumers. Most national governments provide some form of insurance guarantees on this deposit. For example, in the United States the federal government provides guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC), on amounts up to $100,000. To get FDIC guarantees, commercial banks must follow a myriad of regulations. The typical commercial banking process is fairly straightforward. The consumer deposits money into a bank and the bank loans that money to other consumers and companies in need of capital. One can borrow to buy a house, finance a car or finance construction of a home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks can range in size from the simple grocer on the corner to a multinational conglomerate. The commercial bank generates a profit by paying depositors a lower interest rate than the bank charges on loans.[footnoteRef:5] [5: Macey, J.R. And O'Hara, M. 2003. The Corporate Governance of Banks. Economic Policy Review, Federal Reserve Bank of New York. 9: 91-108.]

Importantly, loans from commercial banks are structured as private legally binding contracts between two parties - the bank and the consumer or the company. Banks work with their clients to individually determine the terms of the loans, including the time to maturity and the interest rate charged. One's individual credit history determines the amount you can borrow and how much interest you are charged. Perhaps a company needs to borrow $200,000 over 15 years to finance the purchase of equipment, or maybe your firm needs $30,000 over five years to finance the purchase of a truck. Maybe for the first loan, the consumer and the bank will agree that to an interest rate of 7.5%; perhaps for the truck loan, the interest rate will be 11%. The rates are determined through a negotiation between the bank and the company. Thus, commercial banks make money by taking advantage of the large spread between their cost of funds and their return on funds loaned.

Investment banks

An investment bank operates differently. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary and matches sellers of stocks and bonds with buyers of stocks and bonds. Note, however, that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell equity or debt (stocks or bonds). Because commercial banks already have funds available from their depositors and an investment bank typically does not, an investment bank must spend considerable time finding investors in order to obtain capital. Note that as investment banks are increasingly seeking to become "one-stop" financing sources, many have set aside billions of dollars of their own capital to use loan to clients directly.

Investment banks also underwrite stock offerings just as they do bond offerings. In the stock offering process, a company sells a portion of the equity (or ownership) of itself to the investing public. The very first time a company chooses to sell equity, this offering of equity is transacted through a process called an initial public offering of stock (commonly known as an IPO). Through the IPO process, stock in a company is created and sold to the public. After the deal, stock sold in the U.S. is traded on a stock exchange such as the New York Stock Exchange (NYSE) or in India on the National Stock Exchange (NSE). The equity underwriting process is another major way in which investment banking differs from commercial banking.[footnoteRef:6] [6: Allen, F. And Douglas, G. 2000.]

Regulation and the Scope of Applicable Law

Until 1979, there was no domestic legislation that regulated the conduct of banking business in the United Kingdom.[footnoteRef:7] Indeed, insofar as the banking business comprises the making of loans and advances to customers, the absence of regulation remains a significant feature of the current legislation. Until 1979, the Bank of England operated an informal system of supervision which relied upon an expectation of compliance and the general influence of the central bank in the financial sphere. At that point, however, Parliament passed the Banking Act of 1979, which required that the acceptance of deposits from the public should be subject to prior authorization by the Bank of England. The Act was passed in order to give effect to this country's obligations under the First European Community Banking Directive, which required a formalized system of authorization and supervision for the banking sector. The regulatory framework was subsequently revised and extended by the Banking Act 1987. The main consequences of the 1987 Act were (i) a streamlining of the authorization process, (ii) the introduction of a 'large exposures' reporting system, and (iii) the Bank of England was given greater powers to demand information and to carry out investigations. A notable feature of the 1987 Act - especially when compared with the current legislation - is that the Act regulated who could carry on a deposit-taking business but, subject to minor exceptions - it did not regulate how that business should be carried on, in the sense that there were very limited rules dealing with the conduct of business.[footnoteRef:8] [7: Penn, G.A. And Wadsley, J. 2000. The Law and Practice of Domestic Banking. Sweet & Maxwell: London, UK.] [8: Penn, G.A. And Wadsley, J. 2000.]

It was at this point of time that the incoming tide of European legislation began to become more evident. In 1989, the EC Council adopted its Second Council Directive on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions, which was implemented in the United Kingdom by means of the Banking Coordination (Second Council Directive) Regulations of 1992. These regulations gave effect to the Community's 'passporting' scheme, under which it would no longer be necessary for an EC-based institution to be separately authorized in each of the EC Member States in which it had a branch or provided services. Instead, it would be permitted to establish a branch and undertake local activities in those other countries in reliance on its home State authorization. Although these particular regulations have now been repealed, the passporting system remains in effect through later directives and their implementing regulations, and this forms one of the key pillars of EU banking law.[footnoteRef:9] [9: Penn, G.A. And Wadsley, J. 2000.]

In addition, the Community began to introduce further directives intended to implement the capital adequacy and other prudential requirements laid down by the 1988 Capital Accord published by the Basel Committee on Banking Supervision. The further initiatives included the Own Funds Directive, the Solvency Ratio Directive and two directives dealing with capital adequacy issues. All of these directives have subsequently been consolidated and amended in the light of further recommendations by the Basel Committee in the field of capital adequacy. So it will be seen that the early 1990s saw a significant 'Europeanization' of British banking, mainly as a harmonizing measure with a view to completing the EC's 'single market'.[footnoteRef:10] [10: Caprio, G. And Honohan, P. 2001.]

More recently in a move which was not dictated by considerations of Community law, the government determined that the functions of the central bank should be separated from those of the market regulator and the task of banking supervision. This formed part of a larger plan to provide for unified supervision of the financial markets as a whole by a single regulator. Given the interdependence of the different segments of the financial markets (banking, insurance, fund management, and other businesses) it was argued that this was an appropriate step, although the wisdom of removing bank supervision from the Bank of England has been questioned by some commentators in the wake of the recent financial crisis. The final legislative result of this decision was the Financial Services and Markets Act 2000 (FSMA). It has been pointed out that the 2000 Act succeeded in being both a formidable, and yet at the same time inchoate, piece of legislation. The Act itself answers few of the practical questions to which the scheme of regulation gives rise on a daily basis. Instead, it confers upon the Financial Services Authority a broad rule-making power, and it will almost invariably be necessary to refer to those rules in order meaningfully to deal with any issues that may arise. As noted earlier, the legislation deals not merely with banking but also with other aspects of the financial markets.[footnoteRef:11] [11: Penn, G.A. And Wadsley, J. 2000.]

Therefore, currently banking regulation in the UK can be seen as involving three organizations, the Financial Services Authority (FSA), the Bank of England and the Treasury. Until the banking crisis, UK banking regulation could be described as light-touch - in other words, regulators do not engage in aggressive regulation, preferring to intervene only when necessary, and only in limited ways. In order to protect depositors and to maintain financial stability, the Banking Act of 2009 gave those organizations responsible for banking regulation the collective powers to deal with the crisis in the banking system. One of these powers is the ability to put a failing bank under temporary public ownership. It is noteworthy that the 2009 Turner Review, issued by the Chairman of the FSA, published the findings of his review into the banking crisis and recommended more coordinated international banking regulation, especially the creation of a pan-European regulator to ensure that: 1. Banks hold more assets; 2) Regulation of liquidity; 3) More information to be collected from those institutions that are part of the shadow banking system, like hedge funds; 4) More regulation of overseas banks by host countries - this recommendation is largely in response to the collapse of the Iceland banks, who were unregulated by the UK regulators, but UK citizens suffered large losses; 5) Control of bank employees remuneration and lastly 6) A review of bank's accounting practices. In short, the current UK banking law is in a state of tremendous flux as it learns and adopts the lesson from the Global Sovereign Debt Crisis.[footnoteRef:12] [12: Financial Services Authority. 2009. The Turner Review: A Regulatory Response to the Global Banking Crisis. Accessed 20 Jan 2012. URL: www.fsa.gov.uk/pubs/other/turner_review.pdf ]

Advantages and Disadvantages of Bank Regulation

Banking regulation is often reactive. Regulatory reform closes gaps in the financial system usually following a crisis, shifts in the markets or other change that threatens financial stability. Market participants are constrained by market regulation in setting prices because they have strong incentives to generate revenues and avoid bankruptcy. This means that in order to satisfy their interests, customers usually avoid high prices whilst service providers set prices that generate revenue. Market discipline can be exerted by market participants if they have sufficient information and if they have the incentives and ability to assess bank risk.[footnoteRef:13] Direct market discipline means that market participants can directly influence banks' behavior: uninsured debt holders are at risk and as they bear losses in case of bank failure they require a rate of return which increases with the risk they perceive. If they correctly assess banks' risk, the raise of the funding cost following an increase in risk should restrain excessive risk taking. Indirect market discipline generates a signal about banks' risk which can be used by supervisors into banking supervision in order to better allocate resources.[footnoteRef:14] [13: Macey, J.R. And O'Hara, M. 2003.] [14: Barth, J.R.., Caprio, G. And Levine, R. 2001. "Banking Systems Around the Globe: Do Regulations and Ownership Affect Performance and Stability?" In Prudential Supervision: What Works and What Doesn't, ed. Frederic S. Mishkin. University of Chicago Press: Chicago, IL. ]

Effect of Regulation on Banking Behavior

The Moral Hazard Problem

The subject of market discipline is important because of depositor insurance. Most governments offer deposit insurance for people making deposits with banks in order to maintain a level of discipline in the marketplace. Normally, bank managers have strong incentives to engage in risky loans and other investments; however, mandated deposit insurance eliminates much of the risk to bankers. This constitutes a loss of market discipline. Another significant issue is the downside of lender of last resort -- Moral Hazard. This is the situation in which having insurance against some risk causes the insured party to take greater risk or to take less care in preventing the event that gives rise to the loss. The existence of a public 'safety net' creates a moral hazard, that is, a set of incentives for the protected to behave differently -- irresponsibly or less conservatively because of the existence of protection.[footnoteRef:15] [15: Boyd, J.H., Chun, C. And Smith, B.D. 1998. Moral Hazard Under Commercial and Universal Banking. Journal of Money, Credit, and Banking. 30: 426-468.]

Another Moral Hazard problem is that of the 'too big to fail doctrine'. The issue of excessive risk taking and their potential external consequences presents the notion that a firm's risk exposure is limited to its capital base whilst its external (random) losses are unbounded. This therefore establishes a condition for a firm to believe it is too big to fail. When banks are perceived too big to fail, they have a tendency to take excessive risks to profit in the short-term; they therefore seek to unduly exercise their market power, ruling the less powerful and pricing their services unrelated to their costs or quality. In order to counteract this loss of market discipline, the argument that governments must introduce "hard -- wired" rules and regulations aimed at preventing bank managers from taking excessive risk is viable.[footnoteRef:16] [16: Boyd, J.H., Chun, C. And Smith, B.D. 1998.]

The goal of a fully implemented regulatory program is that the market will become deeper, issuance will be more frequent, debt will be viewed as a more viable means to raise regulatory capital, and debt dealers will be less reluctant to disclose more details on debt transactions.[footnoteRef:17] Prior to the financial crisis, regulators believed that a degree of market discipline would be enhanced by establishing rules. Mandating the issuance of debt encourages banks (especially large complex banking organizations) to engage in less risky activities which in turn provide signals to market participants of the condition of the bank. Large complex banking organizations were being targeted because they are typically associated with systemic concerns of regulators. It should however not be overlooked that although debt allows banks to hold a portion of their liabilities, debt holders and supervisors are both concerned about bank risk. If a bank fails and if its assets value is less than its liabilities, depositors and senior debt holders are compensated first. The aim of subordinated debt proposals to enhance both direct and indirect market discipline as described above is now being overshadowed by the growing focus on convertible debt as a way of balancing market discipline with capital regulatory rules. This is because there is little evidence to suggest whether banks with higher elements of debt in their financing fared any better in the crisis than institutions with lower levels. [17: Barth, J.R.., Caprio, G. And Levine, R. 2001.]

Conclusion

To close, banks are critical to the proper function of the modern economy. Through a careful analysis of how banks operate, one can gain a useful appreciation of the differences between commercial "deposit-oriented" banks and investment banks. These differences in function and objectives result in significantly different regulatory framework for each type of institution, whether it be a government safety net when banks fail or government rules on the degree of investment leverage. The need for this regulation is because of the systemic risks to the economy: the risk that financial difficulties at one or more banks spill over to a large number of other banks or the financial system as a whole. The evolution of the legal framework surrounding this system has been decades in evolving in the United Kingdom and combines elements of the European as well as the international regulatory framework. Despite all this, economists have varying perspectives on the need for regulation and whether it is only necessary in the presence of market failure or deficiency. Various advantages and disadvantages to the regulation of these businesses exist because of the behaviors they encourage in the regulated entities and their customers. The specter of moral hazard is one such example of how regulation can pose as an artificial interloper in the free market and guide banks as well as individuals into making improper decisions. By gaining an understanding of the function of banking in society, the difference in commercial "deposit-oriented" versus investment banks, the role of government regulation and how the regulation of these entities shape their behaviors and their customers, the student of banking law will better be able to understand the debate swirling around him but also be able to contribute in time to a more secure legal and economic framework for all stakeholders involved.

Topic 2: Security for syndicated loans in an international context

Introduction

Borrowing by way of a loan facility can provide a borrower with a flexible and efficient source of funding. If a borrower requires a large or sophisticated facility or multiple types of facility this is commonly provided by a group of lenders known as a syndicate under a syndicated loan agreement. A syndicated loan agreement simplifies the borrowing process as the borrower uses one agreement covering the whole group of banks and different types of facility rather than entering into a series of separate bilateral loans, each with different terms and conditions. A variety of mechanisms exist in common and civil law jurisdictions to deal with the transfer of secured syndicated debt. This paper will examine what these legal mechanisms are and why a difference exists. By examining this phenomenon, the student of law can gain experience both in dealing with international banking law but also the nature of both civil and common law jurisdictions and legal frameworks.

Types of Syndicated Loans

Two types of loan facility are commonly syndicated: term loan facilities and revolving loan facilities: Term or Revolving. Under a term loan facility the lenders provide a specified capital sum over a set period of time, known as the "term." Typically, the borrower is allowed a short period after executing the loan (the "availability" or "commitment" period), during which time it can draw loans up to a specified maximum facility limit. Repayment may be in instalments (in which case the facility is commonly described as "amortising") or there may be one payment at the end of the facility (in which case the facility is commonly described as having "bullet" repayment terms). Once a term loan has been repaid by the borrower, it cannot be re-drawn. In contrast, a revolving loan facility provides a borrower with a maximum aggregate amount of capital, available over a specified period of time. However, unlike a term loan, the revolving loan facility allows the borrower to drawdown, repay and re-draw loans advanced to it of the available capital during the term of the facility. Each loan is borrowed for a set period of time, usually one, three or six months, after which time it is technically repayable. Repayment of a revolving loan is achieved either by scheduled reductions in the total amount of the facility over time, or by all outstanding loans being repaid on the date of termination.

A revolving loan can be made to refinance another revolving loan which matures on the same date as the drawing of the second revolving loan is known as a "rollover loan," if made in the same currency and drawn by the same borrower as the first revolving loan. The conditions to be satisfied for drawing a rollover loan are typically less onerous than for other loans. A revolving loan facility is a particularly flexible financing tool as it may be drawn by a borrower by way of straightforward loans, but it is also possible to incorporate different types of financial accommodation within it - for example, it is possible to incorporate a letter of credit facility, swingline facility or overdraft facility within the terms of a revolving credit facility. This is often achieved by creating a sublimit within the overall revolving facility, allowing a certain amount of the lenders' commitment to be drawn in the form of these different facilities.

In short, syndicated loan agreements may contain a term or revolving facility or they can contain a combination of both or several of each type (for example, multiple term loans in different currencies and with different maturity profiles are not uncommon). There can be one borrower or a group of borrowers with provision allowing for the accession of new borrowers under certain circumstances from time to time. The facility may include a guarantor or guarantors and again provisions may be incorporated allowing for additional guarantors to accede to the agreement.

Legal Framework Regarding Syndicated Loans

International syndicated loans are an important means of financing. After over 60-year development, it has achieved an irreplaceable status on the international capital market. Because of its transnational nature, complexity and accommodation, international direct syndicated loan's legal risks are different from other ordinary commercial loans, which make it a special research value.

In 1997 Parliament enacted the Banking Law, which includes provisions concerning syndicated loans. Bank syndicates are one of the main sources for financing international commercial transactions, large investments and debt restructuring. In granting such loans, banks use the standard instruments of ordinary loans (eg, term, revolving and stand-by facilities). The size and number of syndicated loans is increasing annually. The main beneficiaries of syndicated loans are major international companies (particularly shipyards and the telecommunications and energy industries).

Regulation

The regulation of syndicated loans was introduced in order to create a legal framework that enables the gathering of funds in order to finance large undertakings. Usually the bank representing the syndicate (syndicate agent) is also responsible for the enforcement of security (security agent) and the distribution of received money to other banks. The legislation provides limits on credit concentration. The sum of granted facilities, guarantees, letters of credit, purchased bonds and other receivables against a single entity or holding cannot exceed 25% of a bank's own funds. Moreover, the amount of receivables exceeding 10% of a bank's own funds against a single entity cannot exceed 800% of the entity's own funds. The FSA must be informed of the granting of a loan that exceeds 10% of a bank's funds.

Consequently, banks intending to finance undertakings that require higher capital proportions must establish syndicates. The main advantages are that (i) the cost of the syndicated loan may be lower than an ordinary loan since the risk is lower (being dispersed among several banks), and (ii) the administration and enforcement are carried out by the agent.

Legal Relationships

Syndicated loans are transactions in which at least two banks jointly represent to make available a facility to the borrower. The syndicate agreement establishes the relationship between the members of the syndicate. The facility agreement establishes the relationship between the syndicate and the borrower. In the former, syndicate banks regulate relations between themselves as well as the basic elements of the facility agreement. The syndicate agreement is separated from the loan agreement. Usually, the problem of cross-referencing is solved by, for example, concluding a syndicate agreement as an attachment to the loan agreement. Generally, the agreements are separate and independent. In cases of a secret syndicate where the borrower is unaware of the existence of the syndicate and concludes the loan agreement solely with the bank-agent, the loan agreement does not contain any cross-reference provisions and there is no direct legal connection between the other members of the syndicate and the borrower.