Banking regulation and systemic risk in modern economies

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.]

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.

The principle of proportional risk and responsibility of banks is established according to their proportion in the granted syndicate facility. Consequently, the obligations of banks are not joint and several. However, this does not release the banks from having to perform their duties pursuant to the facility agreement, since a syndicate has no common property and does not conclude the relevant agreement as a uniform entity. Furthermore, the syndicate agent is liable for its proportion, although in practice the agent frequently takes over the liability to disburse the whole loan amount. Regarding the borrower's liability, the common practice is to create a separate legal relationship between the syndicate banks, the syndicate agent and the borrower in which the latter is obliged to repay the agent bank.

This system appears to be contradictory. On the one hand, the responsibility of banks is proportional and the borrower cannot demand complete performance from one bank (or even one agent). On the other hand, the borrower is obliged to repay the whole debt to one bank/agent. A way around this is to retain the proportional responsibility of creditors, creating by virtue of contract a joint and several relationship between the banks in their position as creditor. Then repayment of the loan to any of the creditors has the same effect for all of the syndicate's members. In practice, syndicate banks usually establish fiduciary/trust relationships with the syndicate agent, the legal basis being the syndicate and loan agreements and security documentation. In such a situation the borrower or other entity is obliged to repay the loan and establish security to the syndicate agent, and the latter accepts the repaid sums and security in its own name but on behalf of all syndicate banks. The syndicate agent will enforce its rights according to the fiduciary rules as a trustee. Indeed, the law provides that banks granting a syndicate loan can authorize one of them to act as a security. In such cases a pledgor can establish a pledge in benefit of the security agent to secure receivables under the loan agreement of all syndicate banks. The legal character of a trust relationship between banks and the security agent is difficult to determine; it has some elements of the mandate agreement under Polish civil law but is more akin to an unnamed agreement concluded according to the freedom of contracts.

There is concern as to whether a loan arising from two separate facilities granted in different currencies (and consequently different interest rates) is one syndicate loan or two separate loans. If the facilities constitute one loan, the syndicate can establish one package of securities and the Polish agent bank can represent foreign entities as a security agent. The statutory definition of the loan under Polish banking law provides that the amount and currency are essential parts of the loan agreement. Fortunately, the regulation does not contain any restriction on the number of currencies or facilities in the frame of a single loan, and according to the definition of 'credit' in the Banking Law different tranches in different facilities are still 'pecuniary value'. The fact of plurality on the creditors' side has no influence on the freedom to determine the currency of each facility. The same refers to the interest rate, repayment schedule and security.

International Dimension

The international nature of syndicated loans provides the opportunity to the lender to have preference in 'choice of law', as in case of a dispute, it is his money that would need to be recovered. In case of the Euro bonds, where an investment bank helps in selling securities, the situation becomes different, as the lenders appear on scene after the bond is issued under certain terms including the matter of choice of law. In any case, while exercising the choice, it is preferred that such system is chosen that is familiar to the parties, so that the tendency of using certain type of financial transactions needs not to be changed. Further, the dealing with legal as well as business issues could be convenient. It is also important that the system chosen is greatly mature and the relevant jurisdiction enjoys good reputation for its impartiality. Political stability in that specific jurisdiction and convenience of language are also important factors in choosing a certain system of law. The incident of freezing of foreign currency accounts following imposition of emergency after the atomic tests in 1998, the stock market suffered such a huge loss that it took years to recover. In such a situation no serious financial activity can grow without fear of the unseen. While the enforcing forum is not less important a factor; the most significant factor of having the choice of law clause is the "insulation of the loan contract from legal changes in the borrower's country."

While outlining the contract some of the essential documents would be prepared; for example, in case of a bond issue, the subscription agreement, the trust deed, the agreement between managers, the selling group agreement and the bond instruments themselves, and in case of the syndicated loan, the loan agreement. All of these legal documents would require validity, enforceability and when needed interpretation. This could only be done under an agreed system of law. Determination of rights and liabilities and interpretation of the legal documents would involve a number of laws relevant to the different issue. These may include the securities law, principles of contract, interpretation of contracts law, insolvency law, negotiable instruments law, and the like. All these laws should relate to one system of law, so as to make their interpretation and implementation possible.

There are more than 310 jurisdictions in the world, which are grouped into nine classes i.e. Traditional English, American Common Law, Mixed Roman/common law, Germanic and Scandinavian, Mixed Franco-Latin/Germanic, Traditional Franco-Latin, Emerging Jurisdictions, Islamic Jurisdictions and Unallocated Jurisdictions. These categories are further combined into three major types: Common Law, Napoleonic and Roman-Germanic jurisdictions. This much number of jurisdictions naturally has a potential to create problems in case of international syndicated loans and bonds where different systems of law would be involved. So, it becomes imperative to have 'choice of law' clause in the legal documents.

Conclusion

The term international, in the syndicated loans and bonds, entails multiple laws, forums and jurisdictions. The conflict of laws, in such a case, is natural. Combination of laws, given their different approaches, is not a workable proposition. Harmonization of financial laws at international level is still an idealistic suggestion. So, to form, interpret and execute the international contracts, there is a need to adopt a single system of law. This, the parties to a contract can choose at the time of the concluding of the contract. This is done to ensure the validity, enforceability and interpretation of all the legal documents relevant to the contracts of syndicated loans and bonds. It helps eliminate the uncertainty and unpredictability of the fate of a contract. Most ideally, it is an external law, having a potential to insulate the loan contract from legal changes, especially, in the borrower's country. English law worthy of playing such a role. There is another advantage of choosing it: it doesn't demand any connection of the lender or borrower with England.