Model Law on Licensing, Supervision, and Regulation of Banks

Chapter-by-Chapter Summary and Commentary

In a market economy, that was developing in the early 1990s in eastern Europe and former republics of the Soviet Union, modern commercial banking laws were needed for decentralized financial intermediation for credit institutions. I considered laws of some advanced countries as models but felt that they were too complex. Therefore, I developed a model law, initially for Angola, Vietnam and Czechoslovakia and subsequently the law was refined and drafts I initially prepared were enacted in 22 countries in Eastern and Central Europe, Central Asia and Southeast Asia.

Why are banks regulated and supervised? The basic reasons are often not considered in designing laws for credit institutions. The key factors for banks and why they are subject to the highest degree of supervision and regulation among financial services firms in most countries is that they are (i) significant repositories of the savings of the public as deposit takers, (ii) the most significant sources of credit to the economy, and (iii) the medium for the payments system.

Most countries also have rules on licensing, regulation, and supervision of non-bank financial institutions that extend credit such as consumer and commercial credit companies and microfinance institutions but absent the key three factors, their regulation and supervision should be less comprehensive and less resource intensive for supervisors than for banks. For example, if the funding of consumer or commercial credit companies is from their shareholders or from borrowing from banks or selling commercial paper, the funders of those companies are more sophisticated than ordinary retail depositors and therefore there is less need for prudential rules on how such non-bank institutions conduct their business.

Chapter I.   General Provisions

1. This Chapter defines the coverage of the Law. The banks subject to the Law are banks defined as entities that that take deposits from the public, extend credit for their own account, and are direct participants in the payments clearing and settlement system because their customers may transfer their deposits by cheque. Consumer or commercial credit companies, microfinance banks that do not take deposits, and microfinance banks whose amount of deposits is relatively small are not covered under the Law. Such banks should have limited impact on systemic soundness.
2. The Law treats equally locally-owned and foreign-owned banks. Thus, all banks have the same capital requirements and may engage in the same permissible activities regardless of their ownership.
3. In addition to banks, the Law is applicable to bank shareholders, officers and directors, employees, and affiliated entities of banks that are companies that control the bank or that the bank controls. Significant shareholders and affiliates can have an important influence on a bank and the Law seeks to ensure that this influence is positive. The Law also covers any person or company that illegally takes deposits and prohibits the dissemination of false or misleading information concerning a bank’s status or the taking of deposits. Such provisions could prevent financial frauds like pyramid schemes. The Chapter also contains definitions of key terms that make the law more precise and concise.

Chapter II.   Licensing

4. The Law provides that the Central Bank shall have sole authority to license and revoke the license of banks, unlike laws of some countries where other governmental entities have involvement with such processes that can make decisions more political than technical. The Law contains liberal licensing requirements such that qualified applicants will receive a license. A license will be granted based on the applicant demonstrating to the Central Bank that it has adequate financial and managerial resources and a sound business plan.
5. Thus, an applicant must provide information on: the qualifications and experience of the proposed senior officers and directors of a proposed bank, including business or professional history; the business plan including the organizational structure; the types of financial activities envisaged; projected financial statements for three years; and the business or professional history and financial statements of each person who proposes to be a principal shareholder. A license will be granted if the Central Bank determines that the business plan is based on reasonable assumptions; the bank will comply with all provisions of the Law; the qualifications and experience of its officers, directors and principal shareholders are appropriate for its business plan; and the personal and financial integrity of its officers, directors and principal shareholders is confirmed. A decision will be issued within three months from the submission of a complete application.
6. Licenses for foreign banks will be granted on the same criteria as for locally-organized banks with the addition that the Central Bank must be satisfied that the foreign bank is adequately supervised on a consolidated basis by the home country supervisor.
7. A license may be revoked by the Central Bank if false information was submitted in the license application, the activities of the bank differ significantly from those presented in the application, or another bank that is a significant shareholder in the bank has had its license revoked.

Chapter III.   Organization and Administration of Banks

8. Banks will be organized as limited companies or public companies under the Companies Law with the important difference that the Law contains certain provisions especially desirable for banks that supersede those in the Companies Law. These relate to rights and duties of shareholders and the composition and responsibilities of the board of directors. Banks will have one governing body and at least three directors who do not work full time in the bank and are not connected with principal shareholders or bank management, to seek to ensure that the board fulfills its basic functions of establishing policies of the organization and overseeing their implementation. Best practice is to have a majority of the board composed of independent directors but this is difficult for some countries.
9. Banks are required to seek prior approval of the Central Bank for certain significant corporate actions. If shareholders wish to own more than ten, thirty-five, or fifty percent of the shares of a bank, they must apply for prior approval and the determinations will be made on financial and managerial fitness for such significant ownership interest. These levels of ownership give shareholders certain important rights under many modern company laws.
10. Banks’ equity investments in non-financial companies are limited to fifteen percent of the company invested in and an aggregate amount equal to a percentage of a bank’s regulatory capital. Prior Central Bank approval is required for bank mergers and acquisitions or sale of substantially all of a bank’s assets. Criteria for a license and the effect on competition in particular banking markets would be considered by the Central Bank in deciding on merger and acquisition proposals.
11. Banks must have committees of the board of directors. An audit committee  would review the compliance by the bank with applicable laws and regulations, arrange for the external audit, and oversee internal audit and controls. A risk management committee would review a bank’s asset and liability management policies, which would include the pricing and maturities of its deposits and loans, and credit policies, that would include credit analysis, collateral requirements, and loan administration. A governance committee would identify qualified new members for the board of directors and provide for a program of governance evaluation of the board, its committees, and management.
12. There are requirements for past and present officers, directors, and employees of banks not to disclose nonpublic information that they obtained in their work for a bank.
13. Banks must also inform the appropriate authorities of suspect transactions to seek to prevent money laundering.
14. There are also provisions to seek to prevent exploitation of conflicts of interest by bank officers and directors. They must disclose the financial interests that they or their family members have and must not participate in any action by the bank that affects such interests. There is also a general fiduciary obligation for such persons to place the interest of the bank and the bank’s customers before their own personal interests.

Chapter IV.   Operational Requirements

15. This Chapter provides for two classes of banks whose permissible activities depend upon the amount of their capital. For trust and certain capital markets activities, banks must have a higher amount of capital.
16. The rule that the range of permissible activities that an bank can conduct will depend upon the amount of its capital is based on the policy that banks with the minimum amount of capital should conduct only activities that contain normal banking risk and that more capital is needed to engage in activities that present greater risk or require significant investment in human and material resources to properly conduct the activities. Thus, banks with the minimum capital will be permitted to provide a number of financial services, including receiving deposits; extending credit to natural persons and small business; buying and selling for a bank’s own account debt securities issued or guarantied by governments or central banks that are rated investment grade by internationally recognized rating agencies; and providing payment and collection services.
17. For banks with higher capital, additional financial services they may provide include: dealing in foreign exchange and derivative instruments; trust services; investment portfolio management; underwriting and distribution of debt and equity securities; and dealing in equity securities. Thus, banks with the higher level of capital would be permitted to engage in a full range of banking activities, like those conducted by so-called universal banks.
18. Banks will be subject to prudential requirements in areas including maintaining adequate capital and liquidity and limiting the amount of loans to one borrower or related borrowers in relation to the amount of their capital. Other important prudential instructions will require banks to take provisions or loss reserves for assets whose value is impaired and to limit unhedged positions in foreign exchange.
19. There is a general requirement for banks to refrain from anti-competitive practices, including requiring customers to use certain financial services if they wish to receive another. There are prohibitions on abusive securities-related transactions of a bank or a bank and its affiliate such as a bank providing credit to enable the borrower to purchase securities underwritten or distributed by a bank’s affiliate.
20. Banks must maintain proper corporate records, including minutes of meetings of its board and individual customer accounts, and must notify customers of the true rate of interest on loans and deposits. The Law also contains a rule for non-preferential conditions for banks’ transactions with related parties to seek to prevent abuses. These related parties are banks’ officers and directors, principal shareholders, and their family members and business interests.

Chapter V.   Accounts; Audit; Financial Disclosure

21. Banks must maintain proper accounts consistent with applicable accounting standards that reflect their financial condition and that of their affiliates on both an individual and consolidated basis. Banks must appoint an independent external auditor approved by the Central Bank who shall provide, in addition to the usual audit opinion as to whether the financial statements present a full and fair view of the financial condition of the bank, a review of the adequacy of internal audit and control practices and procedures and make recommendations for improvement and inform the Central Bank about any fraudulent act by any bank employee or any deficiency in the bank’s administration or operations that should be expected to result in a material loss for the bank.
22. An important factor in maintaining banks’ soundness is market discipline which is somewhat rare in developing countries but is to be encouraged. This means that depositors, shareholders and other providers of funding to a bank should withhold their investments if the bank is in deteriorating or poor financial condition. This can usually be determined from banks’ periodic financial statements and the Law requires banks to publish in a national newspaper a fair summary of its quarterly balance sheet and within four months of the end of its financial year its auditor’s report for the preceding financial year, and its annual report.

Chapter VI.  Supervisory Reporting, Meetings and Inspection

23. To enable the Central Bank to perform offsite and onsite supervision, this Chapter requires that banks submit to the Central Bank periodic reports concerning their administration and operations, liquidity, solvency, and profitability, and those of its subsidiaries, for an assessment of their financial condition.
24. The Central Bank will meet semi-annually with officials of banks to assess compliance of banks with applicable law and regulations and to discuss any matter of concern for the bank or the Central Bank.
25. Banks and their subsidiaries will be inspected by staff of the Central Bank or by auditors appointed by the Central Bank. Inspectors will examine the accounts and other records of the bank or subsidiary and require officers and employees to provide information on any matter relating to its administration and operations as they may reasonably request.
    
    

Chapter VII.   Infractions, Penalties; Remedial Measures

26. If a bank or any of its officers, directors or principal shareholders commits an infraction consisting of the violation of a provision of the Law or of any regulation or order of the Central Bank, the Central Bank must impose penalties or require remedial measures that include a written agreement with the bank’s governing board providing for a program of remedial action, orders to cease and desist from such infractions, imposition of fines, suspension or dismissal of officers or directors, and revocation of the license.
27. This Chapter also contains a system of prompt corrective action if a bank’s capital is considerably less than that required. Increasingly strict enforcement measures will be imposed if a bank continues to be undercapitalized, as its capital declines.

Chapter VIII.  Electronic Banking

28. This Chapter permits banks to provide their customers remote access to their accounts that could be especially useful for rural areas. Customers could transfer funds between accounts, initiate payments and apply for credit by computer or a smart phone. It also provides for Internet banks that would exist solely on the Internet. Special operations technology capability is required for electronic banking.

Chapter IX.  Cross-border Supervision; Liaison with Other Supervisors

29. This Chapter states that the Central Bank shall exercise consolidated supervision over branches and subsidiaries of local banks that have such branches or subsidiaries abroad. The Central Bank may communicate and exchange information with foreign and local financial sector supervisors and law enforcement authorities. The Central Bank shall also supervise foreign banks on the same basis as banks organized locally and may communicate information to home country supervisors of foreign banks provided that the Central Bank is satisfied with the degree of confidentiality accorded to such information by the home country supervisor.

Chapter X.   Miscellaneous and Transitional Provisions

29. This Chapter provides for transition by banks to the requirements of the new Law. Thus, their organization, administration, financial condition, and operations will have to conform in a certain time frame.

30. This Chapter also authorizes the Central Bank to issue regulations in implementation of the Law and provides criteria for judicial review of regulatory actions by the Central Bank. It also repeals laws and regulations that are inconsistent with the new Law.