MSc Computing for Financial Services

1
MSc Computing for Financial Services

• COM717M1
• Financial Services Information Systems
• Dr Sandra Moffett

2
Module Overview

• The aim of this module is to introduce students
  to the Financial Services industry as a potential
  working environment. The module will examine the
  various sectors within the industry, with
  particular emphasis awarded to the Financial
  Services Authority (FSA) for corporate status,
  regulations, legislation and career
  opportunities. The role which ICT has played in
  emerging Financial Service practices will be
  investigated. Throughout the module students
  will be developing skills to meet future industry
  requirements in terms of technical, social and
  management potential.

3
Module Aims

• To enable students to comprehend the various
  industries which contribute to the Financial
  Services sector
• To understand the roles available and skills
  required for employment within this fast growing,
  rapidly changing environment in terms of
  technical capability, social communication and
  project management
• To analyse current and emerging ICT developments
  within Financial Services

4
Financial Services Sector?

• Financial Services (FS) is a term used to refer
  to the services provided by the finance industry.
  
• Also used to describe organizations that deal
  with the management of money, includes
  organizations such as banks, credit card
  companies, consumer finance companies, government
  sponsored enterprises, insurance, investment,
  actuarial and brokerages services.
• FS is the largest industry (or industry category)
  in the world.

5
History of FS

• The term financial services became more prevalent
  in the United States partly as a result of the
  Gramm-Leach-Bliley Act (1999), which enabled
  different types of companies in the US financial
  services industry to merge
• In the USA almost every company now which
  previously described themselves as a bank,
  insurance company, or brokerage house, now
  describes themselves in some way as a financial
  services institution
• Allstate Insurance now provides CDS and
  investment brokerage services
• Bank of America offers full-featured brokerage
  products
• ETRADE has expanded into offering bank accounts
  and loans
• Companies usually have two distinct approaches to
  this new type of business.
• 1 - A bank which simply buys an insurance company
  or an investment bank, keeps the original brands
  of the acquired firm, and adds the acquisition to
  its holding company simply to diversify its
  earnings. Outside the U.S. (for example in Japan)
  non-financial services companies are permitted
  within the holding company. In this scenario,
  each company still looks independent, and has its
  own customers, etc (for example Citigroup and JP
  Morgan Chase)
• 2 - A bank simply creates its own brokerage
  division or insurance division and attempt to
  sell those products to its own existing
  customers, with incentives for combining all
  things with one company (for example Washington
  Mutual and Wells Fargo)

6
Changing industry

• Mainly due to four emerging factors, namely
• The globalization of financial markets
• The impact of technology
• The deregulation of the Financial Services
  industry
• The importance of product innovation

7
Globalization of financial markets

• National financial markets are increasingly
  integrated into a global network of markets
• Borrowers can raise funds on financial markets of
  other countries and investors can take advantage
  of opportunities in other nations
• Financial institutions seek to be global to
  expand and retain existing customers reliant on
  foreign trade
• Governments more relaxed UK Conservative
  government in 1979 abolished exchange controls
• Caution
• Loss of local knowledge UK banks know best US
  firms to lend money to?
• International debt crisis Mexico in 1982
• In 1995 Barings bank brought to brink of collapse
  by infamous Nick Leeson operating on behalf of
  SIMEX exchange in Singapore

8
Technology

• Markets e.g. London Stock Exchange switched to
  screen-based trading in 1980s - almost
  instantaneous transfer of price sensitive
  information around the globe
• Store and analyse masses of information
• Enhanced ability to monitor and analyse
  financial, political and economic developments
  better communications, reduced costs
• New complex products to be devised and priced
• ATMs and Internet banking debit card lt5 cost
  of processing a cheque payment
• Higher skills needed posts now requesting
  mathematics, engineering and physics up to PhD
  level
• Caution
• London Stock Exchange had to abandon a planned
  paperless trading system called TAURUS in 1995 at
  cost of 400 million due to problems with the
  system
• High investment costs (though low
  running/maintenance costs) need for backward
  compatibility
• Security issues - hacking

9
Deregulation

• 1980s saw shift towards less regulation process
  of deregulation
• Deregulation in UK followed by deregulation on
  the continent
• UK government introduced series of tax breaks
  such as TESSAs (tax exempt special savings
  accounts) and PEPs (Personal Equity Plans)
• Adopted privatization programme advice,
  consultancy, underwriting fees and public share
  interest
• Most governments need to strike balance between
  regulation and ability for industry to develop
  without overburdensome restrictions.

10
Financial Innovation

• Design of new financial instruments or the
  packing together of existing instruments
• Market broadening innovations work to increase
  the liquidity of markets by attracting new
  investors and providing new opportunities for
  borrowers
• Risk management innovations the effect of
  redistributing financial risk exposure from
  risk-adverse agents to those willing to undertake
  risks
• Arbitraging innovations innovations that use
  agents to exploit arbitrage opportunites either
  within or between different markets seek to
  take advantage of loop-holes in regulatory or tax
  frameworks
• Pricing innovations seek to reduce the cost of
  achieving a specific investment objective
• Marketing innovations innovative methods of
  selling and distributing financial products

11
Types of Financial Markets

• Money market deals in short-term assets that
  can be quickly transformed into money
• Securities market deals with the raising of new
  capital and trading of existing shares and bonds
• Foreign exchange market differing currencies
  are trading for one another
• Derivatives market future obligations to
  buy/sell, or options to buy/sell, underlying
  financial assets are traded
• Distinction can be made between primary and
  secondary markets

12
Primary Markets

• Deals in the issue of new securities such as
  government bonds, local authority bonds and
  shares in newly public corporations.
• Active market participants are merchant and
  commercial banks and investment firms provide
  advice on the terms and timing of an offering,
  might underwrite the issue and assist in
  marketing the offering

13
Secondary Markets

• Deals in financial securities that have already
  previously been issued user of the asset does
  not receive any proceeds from the sale of the
  security, however price of issuers shares
  indicates value of company.
• Screen-based market trading is undertaken by
  geographically dispersed market participants
  linked via telecommunications systems ie
  International Stock Exchange in London
• Call market orders are batched together at
  certain intervals (once or more a day) and
  market-trader holds auction for the stock either
  orally or in writing auction determines market
  price ie London gold bullion market
• Continuous market prices quoted continuously by
  market-traders throughout the trading day ie
  London Stock Exchange or Paris Bourse. New York
  Stock Exchange uses mixed system, call technique
  determines opening prices and continuous trading
  techniques employed throughout the day

14
Classification of Financial Markets (1)

• The type of asset traded may deal with debt
  instruments or equity instruments or combination
  of the two
• The maturity of asset traded money market (debt
  instrument maturity lt 1 year) or capital market
• The date of issue of assets traded primary or
  secondary markets
• The means of settlement immediate delivery is
  referred to as cash market, settlement is
  sometime in future referred to as forward or
  futures market
• The obligation to exchange in some markets
  counterparties must exchange on an immediate or
  future basis such as spot or forward markets, in
  others holder buys the right but not the
  obligation to buy or sell an underlying asset at
  a given date and price in the future, the options
  market

15
Cont ... (2)

• The organisational structure of the market some
  markets like the swap market (over-the-counter
  markets) are where tailor-made products in which
  individual banks design specific products to meet
  individual needs. Others are designed on
  broker-jobber relationship, where clients pass
  buy/sell instructions to brokers who then seek
  best prices from jobbers. Other alternative is
  screen-based market where buy/sell is via
  computer terminals
• The method of sale/pricing Financial assets can
  be sold by various methods
• London Stock Exchange primarily based on system
  of market-makers that both quote prices and
  buy/sell shares.
• The London International Financial Futures
  Exchange (LIFFE) primarily based upon system of
  pit trading where traders set prices and buy/sell
  futures and options around a pit.
• In an over-the-counter market, product is
  tailor-made and pricing is determined directly
  between buyers/ sellers.

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The Efficiency of Financial Markets

• Financial markets are informationally efficient
  if the current market price of a security
  instantly and fully reflects all relevant
  available information (Fama, 1970, p.383)
• Three levels
• Weak-form efficiency if current prices of
  securities instantly and fully reflect all
  information of the past history of security
  prices it should not be possible to make
  consistent excess returns on securities by
  looking at past history of their price movements
  and using this as basis for future trading
• Semi-strong-form efficiency if current prices
  of securities instantly and fully reflect all
  publicly available information it should not be
  possible to make consistent excess returns on
  securities by using publicly available
  information as basis for future trading
• Strong-form efficiency if current prices of
  securities instantly and fully reflects all
  information, both public and private. In other
  words, even traders, directors or analysts with
  access to privileged inside information should
  not be able to make consistent excess returns on
  securities by using inside information as basis
  for future trading

17
Types of FS organizations

• The Central Bank
• The Banking Sector
• Credit card companies
• Consumer finance companies
• Insurance
• Investment
• Actuarial Services
• Brokerages services
• Conglomerates

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The Central Bank

• A key financial institution involved in setting
  the monetary framework within which both the
  economy and financial institutions operate.
• Examples include
• Federal Reserve of the United States
• the Bundesbank of Germany
• the Bank of England, the Bank of Japan
• the Bank of France
• the Bank of Italy
• Functions include
• The implementation of monetary and exchange rate
  policy
• The management of National Debt
• The supervision of the banking sector
• As the banker to the central government and the
  commercial banks
• As lender of the last resort

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Banks

• The primary operations of banks include
• Keeping money safe while also allowing
  withdrawals when needed
• Issuance of cheque books so that bills can be
  paid and other kinds of payments can be delivered
  by post
• Provision of loans and mortgage loans (typically
  loans to purchase a home, property or business)
• Issuance of credit cards
• Allow financial transactions at branches or by
  using Automatic Teller Machines (ATMs)
• Facilitation of standing orders and direct
  debits, so payments for bills can be made
  automatically
• Provide overdraft agreements for the temporary
  advancement of the Bank's own money to meet
  monthly spending commitments of a customer in
  their current account
• Provide Charge card advances of the Bank's own
  money for customers wishing to settle credit
  advances monthly
• Provide cheques guaranteed by the Bank itself
  prepaid by the customer which are the recognised
  as valid by other Banks (travellers cheques).

20
Virtual Banking

• Virtual banking is banking from home as it allows
  transactions that bypass branches and ATMs (e.g.
  internet banking), there is no need to contact a
  bank staff member. Virtual banking has changed
  the way people bank in many ways. In the past,
  people opened a bank account when they first
  started work and stayed with that bank for their
  whole lives now, it is much easier to move an
  account, mortgage or loan from one banking
  institution to another. Many customers look at
  what other banks are offering and change their
  account if they find a better deal, so banks now
  have fewer loyal customers. It is common for
  credit card companies to entice new customers
  with offers such as zero per cent interest for
  the first six months.

21
The Top Ten

• Top 10 banks in the world according to the
  Economist (as at end 2004)

22
Credit Card Companies

• Barclaycard
• MBNA
• Virgin
• HSBC
• AA
• BT
• Morgan Stanley
• Post Office
• Natwest

• Lloyds TSB
• Cahoot
• Halifax One
• Hilton
• RSPCA
• and many more

23
The Top Five
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Consumer Finance Companies

• Consumer finance covers a wide range of
  activities, including loans from banks and
  indirect finance such as hire-purchase
  agreements, and loans by specialist retail
  finance companies.
• At the most respectable end of the market,
  consumer finance is an integral part of retail
  banking and an important source of unsecured
  loans
• However, in many countries some 'consumer
  finance' companies are little different from loan
  sharks, offering considerably higher interest
  rates than those available on other unsecured
  loans.
• On another view, however, such companies are
  beneficial because they offer credit to sectors
  of society which are otherwise excluded from
  financial markets, and the credit offered is no
  worse than the alternative credit cards.

25
Insurance

• Insurance, is a form of risk management primarily
  used to hedge against the risk of a contingent
  loss. Insurance is defined as the equitable
  transfer of the risk of a loss, from one entity
  to another, in exchange for a premium.
• The Insurer is the company that sells the
  insurance. The Insurance rate is a factor used to
  determine the amount (premium) to be charged for
  a certain amount of insurance coverage.
• Risk management, the practice of appraising and
  controlling risk, has evolved as a discrete field
  of study and practice.

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Principles of Insurance (1)

• Commercially insurable risks typically share
  seven common characteristics
• (Mehr and Camack Principles of Insurance, 6th
  edition, 1976, pp 34 37)
• A large number of homogeneous exposure units -
  the vast majority of insurance policies are
  provided for individual members of very large
  classes (e.g. automobile insurance). The
  existence of a large number of homogeneous
  exposure units allows insurers to benefit from
  the so-called law of large numbers which in
  effect states that as the number of exposure
  units increases, the actual results are
  increasingly likely to become close to expected
  results. There are exceptions to this criterion.
  Lloyds of London is famous for insuring the life
  or health of actors, actresses and sports
  figures. Satellite Launch insurance covers events
  that are infrequent.
• Definite Loss - the event that gives rise to the
  loss that is subject to insurance should, at
  least in principle, take place at a known time,
  in a known place, and from a known cause. The
  classic example is death of an insured on a life
  insurance policy. Fire, automobile accidents, and
  worker injuries may all easily meet this
  criterion. Other types of losses may only be
  definite in theory. Occupational disease, for
  instance, may involve prolonged exposure to
  injurious conditions where no specific time,
  place or cause is identifiable. Ideally, the
  time, place and cause of a loss should be clear
  enough that a reasonable person, with sufficient
  information, could objectively verify all three
  elements.
• Accidental Loss - the event that constitutes the
  trigger of a claim should be fortuitous, or at
  least outside the control of the beneficiary of
  the insurance. The loss should be pure, in the
  sense that it results from an event for which
  there is only the opportunity for cost. Events
  that contain speculative elements, such as
  ordinary business risks, are generally not
  considered insurable.

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Cont (2)

• Large Loss - the size of the loss must be
  meaningful from the perspective of the insured.
  Insurance premiums need to cover both the
  expected cost of losses, plus the cost of issuing
  and administering the policy, adjusting losses,
  and supplying the capital needed to reasonably
  assure that the insurer will be able to pay
  claims. There is little point in paying insurance
  costs unless the protection offered has real
  value to a buyer.
• Affordable Premium - if the likelihood of an
  insured event is so high, or the cost of the
  event so large, that the resulting premium is
  large relative to the amount of protection
  offered, it is not likely that anyone will buy
  insurance, even if on offer. Further, the premium
  cannot be so large that there is not a reasonable
  chance of a significant loss to the insurer. If
  there is no such chance of loss, the transaction
  may have the form of insurance, but not the
  substance.
• Calculable Loss - there are two elements that
  must be at least estimatable, if not formally
  calculable the probability of loss, and the
  attendant cost. Probability of loss is generally
  an empirical exercise, while cost has more to do
  with the ability of a reasonable person in
  possession of a copy of the insurance policy and
  a proof of loss associated with a claim presented
  under that policy to make a reasonably definite
  and objective evaluation of the amount of the
  loss recoverable as a result of the claim.

28
Cont (3)

• Limited risk of catastrophically large losses -
  the essential risk is often aggregation. If the
  same event can cause losses to numerous
  policyholders of the same insurer, the ability of
  that insurer to issue policies becomes
  constrained, not by factors surrounding the
  individual characteristics of a given
  policyholder, but by the factors surrounding the
  sum of all policyholders so exposed. Typically,
  insurers prefer to limit their exposure to a loss
  from a single event to some small portion of
  their capital base, on the order of 5. Where the
  loss can be aggregated, or an individual policy
  could produce exceptionally large claims, the
  capital constraint will restrict an insurers
  appetite for additional policyholders.
• The classic example is earthquake insurance,
  where the ability of an underwriter to issue a
  new policy depends on the number and size of the
  policies that it has already underwritten. Wind
  insurance in hurricane zones, particularly along
  coast lines, is another example of this
  phenomenon.
• In extreme cases, the aggregation can affect the
  entire industry, since the combined capital of
  insurers and reinsurers can be small compared to
  the needs of potential policyholders in areas
  exposed to aggregation risk.

29
Insurers business model

• Insurers make money in two ways
• 1 - through underwriting, the process by which
  insurers select the risks to insure and decide
  how much in premiums to charge for accepting
  those risks
• 2 - by investing the premiums they collect from
  insureds.
• Underwriting is the most difficult aspect of the
  insurance business. Using a wide assortment of
  data, insurers predict the likelihood that a
  claim will be made against their policies and
  price products accordingly. To this end, insurers
  use actuarial science to quantify the risks they
  are willing to assume and the premium they will
  charge to assume them. Data is analyzed to fairly
  accurately project the rate of future claims
  based on a given risk. Upon termination of a
  given policy, the amount of premium collected and
  the investment gains minus the amount paid out in
  claims is the insurer's underwriting profit on
  that policy. Of course, from the insurer's
  perspective, some policies are winners (i.e., the
  insurer pays out less in claims and expenses than
  it receives in premiums and investment income)
  and some are losers (i.e., the insurer pays out
  more in claims and expenses than it receives in
  premiums and investment income)
• Insurance companies also earn investment profits
  on float. Float or available reserve is the
  amount of money, at hand at any given moment,
  that an insurer has collected in insurance
  premiums but has not been paid out in claims.
  Insurers start investing insurance premiums as
  soon as they are collected and continue to earn
  interest on them until claims are paid out.

30
Types of Insurance companies

• Insurance companies may be classified as
• Life insurance companies, which sell life
  insurance, annuities and pensions products
• Non-life or general insurance companies, which
  sell other types of insurance
• General insurance companies can be further
  divided into two sub categories
• Standard Lines - main stream insurers. These are
  the companies that typically insure your car,
  home or business. They use pattern or "cookie
  cutter" policies without variation from one
  person to the next
• Excess Lines - typically insure risks not covered
  by the standard lines market, more customisation
  of policies

31
Actuarial Services

• Actuaries apply financial and statistical
  theories to solve real business problems. These
  business problems typically involve analysing
  future financial events, especially when the
  amount of a future payment, or the timing of when
  it is paid, is uncertain. A lot of actuaries
  work might be thought of as risk management,
  assessing how likely an event may be and the
  costs associated with it
• Understanding how businesses operate, how
  legislation may impact and how financial
  economics can affect values are all vital skills
  for an actuary. However, what differentiates
  actuaries is their core mathematical, economic
  and statistical understanding and their ability
  to apply this to real financial problems

32
Brokerage Services

• Organizations that provide Intermediation or
  advisory services i.e. insurance brokers,
  mortgage brokers and stock brokers
• The aim of the broker is to find the most
  attractive deal for the purchaser at that given
  moment in time, they are not associated with one
  mutual organization, therefore they can source
  from numerous companies

33
Conglomerates

• A financial services conglomerate is a financial
  services firm that is active in more than one
  sector of the financial services market e.g. life
  insurance, general insurance, health insurance,
  asset management, retail banking, wholesale
  banking, investment banking, etc.
• A key rationale for the existence of such
  businesses is the existence of diversification
  benefits that are present when different types of
  businesses are aggregated i.e. bad things don't
  always happen at the same time. As a consequence,
  economic capital for a conglomerate is usually
  substantially less than economic capital is for
  the sum of its parts

34
Regulation of the Financial Sector

• Regulation has a major impact upon the operation
  and developments of financial markets, often
  revised and adjusted in response to changes in
  market structure, market development, new
  financial instruments and occasional financial
  scandal or crisis. Seen as a means of exerting
  some degree of control over markets and means of
  maintaining confidence and stability in the
  financial system.
• Government intervention rationalised on grounds
  of market failure, left to itself market would
  produce a sub-optimal outcome
• Four instances of market failure frequently cited
  as needing government intervention to correct
• The externalities problem
• The problem of asymmetric information
• The moral hazard problem
• The principal-agent problem

35
The externalities problem

• The financial system provides a payments
  mechanism for the entire economy, and financial
  institutions play a pivotal role of linking both
  users and lenders of funds. This means that
  problems in the financial sector can potentially
  have a disastrous effect on the entire economy
• The failure of firms that produce goods or
  services, or even whole industries, is less
  likely to have devastating effects throughout the
  entire economy for most countries than the
  collapse of a leading bank or the financial sector

36
The problem of asymmetric information

• Directors and managers of companies as well as
  financial institutions have available to them an
  information set on the soundness of their own
  company or institution and its likely policies
  that is superior to those that earlier lend to or
  invest in that company or institution. This could
  lead to problems such as insider trading and the
  concealment of relevant information from
  investors. For this reason, many countries have
  adopted insider trading laws prohibiting trading
  in shares on information that is not publicly
  available. A further set of regulations imposes
  disclosure requirements on companies to make
  public a great deal of financial information to
  potential and actual investors.

37
The moral hazard problem

• Moral hazard means that insuring against an event
  occurring will make the event more likely to
  occur than if the event was not insured against.
  For instance, a deposit insurance protection
  scheme will guarantee investors their funds
  should a deposit-taking institution get into
  difficulty. However, this may encourage
  depositors to channel more of their funds into
  risky financial institutions which are more
  likely to run into problems and thereby lead to a
  higher loss of deposits than if no deposit
  protection insurance policy existed. This will be
  even more the case of financial institutions take
  on more risk than they otherwise would, knowing
  that investors will be protected if the
  institution encounters problems

38
The principal-agent problem

• Directors and managers of financial institutions
  act as agents for the shareholders and investors
  in the institution (the principles). There is a
  potential problem that the directors and managers
  will pursue their own interests at the expense of
  the shareholders and investors. For example, the
  managers may have performance-related bonuses
  that encourage them to high risks which imperial
  the funds of shareholders and investors. For this
  reason, they are obliged to disclose information
  on the financial performance of the company and
  are subjected to rules on their dealings

39
Types of Government regulation

• Structural regulation covers the different
  types of activities, products and geographical
  boundaries within which financial institutions
  can operate
• Prudential regulation covers the internal
  management of a financial institution ie the
  setting of ratios to ensure that the institution
  has sufficient capital to absorb possible losses,
  and sufficient liquidity to meet obligations
• Investor protection covers measures designed to
  protect investors from mismanagement of funds,
  malpractice and fraud

40
Statutory versus self-regulation

• Statutory regulation is part of the law and is
  usually supervised by the authorities
• With self-regulation supervision and enforcement
  is left to market participants/practitioners
  usually in the form of various regulatory bodies
• Self-regulation is more flexible and can be
  quickly adapted to fast changes in FS industry
• Market practitioners more effective at spotting
  breaches of regulations leads to higher
  professional standards and rooting out fraud as
  practitioners are better able to judge what
  constitutes unacceptable standards
• - Dependant upon members for funding hence
  judgements can favour members opinions rather
  than general consumers
• - may impose too onerous requirements on new
  entrants proposing innovative fashions, members
  have vested interest in preserving status quo

41
Regulation in the UK

• Deregulation
• Abolition of exchange controls 1979
• Government legislation only enforceable at
  national level, globalisation so option to
  operate in alternative country
• At beginning of 80s feeling that London was
  losing too much business to USA and other
  countries, prompted big bang in 1986 (covered in
  next slide)
• Legislation largely ineffective and caused
  distortions in financial markets
• Regulation
• Prompted by innovative products such as options,
  junk bonds, swaps, etc. legislation required as
  response to market developments
• Three major pieces of legislation
• Big Bang, 1986, the Financial Services Act 1986
  and Banking Act 1987 led to creation of
  Financial Services Authority (FSA) in 1997

42
Big Bang 1986

• October 1986 witnessed so-called Big Bang of
  deregulation of Londons Stock Exchange
• Admission to the Stock Exchange was opened up to
  corporations whereas before membership had been
  restricted to private partnerships
• The broker-jobber divide was ended and firms were
  permitted to be both market-makers in shares and
  advisers/brokers
• Fixed minimum commissions were abolished
• Successful in maintaining London as key financial
  centre
• Technology improved speed of execution of share
  deals and enabled greater volume
• Abolition of fixed commissions, increased market
  capacity and greater competition resulted in
  halving of transaction costs with large share
  deals, gilt trading commissions disappeared and
  profitability was determined by bid-ask spread

43
The Financial Services Act 1986

• Came into force on 29th April 1988 to maintain
  investors confidence in financial system
  following number of well-publicised cases of
  fraud
• Imposed a number of statutory requirements on FS
  industry but favoured self-regulation
• Creation of Securities and Investment Board (SIB)
  which recognises number of self-regulatory
  organisations (SROs) i.e. Personal Investment
  Authority (PIA)
• SIB and SROs received much criticism
• Dependant on member subscriptions
• Framework perceived as unwieldy and fragmented,
  large degree of overlap between SROs
• Competition between SROs - lowering of standards
  to attract members
• Call for SIB and SROs to be combined into single
  coherent body FSA (covered in later slides)

44
The Banking Act 1987

• Provided a new framework for the Bank of England
  to conduct its supervision of the banking sector
  following the international debt crisis which
  commenced with Mexican moratorium of 1982 large
  potential losses on loan portfolio to Latin
  America
• Act ended distinction between recognised banks
  and licensed deposit-taking institutions to
  create a single class of authorised
  institutions subject to common rules and
  regulation.
• Act clarified criteria of who constituted a fit
  and proper person to run a bank
• Set up new board of banking supervision to assist
  Bank of England supervise banking sector
• Banks required to report any large individual
  exposure and to provide certain other information
  to Bank of England
• Criminal offence to knowingly and recklessly
  provide false info
• BoE empowered to seek audits on institutions
  internal control systems
• BoE power of access and entry to an institution
  where contravention of Act suspected
• Additional criteria establishing prudential rules
  relating to capital and liquidity ratios,
  definition and measurement of capital and
  supervision of off-balance-sheet exposure

45
Financial Services Authority

• In May 1997 the Government announced major
  reforms to the regulation of financial services -
  nine different financial Regulators into a single
  body
• The FSA (Financial Services Authority),
  officially launched on 28th October, was formed
  to regulate all banks, building societies, life
  assurance and general insurance companies,
  stockbrokers, investment managers, financial
  advisers and more besides
• The legislation to be established in two parts
• first changes to the Banking Act (early part of
  1998) to transfer responsibility for banking
  supervision from the Bank of England to FSA
• followed by a major bill to sweep up the existing
  legislation such as the 1986 Financial Services
  Act into a new and comprehensive Act the
  Financial Services and Market Act 2000
• http//www.opsi.gov.uk/Acts/acts2000/20000008.htm
  

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The role of FSA

• In discharging its general functions the
  Authority must, so far as is reasonably possible,
  act in a way -   
• (a) which is compatible with the regulatory
  objectives and 
• (b) which the Authority considers most
  appropriate for the purpose of meeting those
  objectives
• The regulatory objectives are -   
• (a) market confidence 
• (b) public awareness 
• (c) the protection of consumers and 
• (d) the reduction of financial crime
• http//www.fsa.gov.uk/

47
European Regulation

• EU is common market ensuring free trade for goods
  and services and free movement of factors of
  production (capital and labour)
• White paper of 1985 created single European
  market paved the way for free internal market
  in FS within a common regulatory structure
• The principle of mutual recognition e.g.
  British bank able to sell product range in Italy
  regardless of whether Italian banks are allowed
  to sell these products/services
• Agreement on what constitutes the minimum of
  reasonable standards to be applied European
  Commissions overall approach has been to achieve
  liberalisation through the passport principle
  a licence obtained in one EU member state should
  be sufficient to qualify licensee to sell its
  products/services in all EU countries
• Two key EU legislative pieces affecting Banking
  sector are First and Second Banking Directives
• http//www.hm-treasury.gov.uk/documents/financial
  _services/eu_financial_services/fin_eufs_index.cfm
  
• http//www.fsa.gov.uk/Pages/Library/Communication
  /Speeches/2004/SP178.shtml

48
First Banking Directive 1977

• Aimed to end restrictions on the setting up of
  foreign branches by a bank in another Community
  country and to ensure the principle of free
  establishment
• Aimed to create equal regulation of domestic and
  foreign banks within a member state whilst
  allowing different regulations to exist between
  member state
• Directive covered the co-ordination of national
  laws, regulation and administrative procedures
  relating to setting up of banking activity bank
  free to establish branch or subsidiary in another
  member state provided it operated under
  supervision of host country
• Range of products offered by branch restricted by
  host countrys legislation

49
Second Banking Directive 1989

• Adopted in 1989 to establish a list of banking
  activities to be covered by the principle of
  mutual recognition as from Jan 1993
• Established single banking licence valid
  throughout EU bank has freedom to operate in
  any member state without further authorisation
  from host state regardless of whether activities
  are allowed in host country
• Shift from First Directive responsibility on
  home country, unlimited product offerings

50
International regulation the Basle Accord 1988
(1)

• Failures of Bankhaus Herstaatt and Franklin
  National in 1974 led to increased interest in
  prudential supervision at international level
  questions impact of foreign bank failure on
  domestic banks, ensures that foreign subsidiaries
  do not escape regulatory controls
• Basle Committee on Banking Regulation and
  Supervisory Practice, consisting of senior
  central banking officials from G-10 countries,
  created Basle Accord 1988 with overall aim of
  ensuring soundness and stability of international
  banking system
• To ensure greater consistency of capital adequacy
  ratios between banks of different countries
• To try and improve capital adequacy standards to
  reflect the risk profile of different banks

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cont (2)

• Bank capital in two tiers
• Tier 1 core capital consists of common stock
  equity, certain preferred stock, net reserves,
  minority interests in consolidated subsidiaries
  (4)
• Tier 2 supplementary capital consists of
  loan-loss reserves, certain preferred stock,
  perpetual debt (no maturity date), hybrid capital
  instruments, subordinated debt and equity
  contract notes (8)
• Implemented from Jan 1994 all banks are expected
  to maintain a capital ratio that is risk-weighted
  on basis of their assets, so if they have to
  write off some assets, the bank would not be
  endangered. Five category credit risk 0, 10,
  20, 50 and 100
• Calculation example in next slide

52
Risk weighting system under Basle Accord
53
Example capital reserves

• Bank A
• Tier 1 - 0.04 X 1900 million 76 million
• Tier 2 0.08 X 1900 million 152 million
• TOTAL 228 million
• Bank B
• Tier 1 0.04 X 2850 million 114 million
• Tier 2 0.08 X 2850 million 228 million
• TOTAL 342 million

54
Summary

• This lecture covered
• Overview of Financial Services Industry
• History
• FS markets
• FS organisation types
• Regulation
• Legislation
• Financial Services Authority
• EU regulation
• International regulation