Functions and Power of Bank Regulator
Commercial banks have important public roles. Their major public roles are money supply, payment system, and insured deposits. Bank regulator regulates the banks because of these important public roles of the banks. The primary responsibilities of bank regulators are 1) chartering, 2) regulating, 3) supervising, and 4) examining. In addition to these, the regulator has to perform other functions such as approval of bank mergers, lending money to banks, and so on.
The central bank in general has a right to charter the banks. For example, in the U.S.A. the Office of the Comptroller of the Currency and State Banking Commissions have the right to charter banks. Similarly, in Nepal, Nepal Rastra Bank has the right to charter the banks and financial institutions in Nepal. The regulator examines the documents and other details submitted by applicants before chartering the bank. In Nepal, the Banks and Financial Institutions Act has empowered Nepal Rastra Bank to grant approval or refuse the application for the incorporation of banks. Therefore, the applicant should take prior approval from Nepal Rastra Bank for the incorporation of banks and financial institutions in Nepal.
By bank regulation, we mean the formulation and issuance by authorized agencies of specific rules or regulations under governing law for the structure and conduct of banking. In Nepal, NRB as a regulatory authority frames necessary rules and regulations to realize the objectives of the Banks and Financial Institutions Act, 2016.
Bank supervision is concerned primarily with the safety and soundness of individual banks. It includes general and continuous oversight to assure that banks are operated prudently in accordance with applicable statutes and regulations. The regulator supervises banks and financial institutions to ensure that banks and financial institutions are complying with banking regulations, governing acts, and directives issued by regulating authorities. Bank supervisors have a variety of options at their disposal to deal with the banks that are not complying with rules and regulations. First, a regulator may issue a memorandum of understanding (MOU) to the banks detailing the changes that must take to put the banks back in good standing. The second option for a regulator is to issue a cease and desist order that prohibits a bank or a person from continuing a particular course of conduct. Finally, a regulator can close the banks.
Banks face two types of examination: (1) examination of financial health (safety and soundness of the bank) and (2) compliance with all of the relevant laws and regulations. Regulators in many countries adopt the uniform financial rating system which is known as CAMELS. This acronym stands for capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L), and sensitivity (S).
i) Capital adequacy: In capital adequacy, the regulator examines the amount of regulatory capital that banks are required to maintain based on their risk-weighted assets.
ii) Asset quality: In asset quality, the regulator examines the quality of assets especially loans and advances, and investment. For the purpose of regulatory purposes, assets are classified into performing assets and nonperforming assets. Loans and advances are classified into pass loans, restructured and rescheduled loans, loans on a watch list, substandard loan, doubtful loan, and loss loan. Substandard, doubtful, and loss loans are nonperforming loans and the rest are performing assets. A higher proportion of nonperforming loans implies a low quality of assets and there should be sufficient allowances for these loans. So, the regulator examines the different types of assets and loan allowances for nonperforming loans.
iii) Management: In this component, the regulator examines the capability of the board of directors and management to measure, monitor, and control the risk and maximize the wealth of shareholders.
iv) Earnings: In this component, the regulator examines the profitability of the concerned banks. It uses different measures of profitability.
v) Liquidity: In this component, the regulator examines the ability of a bank to meet its financial obligations and the needs of its customers.
vi) Sensitivity: In this component, the regulator examines the market risk, especially interest rates risk and foreign exchange risk, and the ability of the banks to manage the market risks.
After examination of each component of CAMELS, the regulator prepares composite ratings on 5 point scale. In composite rating, 1 indicates that the bank is sound in every aspect, and 5 indicates the most unsafe and unsound financial health of the bank. Rating 1 and rating 5 are the extremes ends of the bank performance.
Thus, the regulator examines whether banks are complying With the relevant rules and regulations.