In recent days, government officials and regulatory authorities have reportedly announced that the activities of some unhealthy banks will be terminated.
The idea that banking supervision should be strengthened by giving more powers to supervisory authorities who should exercise those powers in a timely manner should be supported. But the important question is what is meant by an unhealthy bank? A bank that has had many errors? Or a bank that takes more risks?
Paying attention to this key question can play a serious and decisive role in determining the cases of banks that should be dealt with by supervision, and at the same time, neglecting this important issue can lead to wrong decisions that will not only harm banks but the entire community, Hamid Qanbari, a central banking expert, prefaced an editorial for Donya-e-Eqtesad with this note. A translation of the full text follows:
To explain the issue, let's assume that we are faced with two banks. The first bank does not comply with some of the Central Bank of Iran’s directives and insists on noncompliance; for example, when it is summoned to CBI to explain its activities, it does not attend; it does not allow inspectors into its bank branches; it prepares the contracts concluded with customers in only one copy and does not give a copy to clients; it collects more interest from the loans given to clients and at the same time gives less interest to the depositor.
It even finds fictitious dividends and distributes it among shareholders, but all these measures are not severe enough to affect the capital adequacy of the bank and the bank remains in a good situation.
On the other hand, another bank promptly attends all the meetings held by the regulatory authorities and provides all the requested information and statistics. It undertakes full cooperation and coordination with the inspectors. including depositors and borrowers, do not complain about it, but at the same time, in terms of capital adequacy, it is in a very dangerous condition and may reach a situation where it does not have enough resources to pay customers' deposits on demand. We call the first bank an error-prone bank and the second one a high-risk bank.
The question is, if we are going to ban a bank from continuing to operate, which one should it be? In response, we say that it is the risky bank that should be prohibited from operating. It is clear that errors can lead to hazards in many cases.
Failure to comply with the orders and requirements of regulatory authorities can make the bank's capital adequacy situation worse. Basically, many regulations and directives have been established with a view to prevent the occurrence and escalation of risks, and keep risks at an acceptable level. The example presented above was only to explain the difference between error and risk in banking supervision, which is of fundamental importance.
Two Types of Regulation and Supervision
In the texts related to bank supervision, two types of regulation and supervision are distinguished: conduct of business regulation and prudential regulation. Prudential regulations or supervision are established and implemented to ensure the financial condition and risk management of the bank. A violation of prudential regulations does not necessarily mean that a bank has committed an error. For example, banks may have kept a specific type of asset (such as mortgage bonds) among their assets.
The unexpected collapse of the housing market and the decline in the value of these bonds can cause the capital adequacy situation of these banks to suffer, and therefore they are obliged to take measures to correct their capital adequacy situation and return it to the desired state. That is, creating a problem in the capital adequacy of a bank does not necessarily mean that the bank has violated it.
These problems may occur due to market developments and factors beyond the control and will of a bank. Of course, banks are required to make the necessary predictions and precautions for possible market fluctuations, according to the Central Bank's instructions, but there are always unpredictable situations.
In short, the logic of monitoring business operations is different from the logic of prudential monitoring, and these two types of monitoring require two different mindsets. The importance of this difference is to such an extent that in a number of countries, two different supervisory authorities have been established under the title of "Commercial Operations Supervisory Authority" and "Prudential Supervisory Authority" and each of them supervises banks according to their target. Banks are required to be accountable to both regulatory authorities.
Now, the question raised at the beginning of this article should be raised again: What is meant by unhealthy and irredeemable banks? Does ‘unhealthy’ refer to banks that do not follow orders or banks that are in dire financial condition? Will financial statements and the status of assets and liabilities be the main criteria in regulatory measures, or in cases of violations of directives related to business operations?
A look at the experience of banking supervision in recent years and the past decades shows that sometimes banks targeted by the government had a favorable situation in terms of financial status, but their main problem was noncompliance with the government’s orders.
Of course, compliance with the regulatory authorities, orders and directives is important and should be taken seriously, but more serious and more important is managing the bank's risks and not creating a systemic crisis.
