Banks and Financial Institutions

Banks

The most common type of FI is the commercial bank. In the most general case, a bank accepts deposits from both consumers and businesses, and then lends some portion of those deposits to other entities. The acceptance of deposits and provision of loans are the primary criteria used to define a bank, sometimes referred to as a depository institution, for the purposes of regulation. In some cases, a bank may be limited to servicing certain sectors or customer bases, but the deposit and loan criteria are still present. Banks are subject to specific legislation and regulation, which affect whether and how they deliver services.

A. Bank Functions and Services

1. Commercial Banks

A commercial bank is an FI that accepts deposits and makes commercial loans. Commercial banks range from small, single-site community banks with several million dollars in assets to large, global FIs with trillions in assets.^[1] The rules and charters governing commercial banks vary across countries. In the United States, commercial banks must possess a federal or state charter.

Banking systems in most countries have a few large FIs operating on a national basis. A global commercial bank operates in multiple countries in more than one region, providing services to both domestic and multinational companies. Differences in banking structures and financial regulations may impact the way in which global commercial banks offer services in certain countries. This is because a global commercial bank is required to follow the guidelines of the country in which it is operating, no matter where the bank is headquartered.

Country-level differences in banking practices can also lead to differences in the way that accounts are handled. For example, in certain countries demand deposit account holders are allowed to earn interest on positive account balances, and accounts may have automatic overdraft provisions for negative balances.

The primary services offered by commercial banks include depository accounts and credit services. Other core services include transaction processing and information reporting. Depending on their client base, commercial banks may also offer other services, including trade services, foreign exchange (FX) services, and financial risk management services. A commercial bank may offer these services itself, or it may work with other partner or correspondent banks to provide some services, especially on a cross-border basis.

a. Depository Account Services

Companies use commercial bank accounts to store cash, both for transactional and security reasons. Bank accounts enable companies to make and receive payments in a variety of formats, both domestically and on a cross-border basis. Depending on the credit rating of the bank, bank accounts can also provide a relatively secure location for surplus cash, especially in the short term. Managing short-term investments is discussed in more detail in Chapter 13, Short-Term Investing and Borrowing.

Commercial banks typically offer a number of different types of deposit accounts, each of which will have different functionality, terms, and conditions. In some locations, companies may be restricted to holding only certain types of bank accounts or they may be required to gain regulatory approval before opening an account. In China, for example, most nonresident foreign companies require central bank approval before opening an account denominated in Chinese renminbi (RMB). Companies may also be required to hold a particular type of bank account, as in the United Arab Emirates (UAE), where companies must pay their UAE-based employees via direct debit from a bank account located in the United Arab Emirates. Bank account management is discussed in more detail in Chapter 7, Relationship Management and Financial Service Provider Selection.

b. Credit Services

A primary function provided by commercial banks is financial intermediation, in which a bank lends funds deposited by savers to entities needing capital. Commercial banks offer a wide range of business loans that vary by:

• Borrower type

• Use of proceeds

• Loan maturity

For example, commercial bank loans may have a medium- or longer-term maturity and may be secured with collateral. Loan repayment may be made with the borrower’s general operating cash flow, but in some cases repayment may be restricted to cash flows generated by the asset being financed. Loans are often collateralized by the company’s property, plant, or equipment, but the collateral may be limited to the specific asset being financed (e.g., equipment loans or property loans). Leasing divisions of banks provide an alternative to medium- and long-term loans for financing capital equipment.

Short-term business loans (usually with a term of less than a year) may be made to finance investments in operating working capital (e.g., accounts receivable and inventory). Such loans may take a couple of different forms:^[2]

• With a term loan or term note, a business borrows a specific amount to be repaid by a specific date.

• With a revolving line of credit (i.e., a revolver), a business can borrow up to a specified amount, repay all or part of the outstanding balance, and borrow again in the future. The revolver may have a “cleanup” (or resting) period provision in which the borrower must pay down the balance on the credit line for a relatively short period of time (e.g., 30 days).

An overdraft facility allows a business to effectively borrow from a bank by withdrawing funds from a bank account such that the account has a debit balance. Where permitted, banks offer overdraft facilities up to a specified limit (the overdraft limit). Overdraft facilities are usually repayable on demand, meaning the bank can withdraw a facility without notice or explanation. Overdrafts are usually unsecured.

Another way that FIs can facilitate the acquisition of credit for corporate and institutional customers is through the issuance of commercial paper (CP) and, in the case of sub-sovereign governments and agencies, the issuance of municipal securities (commonly called munis). CP consists of unsecured, discounted, short-term promissory notes issued by companies or commercial bank holding companies. FIs typically act as agents to place CP with investors. CP is rated for default risk by credit rating agencies, and the rating has a significant effect on the interest rate. Munis (i.e., sub-sovereign securities) are bonds or notes issued by city, county, or state government entities and generally have some type of income tax exemption for any interest paid on them. Municipal securities are also rated for default risk.

Banks also offer loan sales and private placements. Loan sales involve the structuring of lending facilities so that short-term loans can be sold to other banks and investors. Private placements are the direct sales of long-term notes to institutional investors (e.g., insurance companies and hedge funds).

c. Transaction Processing

Most commercial banks provide transaction-processing services related to check, card, and electronic payments. In most countries, banks control access to the various payment systems, and any payment other than a cash transaction usually goes through a bank at some point in the process. That said, there has been a growth in nonbank payment processing services, both on a domestic and a cross-border basis. Payments are discussed in more detail in Chapter 4, Payment Instruments and Systems, and in Chapter 12, Disbursements, Collections, and Concentration.

d. Information Reporting

Financial information is critical for efficient management of a firm’s treasury operations. Commercial banks provide a variety of information-reporting services that may include both bank-specific and external information. Information-reporting services include account balances, transaction details, information relating to loans and lines of credit, FX rates, and investment rates. Balance reporting may be limited to account balances at a single bank, or can include balances from multiple domestic and international banks. Bank information-reporting solutions are also used to initiate payments and make decisions on exception items.

Open banking technology and regulation is reducing banks’ ability to control access to bank-provided information. For example, in the European Union, the second Payment Services Directive (PSD2) enables account information service providers (AISPs) to access bank account information, with customer consent, in order to aggregate, via an application programming interface (API), all bank account positions from multiple banks.

e. Trade Services

Some banks provide a wide range of services to facilitate the payment and collection of trade obligations. These are often used for international business, but sometimes they are also used domestically. Trade is discussed in more detail in Chapter 12, Disbursements, Collections, and Concentration.

f. Foreign Exchange (FX) Services

Most banks offer FX services to corporate customers to facilitate international business and trade, including the following services:

• Foreign currency payments. The simplest form of FX service is a bank’s facilitation of the sending (or receiving) of cross-border foreign currency payments from (or into) a customer’s bank account that is denominated in that customer’s operating currency.

• Foreign currency accounts. Most banks targeting business and corporate customers offer foreign currency accounts, where deposit balances may be held in a currency other than that of the country of location. Foreign currency accounts are most often available in the major international currencies, including Canadian dollars (CAD), euro (EUR), British pounds sterling (GBP), Japanese yen (JPY), and US dollars (USD).

• Multicurrency accounts. Some banks (and payment service providers) offer multicurrency accounts, in which a customer can use one account to make and receive payments in several currencies. In this scenario, the provider typically operates a series of virtual accounts^[3] in which the balances in each participating currency are managed. The multicurrency account can be domiciled in the holder’s jurisdiction, making these accounts an attractive cash management tool, especially for smaller businesses.

• Foreign currency transaction services. Some banks also allow companies to buy or sell internationally traded currencies for either immediate (spot market) or future (forward market) use.

Some FX services are also available from specialist nonbank providers, including international money transfer providers.

g. Financial Risk Management Services

Financial risk management services help mitigate the effects of adverse changes in interest rates, FX rates, and commodity prices. Such services include instruction on potential risk mitigation techniques, which might involve the use of financial derivatives. Financial derivatives include forwards, futures, swaps, and options. These instruments are known as derivatives because their market value is derived from an underlying asset (e.g., a currency, a commodity, or a security). Financial risk management is discussed in more detail in Chapter 17, Financial Risk Management.

2. Investment Banks

Investment banks provide a wide range of financial services related to the issuance and trading of securities. The functions offered by investment banks are generally much broader than the narrow range of investment banking services typically offered by commercial banks. Investment banking services provided include (1) securities underwriting; (2) providing custodial services; (3) facilitating mergers, acquisitions, divestitures, and other corporate reorganizations; and (4) acting as a broker/financial advisor for institutional clients. There is a more detailed discussion of investment banking activity in Chapter 6, Capital Markets.

3. Universal Banks

A universal bank is one that offers both commercial and investment banking services, with investment banking services offered through the investment banking arm of a commercial bank’s holding company. In the United States, the 1933 Glass-Steagall Act prohibited banks from providing both commercial and investment banking services, until the act was fully repealed by the 1999 Gramm-Leach-Bliley Act. Restrictions were partially reinstated by the adoption of the Volcker rule (part of the 2010 Dodd-Frank Act). In the United Kingdom, the 2013 Financial Services (Banking Reform) Act required the largest UK banks to separate (or “ring-fence”) their commercial and investment banking activities.

4. Industrial Banks

An industrial bank (or an industrial loan company) is an FI with a limited scope of services. Industrial banks sell certificates called investment shares and can also accept customer deposits. They then lend the deposits out via installment loans to consumers and small businesses. Industrial banks accept deposits but they do not offer checking accounts. Because of their limited services, industrial banks do not fall under general banking regulatory authority, are locally chartered, and may be owned by nonbank holding companies. As an example, automobile manufacturers have established industrial loan companies to facilitate consumer sales.

5. Central Banks

A central bank or reserve bank provides banking services to a country’s government and banking sector. Central banks are usually also responsible for issuing currency and implementing government monetary policy. Some central banks are also responsible for supervising commercial banks and the country’s payment systems.

a. Central Bank Functions

Central banks typically bear responsibility for one or more of the following functions:

• Monetary policy. Many central banks are responsible for implementing monetary policy. This is typically done using tools such as (1) the reserve requirement ratio, which stipulates the minimum percentage of deposits that a bank must keep on hand; (2) open market operations, which include the purchase and/or sale of government securities; and (3) the setting of an official interest rate used for lending to financial institutions (e.g., this rate is referred to as the discount rate in the United States). Additional explanation of monetary policy is provided below.

• Currency issuance. Many central banks are responsible for issuing currency, which they provide to FIs and other investors in exchange for government bonds. The income derived from this activity is called seigniorage^[4] and is used to fund the central bank’s operations or is remitted to the country’s government.

• Supervision and regulation. Central banks may be directly responsible for supervising and regulating the country’s commercial banks. An example of this is the US Federal Reserve.

• Government services. Some central banks provide financial services to their own government, taking the place of commercial banks. They are in effect the government’s bank. This can include providing basic deposit and safekeeping services, as well as the sale and redemption of government securities.

• Depository institution services. Central banks may provide various services to FIs. These services can include the operation of clearing and settlement systems, the provision of coin and currency, and the holding of reserve balances. Central banks may also act as the “lender of last resort,” by providing loans to FIs unable to raise funds in the interbank market.

b. Monetary Policy

Financial institutions play a key role in the implementation of the monetary policy set by a country’s central bank. Monetary policy is the management of money supply and interest rates to target inflation and, indirectly, economic growth. The primary tools in monetary policy are the interest rates set by the country’s central bank (e.g., the Federal Open Market Committee in the United States or the Monetary Policy Committee of the Bank of England), central bank money market operations, and local reserve requirements. Changes to any of these are transmitted through the economy (i.e., the monetary policy transmission mechanism) via their effects on the size of the country’s money supply.^[5]

The transmission mechanism works in three ways:

• Changes in interest rates. If a central bank increases the rate of interest it charges commercial banks, the commercial banks will usually increase the rates of interest they charge their customers, which will, in turn, reduce demand for loans. The interest rate change may also have an effect on asset prices, including the exchange rate, which will alter incentives in the market and influence pricing, purchasing, and investment decisions.

• Changes in reserve requirements. Central banks (and other bank supervisors) require commercial banks to hold a certain proportion of assets as reserves (often, but not always, with the central bank). Increasing a reserve requirement will reduce the ability of a bank to create loans, which will directly reduce the size of the money supply. Reducing a reserve requirement will have the opposite effect. Reserve requirements produce a multiplier effect in association with bank lending. If a bank accepts a deposit of $10 million, it has to hold a proportion in reserve. If the reserve ratio is 10%, then the bank must retain $1 million of that deposit and may lend out the remaining $9 million. The $9 million might be used by a company to pay its suppliers, who will then place the funds on deposit with their banks. Those banks will (collectively) need to hold $900,000 as reserves but can write $8.1 million in new loans. The process of recycling deposits in this way allows banks to create money in the form of loans, increasing the money supply, and is known as fractional reserve banking. A certain amount of deposit growth is critical to economic growth, but too much growth can lead to inflation and other economic problems.

• Central bank money market operations. Most central banks engage in open market operations, in which they buy (or sell) government securities to reduce (or increase) market interest rates. For example, in reaction to the 2007–2009 global financial crisis, the practice of quantitative easing (in which central banks purchased a range of money market assets) helped to keep interest rates low in an attempt to boost economic activity, while also ensuring companies and FIs had access to short-term liquidity.

6. Other Banks

There are a number of types of other banks. One example is an export credit bank or export credit agency (ECA), which provides companies with financing and insurance products to support the exporting of goods, especially into emerging markets. ECAs can be government-owned or private institutions that act as the intermediary between the government and the exporting companies.

B. Bank Regulation

This section outlines the role of legislation, regulation, and supervision to ensure the stability of, and public confidence in, the financial system.

1. Prudential Regulation and Supervision of Banks

The primary job of bank regulators is to monitor the credit and liquidity risks relating to potential bank failures and to implement safeguards that can reduce the overall risk of systemic failure (i.e., the collapse of the entire banking system). There are several approaches regulators can take to address these risks, and most countries impose regulatory oversight of some type on the traditional banking functions. Such oversight results in restrictions on the banks’ actions in order to manage the overall riskiness of the financial system and reduce the impact of potential bank failures. There are two stages in a bank supervisory regime: (1) initial chartering and (2) ongoing supervision and surveillance of chartered (or licensed) banks.

a. Initial Bank Chartering or Licensing

The chartering or licensing process generally refers to the establishment or opening of banks and other depository institutions (e.g., credit unions or savings banks) and the guidelines as to the types of financial services they are allowed to offer. Some countries have very clear distinctions between different types of depository institutions and their services, while other countries allow single institutions to offer a broader range of services. Chartering regulations also typically specify the amount of capital needed to open a bank and may also limit the ownership of banks in a country by foreign entities. The United States has a dual banking system, in which banks are either federally or state chartered.

b. Bank Monitoring and Surveillance

Once licensed to operate, banks will be under the supervision of one or more regulators. This is usually in the form of on-site examinations, as well as requirements that the bank produce accounting statements and other operational and financial reports on a regular basis to be evaluated off-site. The degree of monitoring can vary significantly across countries.

Regulators set a number of requirements and may perform stress or other tests to assess the robustness of each bank’s balance sheet. The requirements include the imposition of:

• Capital and liquidity requirements. One of the primary regulatory approaches is the setting of minimum capital levels required of banks operating within the country. Capital requirements determine how much capital (usually defined as equity funds) the owners of a bank must contribute to the business. This is typically in the form of a ratio of the bank’s capital to at-risk assets, where the latter includes loans and other investments. The higher the ratio of capital to assets, the lower the bank’s risk. Many regulators use the concept of tiered capital, in which common equity is the first tier (i.e., most stable) while preferred stock and long-term debt form a second tier (i.e., less stable). The concept of tiered capital allows regulators to differentiate the risks of banks with identical ratios of capital to assets.

• Minimum asset quality requirements. A second regulatory approach related to the safety and soundness of the banking system is to ensure proper investment policies and diversification on the part of each bank. An example of this would be regulations to ensure that banks make loans that are properly priced for default risk. In most countries, the regulatory authorities will monitor the quality of the loan and investment portfolios of the banks closely, and will generally place restrictions on how much can be loaned to or invested in a particular company or industry sector. These are referred to as impairment of capital rules. The basic idea is to limit the chances that the failure of one large company, and the resulting defaults on its loans, could lead to a bank’s failure.

As part of their supervisory activities, regulators may assess each bank’s net interest margin. Defined as the difference between the interest rate at which the bank lends to borrowers and the interest rate that the bank pays to depositors for funds held on deposit, net interest margin is one of the primary sources of earnings for banks. The bank’s intermediary function results in default/credit risk (i.e., if the borrower does not repay the loan) and liquidity risk (i.e., if depositors withdraw their deposits with little notice). From a bank’s point of view, these risks could result in the possible failure of the bank. From the perspective of the economy in general, the risks from bank failures include depositors losing their money and potentially a collapse of the entire banking system.

c. Basel Capital Accords

Many countries base their monitoring and surveillance regimes on the Basel Accords, which have evolved since 1988, when the Basel Committee on Banking Supervision (BCBS) published an initial set of minimum capital requirements for banks. This was originally known as the 1988 Basel Capital Accord, and eventually Basel I. Basel I established minimum capital ratios for large banks based upon the credit risk of the various assets of each bank.

In 2004, the BCBS published the second set of Basel Accords, typically referred to as Basel II. Basel II expanded the risk ratings implemented by Basel I and added an assessment of operational risk to the existing credit risk evaluation in establishing core capital requirements for major banks. Basel II was based upon three so-called pillars:

• Minimum capital requirements to address credit and operational risk

• Supervisory review, which provided a framework for dealing with and evaluating risk

• Market discipline, which focused on disclosure requirements regarding risk metrics and capital adequacy

The third Basel Accords (Basel III) were developed in 2011 in response to the global financial crisis of 2007–2009. Basel III extended Basel II to address stress testing and market liquidity risk, as well as capital adequacy. Basel III was largely implemented by the end of 2018 to strengthen the regulation, supervision, and risk management of the banking sector, although some components of the risk management element are being implemented more gradually, with Basel III due to be fully implemented by the beginning of 2028. As part of Basel III, core capital requirements were increased by approximately 2%, and minimum leverage and liquidity requirements were introduced.

Basel III’s stated goals are to:

• Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source

• Improve risk management and governance

• Strengthen banks' transparency and disclosures

The reforms target:

• Bank-level regulation, which will help raise the resilience of individual banking institutions to periods of stress

• System-wide risks that can build up across the banking sector, as well as the procyclical amplification of these risks over time

These two approaches to supervision are complementary, as greater resilience at the individual bank level reduces the risk of system-wide shocks. Basel III also recognizes the existence of two tiers of systemically important banks (i.e., global and domestic), to which additional requirements apply.

In summary, Basel III includes the following requirements:^[6]

• Minimum capital levels. All banks are required to hold minimum common equity of 4.5% of risk-weighted assets (RWA), plus a capital conservation buffer of 2.5% of RWA, as well as a countercyclical buffer of between 0% and 2.5% of RWA.

• Leverage ratio. All banks must maintain a minimum 3% of equity against all on- and off-balance-sheet exposures. (Some national regulators have imposed a higher leverage ratio.)

• Liquidity coverage ratio. All banks must hold a sufficient quantity of high-quality liquid assets to cover net cash outflows over a stressed 30-day period. Banks are required to distinguish between “operational” and “non-operational” corporate deposits when forecasting the level of net cash outflows.

• Net stable funding ratio. All banks are required to closely match the maturities of their assets and liabilities.

2. Deposit Insurance

Deposit insurance, which is referred to as a deposit guarantee in some countries, is intended to protect the assets of smaller deposit customers (typically consumers, although corporate accounts are also often covered up to a certain amount) who would be most harmed by a bank failure. To this end, most deposit insurance regulations place some limit on the amount of funds that will be guaranteed. A trade-off associated with the protection afforded by deposit insurance is the concept of moral hazard. If the depositors know that their money is insured regardless of which bank they use, then the depositor has a reduced incentive to investigate the bank’s creditworthiness. From the banker’s perspective, the moral hazard issue is that the bank may undertake a higher level of risk (e.g., make riskier loans or investments), knowing that if the bank fails, the government will protect depositors.

Ultimately, the key benefit of deposit insurance or a deposit guarantee is that it increases the overall confidence in the banking system, especially on the part of smaller depositors. Depositor confidence in any bank is critical to that bank’s survival. A lack of consumer confidence can lead to “bank runs,” in which a large number of depositors demand the return of their deposits all at once. Since banks are in the business of lending deposits out to other customers, they rarely have enough currency on hand to pay off a large group of depositors simultaneously and can therefore be forced out of business. During the Great Depression, many banks were forced to close due to bank runs, rather than actual insolvency. During times of financial crisis, some regulators have increased the levels of deposit insurance in order to bolster consumer confidence and prevent a panicked withdrawal of funds by depositors.

3. US Approach to the Regulation and Supervision of Banks

Each country has its own system of banking supervision and regulation, which is implemented via specific laws and regulations. This section highlights the key legislation and regulations that apply to the US banking system, illustrating how legislation empowers specific regulatory authorities to issue and enforce specific rules and regulations. Because rules vary between jurisdictions, a company should understand the implications of all relevant regulations and legislation in every country in which it operates.

a. Federal Reserve Act (1913)

The Federal Reserve Act established the Federal Reserve System (the Fed) and provided the foundation for the current banking system. It requires all banks with a national charter granted by the Office of the Comptroller of the Currency (OCC) to become Reserve banks, and thus become subject to Fed regulation, supervision, and reserve requirements. The act also empowered the Fed to create a national check collection and settlement system through member banks.

b. Federal Reserve Regulations

The Fed defines and enforces several key US banking regulations that impact treasury professionals.^[7] Some of the major regulations are outlined below.

i. Regulation D

Regulation D implements the reserve requirement provision of the Federal Reserve Act of 1913, and imposes uniform reserve requirements on all depository institutions, with different levels of reserves for different types of deposits.

ii. Regulation Q

There have been two versions of Regulation Q. The original Regulation Q implemented the interest-bearing account restriction of the Glass-Steagall Act of 1933 and barred the paying of interest on any corporate demand deposit accounts. Interest rate ceilings initially set by this regulation on all commercial bank deposit accounts were partially phased out in 1986 by the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980, and the final restrictions on corporate demand deposits were removed by the Dodd-Frank Act of 2010.

The current Regulation Q was introduced in 2013 and implements the Basel III minimum capital requirements and capital adequacy standards for all banks regulated by the Federal Reserve.

iii. Regulation Y

Regulation Y implements various provisions of the Bank Holding Company Act of 1956, the Change in Bank Control Act of 1978, and subsequent revisions covering the acquisition of control of banks and bank holding companies. It defines and regulates the nonbanking activities in which bank holding companies and foreign banking organizations in the United States may engage, including anti-tying restrictions.

iv. Regulation BB

Regulation BB implements the provisions of the Community Reinvestment Act of 1977 as revised in 1995, and requires banks to help meet the credit needs of the entire community in which they do business.

v. Regulation VV

Regulation VV implements the Volcker rule, section 619 of the Dodd-Frank Act, which is discussed below.

vi. Regulation WW

Regulation WW imposes minimum liquidity requirements on large and internationally active banking organizations and is based on the liquidity coverage ratio (LCR) introduced in Basel III.

c. Glass-Steagall Act (also known as the Banking Act of 1933)

The Glass-Steagall Act was passed to address major issues and problems with the financial services industry stemming from the Great Depression. As initially written, the act:

• Prohibited commercial banks from underwriting securities except for government issues

• Prohibited securities firms from engaging in bank-like activities, such as deposit gathering

• Required the Fed to establish interest rate ceilings on all types of accounts and prohibited the payment of interest on demand deposits (provisions of this act were incorporated in Federal Reserve Regulation Q)

• Created the Federal Deposit Insurance Corporation (FDIC) to guarantee deposits up to a stipulated maximum amount in order to restore faith in the banking system after numerous Depression-era bank failures

The Gramm-Leach-Bliley Act of 1999, discussed below, repealed almost all of Glass-Steagall with the exception of deposit insurance under the FDIC.

d. Anti-tying Amendments to the Bank Holding Company Act (1970)

The term tying refers to the act of requiring an organization or individual to purchase a product or service in order to be allowed to obtain a separate product or service. Under the 1970 amendments to the Bank Holding Company Act of 1956, the federal government prohibits tying in financial services, in an effort to increase competition and remove unfair banking practices. In general, the regulations provide that an FI may not condition the extension of credit on the requirement that the borrower obtain other services from the FI. There are some broad exclusions to the general rule as a result of what is called the traditional bank product exception. Under this exception, banks may condition the terms, including price, of an offer based on the requirement that the customer purchase or use other products from the bank, as long as all of the products are available separately to the same customer.

e. Gramm-Leach-Bliley Act (1999)

The Gramm-Leach-Bliley Act (also called the Financial Services Modernization Act) eliminates many of the provisions of the Glass-Steagall Act, especially those that created barriers among the functions of commercial banking, investment banking, and insurance. Specifically, this regulation:

• Permits the creation of financial holding companies (FHCs) that can engage in any activity that the Fed considers financial in nature or incidental to it

• Establishes the Fed as the primary regulator of FHCs, which are subject to consolidated capital requirements at the parent-company level and bank-style risk management at all levels

• Allows easier entry by foreign banks into the US financial services market

• Includes key provisions relating to consumer protection, including specific regulations regarding the protection of nonpublic personal information

f. Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

The Dodd-Frank Act introduced a number of measures^[8] aimed at strengthening the financial sector, including:

• The formation of the Financial Stability Oversight Council and the Consumer Financial Protection Bureau (both discussed in Chapter 2, Legal, Regulatory, and Tax Environment).

• The requirement for the Federal Reserve to conduct annual stress tests on the largest and most complex financial institutions.

• The introduction of the Volcker rule. Named for Paul Volcker, the former Fed chairman who first suggested it, the rule limits an FI’s ability to engage in proprietary trading for its own portfolio. In 2018, Congress passed the Economic Growth, Regulatory Relief, and Consumer Protection Act, which exempted banks with assets valued at less than $10 billion from the Volcker rule.

Nonbank Financial Institutions: Functions and Services

Companies also obtain financial services from a range of nonbank financial institutions/intermediaries (NBFIs), which generally focus on specific markets. Examples of NBFIs include brokers (or broker-dealers), private equity firms, captive finance companies, insurance companies, asset-based lenders, and asset managers.

Nonbank financial institutions are sometimes collectively referred to as constituting a “shadow banking” system. Many of the services they provide are similar to those offered by the different types of banks outlined above, in that they facilitate the extension of credit or take deposits outside the strict prudential bank supervisory regime. However, because NBFIs are not subject to the same level of regulation as banks, they are also outside the banking system’s systemic protections, such as access to central bank funding and deposit insurance schemes, and therefore represent a risk to financial stability in those countries with a relatively large shadow banking system.

One of the consequences of the global financial crisis of 2007–09 has been an increased awareness among legislators and regulators of the major role played by the shadow banking system. Two areas have been of specific concern:

• The role of asset managers, including hedge funds and money market funds, and therefore the risk of contagion in the event of a collapse of a fund. Regulators have become more aware of the importance of money market funds as providers of money market liquidity (both as purchasers of money market instruments and as locations for surplus short-term cash). In particular, regulators have become more concerned that the failure of one money market fund could affect money market liquidity more generally as a result of contagion. The regulation of money market funds is discussed in more detail in Chapter 5, Money Markets.

• The growth in the use of all forms of financial derivatives, including credit derivatives, beyond the oversight of central banks and other financial regulators. The lack of central clearing has made it difficult for banks, and therefore regulators, to understand the nature of each institution’s exposure to different financial risks, posing a growing threat to the stability of the financial system in the event of another crisis. The regulation of the use of derivatives is discussed in more detail in Chapter 17, Financial Risk Management.

A. Broker-Dealers

A broker-dealer, or brokerage firm, is an entity that trades securities for its own account or on behalf of its customers. When executing trade orders on behalf of a customer, the institution acts as a broker. A broker that executes trades for its own account is also a dealer,^[1] and may be referred to as a broker-dealer.^[2] Securities bought from clients or other firms in the capacity of a dealer may be sold to clients or to other firms, acting again in the capacity of a dealer, or they may become a part of the broker-dealer’s own holdings.

When acting as dealers, brokerage firms take positions in securities so they can facilitate market transactions by acting as the counterparty^[3] in the purchase and sale of securities. The price at which the dealer will sell a security is known as the ask price, while the price at which the dealer will purchase a security is known as the bid price. The difference between the ask and bid prices is called the spread, and represents the dealer’s gross profit on a specific transaction. Dealers also enter into repurchase agreements, which are money market transactions used to finance a dealer’s securities inventories. Money markets and related securities fall under the jurisdiction of a variety of regulators, depending on the parties to the transaction, the securities involved, and the markets or exchanges on which the instruments are traded.

In addition to trading securities, brokerage firms assist investment banks in the process of issuing new securities by handling the sale of those securities. This may be done as part of an initial public offering (IPO) by a privately owned firm that is becoming a publicly owned company, or it may involve selling new securities and debt offerings issued by existing public companies. More information on investment banking activities involving the issuance and sale (distribution) of securities is provided in Chapter 6, Capital Markets.

Broker-dealers can hold securities in their name, in the customer’s name, or in a “street name.” In the latter case, the securities are held in the broker’s name on behalf of the broker’s customer. Holding securities in street name does not affect the rights of the actual owner of the securities, but does eliminate the need to reregister or reissue securities in the name of the actual owner. This was originally done to simplify trading, as reregistration of securities once took several days. Although this is no longer an issue due to electronic trading systems and the ability to change ownership names immediately, money market securities are still frequently held in street name. This practice also permits investors to keep their investment activities anonymous, absent any legal requirements for public disclosure.

Although many broker-dealers are independent firms solely involved in broker-dealer services, others are business units or subsidiaries of commercial banks, investment banks, or investment companies.

Brokerage firms can be institutional and/or retail brokers. Institutional brokers’ clients are mostly large institutions (e.g., hedge funds or large corporations). Institutional brokers generally transact in large blocks of securities. Retail brokers typically handle smaller investment accounts and transactions for individuals, and may have offices in multiple locations, as well as research services to assist retail clients. Brokers are compensated through fees and/or commissions. The commission rates charged by institutional brokers may be lower than the rates charged by retail brokers, but the actual commissions received will be higher, due to the larger dollar volumes of the institutional transactions.

Brokerage firms can be further categorized into either discount or full-service firms. Discount brokerages let investors make trades at reduced prices, but provide little or no investment advice. Full-service brokerages have research analysts that provide investment advice to institutions and individual investors. Because of the potential for conflict of interest, full-service brokerages must provide research to their clients separately from transaction and distribution services. This separation means that research has some guarantee of independence; there should be no linkages between the part of the firm that offers investment advice and the part that is involved in the distribution of new securities. Some full-service brokerages also manage investment portfolios for institutions and individuals.

Some brokerage firms offer a range of asset management services, referred to as prime brokerage services, that are specifically tailored to fund managers and other high-volume direct users of the money and capital markets. Prime brokerage services include clearing and custody, securities lending, collateral financing, equities financing, and account management.

B. Other Nonbank Financial Institutions

1. Private Equity Firms

Private equity firms use capital raised from institutional investors and from high-net-worth individuals/family offices to invest in privately held companies. Target companies may be privately held companies where the owners want to withdraw from ownership of the company. Private equity firms may also take over a listed company, by purchasing all the shares, and then delist the stock. Private equity firms vary in their approach to the management of the companies they own. A common approach is to follow a strategy of acquiring underperforming firms and try to generate value by improving operational efficiency.

2. Captive Finance Companies

A captive finance company is a subsidiary of a large industrial corporation that finances purchases solely of the corporation's products. These NBFIs typically raise funds in the CP market and lend to other companies and individuals that purchase products from the parent corporation. Having a captive finance company allows the parent firm to extend credit to customers without putting itself directly at risk. Many automobile producers operate captive finance companies.

3. Factors and Invoice Discounters

Factors and invoice discounters are entities that provide short-term financing to companies by purchasing accounts receivable at a discount. There is more detail on both in Chapter 10, Introduction to Working Capital.

4. Asset-based Lenders

Asset-based lending (ABL) is provided by both banks and nonbank specialist lenders. With ABL, loans are secured by collateral that is pledged by the borrower. The amount of credit available to the firm is based on the quality of the collateral, which is usually in the form of accounts receivable or inventory. A borrowing base is determined by multiplying the value of eligible collateral by a percentage rate, known as an advance rate. Due to the emphasis on collateral, asset-based lenders monitor the collateral closely and consequently make frequent adjustments to the available credit.

5. Insurance Companies

Insurance companies are considered NBFIs as they are institutional investors and risk management partners. As institutional investors, insurance companies make significant investments in the commercial real estate and bond markets. In addition, they now compete with banks for short- and medium-term loans. They also provide mortgage funding, leasing services, guaranteed investment contracts (similar to bank certificates of deposit [CDs], generally paying interest for one to five years), and universal life insurance policies with long-term savings features.

From a risk management perspective, the use of insurance is an important element of an enterprise risk management strategy. There is more detail on the use of insurance to manage risk in Chapter 16, Enterprise Risk Management.

6. Asset Managers

Asset managers manage invested funds in both the money and capital markets. Companies can place cash with asset managers for terms as short as overnight to more than two years, depending on the conditions applied by the asset manager. Some asset managers specialize in particular markets (e.g., money market fund managers), while others offer a range of mutual funds to meet different investment requirements (e.g., short-duration funds and bond funds). Asset managers allow companies to diversify their investments by asset class, type of issuer, and geography. There is more detail on the role of asset managers in Chapter 5, Money Markets.

7. Credit Unions

Credit unions are member-owned, not-for-profit financial cooperatives that can provide financial services similar to those offered by other types of FIs, including banks and insurance companies. Credit unions can also provide access to various payment networks to affiliated clients.

Membership in a credit union was originally restricted to individuals with a common affiliation, such as an employer, association, community organization, or geographic location, but membership was later expanded to include businesses. Members/owners often enjoy higher savings and lower lending rates compared to banks.

Credit unions operate in over 100 countries^[4] and are chartered by either federal or state agencies. In the United States, the National Credit Union Administration (NCUA) charters and supervises federal credit unions (about 60% of the total), while the remaining 40% are chartered at the state level. Additionally, NCUA insures the deposits for all federally chartered credit unions and almost all of the state-chartered credit unions through the National Credit Union Share Insurance Fund (NCUSIF).

8. Financial Technology (FinTech) Companies

FinTech is an umbrella term encompassing any technology company that provides financial services. Some FinTech companies operate in direct competition with traditional FIs, for example by providing payment services. Other FinTech companies work in collaboration with traditional FIs, such as treasury management system providers. FinTech companies are discussed in more detail in Chapter 4, Payment Instruments and Systems, and Chapter 15, Technology in Treasury.

Fiduciaries

A fiduciary is an individual or institution to which certain property is given to hold in trust according to a trust agreement. Not all fiduciaries are FIs, but FIs—both bank and nonbank—often provide fiduciary services (or trust services). A fiduciary has duties and responsibilities that are legally enforceable and that must be executed in a prudent and timely manner.

Fiduciary services provided to corporate customers include:

• Establishing and managing employee pension plans or qualified employee benefit plans

• Acting as a corporate trustee for corporate bond or preferred stock issues

• Monitoring compliance with bond indenture agreements, which are the contractual arrangements between bond issuers and bondholders

• Acting as a transfer agent by keeping records of each purchase and sale of stocks and bonds, including maintaining records of a corporation’s shareholders by name, address, and number of shares

• Acting as a registrar by compiling and maintaining lists of current stockholders and bondholders for the purpose of remitting dividend and interest payments

• Acting as an issuing agent by distributing securities to investors on behalf of an issuer

• Acting as a paying agent by receiving funds from an issuer of stocks or bonds to pay dividends to stockholders and to pay principal and interest to bondholders

• Acting as an issuing and paying agent (IPA), in which the roles of issuing agent and paying agent are combined

• Offering custody services (such as providing safekeeping for securities), and buying, selling, receiving, and delivering securities based on terms outlined in a custody agreement

Custody services are discussed in more detail in Chapter 13, Short-Term Investing and Borrowing.