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Banking

I INTRODUCTION

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Banking, transactions carried on by any individual or firm engaged in providing financial services to consumers, businesses, or government enterprises. In the broadest sense, banking consists of safeguarding and transfer of funds, leading or facilitating loans, guaranteeing creditworthiness, and exchange of money. These services are provided by such institutions as commercial banks, savings banks, trust companies, finance companies, and merchant banks or other institutions engaged in investment banking. A narrower and more common definition of banking is the acceptance, transfer, and, most important, creation of deposits. This includes such depository institutions as commercial banks, savings and loan associations (more common in the United States), building societies, and mutual savings banks. All countries subject banking to government regulation and supervision, normally implemented by central banking authorities. For further information on central banks and investment banking, see the relevant articles.

II ASPECTS OF BANKING

The most basic role of banking, safeguarding funds, is done through vaults, safes, and secure facilities that physically store money. These physical deposits are in most cases insured against theft, and in most cases against the bank being unable to repay the funds. In some banks, the service is extended to safe deposit boxes for valuables. Interest given on savings accounts, a percentage return on the bank’s investments with the money, gives an additional incentive to save. Transfer of funds can be handled through negotiable instruments, cheques, or direct transfers performed electronically. Credit cards and account debit cards, electronic cash tills, computer online banking, and other services provided by banks extend their usefulness by offering customers additional ways of gaining access to and using their funds. Automated clearinghouses perform similar services for business customers by handling regular payments, such as wages, for a company banking with the bank. Longer-term schemes for providing regular income on savings are often offered through trust funds or other investment schemes.

Loans to bank customers are drawn on the funds deposited with the bank and yield interest, which provides the profits for the banking industry and the interest on savings accounts. Banks also provide foreign exchange facilities for individual customers, as well as handling large international money transfers. Investment banks engage chiefly in financing businesses and trading in securities.

III EARLY BANKING

Many banking functions such as safeguarding funds, lending, guaranteeing loans, and exchanging money can be traced to the early days of recorded history. In medieval times the Knights Templar, an international military, and religious order, not only stored valuables and granted loans but also arranged for the transfer of funds from one country to another. The great banking families of the Renaissance, such as the Medici in Florence, were involved in lending money and financing international trade. The first modern banks were established in the 17th century, notably the Riksbank in Sweden (1656) and the Bank of England (1694).

In the 17th century, English goldsmiths provided the model for contemporary banking. Gold was stored with these artisans for safe keeping and was expected to be returned to the owners on demand. The goldsmiths soon discovered that the amount of gold actually removed by owners was only a fraction of the total stored. Thus, they could temporarily lend out some of this gold to others, obtaining a promissory note for principal and interest. In time, paper certificates redeemable in gold coin were circulated instead of gold. Consequently, the total value of these banknotes in circulation exceeded the value of the gold that was exchangeable for the notes.

Two characteristics of this fractional-reserve banking remain the basis for present-day operations. First, the banking system’s monetary liabilities exceed its reserves. This feature was responsible in part for Western industrialization, and it still remains important for economic expansion, though a risk of creating too much money is a rise in inflation. Second, liabilities of the banks (deposits and borrowed money) are more liquid—that is, more readily convertible to cash—than are the assets (loans and investments) included on the banks’ balance sheets. This characteristic enables consumers, businesses, and governments to finance activities that otherwise would be deferred or cancelled; at the same time, it opens banks to the risk of a liquidity crisis. When depositors en masse request payment, the inability of a bank to respond because it lacks sufficient liquidity means that it must either renege on its promises to pay or pay until it fails. A key role of the central bank in most countries is to regulate the commercial banking sector to minimize the likelihood of a run on a bank, which could undermine the entire banking system. The central bank will often stand prepared to act as lender of last resort to the banking system to provide the necessary liquidity in the event of a widespread withdrawal of funds. This does not equal a permanent safety net to save any bank from collapse, as was demonstrated by the Bank of England’s refusal to rescue the failed investment bank Barings in 1995.

IV BANKING IN BRITAIN

Since the 17th century, Britain has been known for its prominence in banking. London still remains a major financial centre, and virtually all the world’s leading commercial banks are represented.

Aside from the Bank of England, which was incorporated, early English banks were privately owned rather than stock-issuing firms. Bank failures were not uncommon; so, in the early 19th century, joint-stock banks, with a larger capital base, were encouraged as a means of stabilizing the industry. By 1833 these corporate banks were permitted to accept and transfer deposits in London, although they were prohibited from issuing banknotes, a monopoly prerogative of the Bank of England. Corporate banking flourished after legislation in 1858 approved limited liability for joint-stock companies. The banking system, however, failed to preserve a large number of institutions; at the turn of the 20th century, a wave of bank mergers reduced both the number of private and joint-stock banks.

The present structure of British commercial banking was substantially in place by the 1930s, with the Bank of England, then privately owned, at the apex, and 11 London clearing banks ranked below. Two changes have occurred since then: the Bank of England was nationalized in 1946 by the post-war Labour government; and in 1968 a merger of the largest five clearing banks left the industry in the hands of four players: Barclays, Lloyds (now Lloyds TSB Group), Midland (now part of HSBC Holdings), and National Westminster (taken over by the Royal Bank of Scotland in 2000). Financial liberalization in the 1980s resulted in the growth of building societies, which in many ways now carry out similar functions to the traditional clearing banks.

The clearing banks, with their national branch networks, play a critical role in the British banking system. They are the key links in the transfer of business payments through the checking system, as well as the primary source of short-term business finance. Moreover, through their ownership and control over subsidiaries, the big British banks influence other financial markets dealing with consumer and housing finance, corporate finance and investment, factoring, and leasing.

A restructuring in the banking industry took place in the late 1970s. The Banking Act of 1979 formalized the Bank of England’s control over the British banking system, previously supervised on an informal basis. Only institutions approved by the Bank of England as “recognized banks” or “licensed deposit-taking institutions” are permitted to accept deposits from the public. The act also extended Bank of England control over the new financial intermediaries that have flourished since 1960.

Like many central banks, the issue of the Bank of England’s independence in setting interest rates and so influencing inflation and demand-side economics has long been an issue of debate. For a central bank to be able to ensure monetary and financial stability for the nation requires the political bias of government decision-making to be removed. As a result of a series of costly decisions by the British Conservative government in 1992, which saw Britain being forced to withdraw from the Exchange Rate Mechanism of the European Union, greater power was granted to the Bank of England to control inflation. In 1997 a new, Labour government handed operational independence to the Bank of England and an annual remit to set interest rates to ensure inflation does not rise above 2.5 percent. This is done by the Monetary Policy Committee.

London has become the centre of the Eurodollar market; participants include financial institutions from all over the world. This market, which began in the late 1950s and has since grown dramatically, borrows and lends dollars and other currencies outside the currency’s home country.

V BANKING IN THE UNITED STATES

The United States banking system differs radically from those in such countries as Canada, the United Kingdom, and Germany, where a handful of organizations dominate banking. In the past, geographical constraints on expansion prevented banks from moving beyond their state or even beyond their county. Thus, many small bankers were protected from competition. The result is a national network of almost 12,000 commercial banks. More recently, most states, as well as the federal government, have loosened the regulation of banks, especially in the area of mergers and acquisitions. Many banks have grown by taking over other banks inside and outside their home states. The largest banks account for the bulk of banking activity. Fewer than 5 percent of the banks in the United States are responsible for more than 40 per cent of all deposits; 85 percent of the banks hold less than one-fifth of total deposits. The Federal Reserve System, composed of 12 Federal Reserve Banks and 25 Federal Reserve Districts throughout the United States, is the central bank, banker to the US government, and supervisor of the nation’s banking industry.

The US banking system is distinguished by a tradition of thrift institutions established to remedy the commercial sector’s historic neglect of the non-business consumer market. Savings and loan associations (SLAs), which first appeared in the 1830s, were patterned after cooperative movements in Scotland and England. Dealing mostly in residential real estate mortgages, and particularly in home mortgage loans, SLAs exist primarily to support home ownership. In the late 1980s, the failures of many SLAs caused the government to overhaul the industry and place it under federal supervision. American savings banks, established with similar intentions, invest the deposits of customers in stocks and bonds, especially government bonds, and also provide mortgage services. Credit unions likewise invest money on behalf of members.

While government regulation of commercial banking since the mid-1930s has led to a low failure rate and preserved a substantial amount of competition in some markets, local monopolies have also been implicitly encouraged. Moreover, stringent regulations have caused some bankers to devote considerable resources to circumventing government controls. Rethinking of the role of government regulation in the economy, in general, may lead towards even further liberalization of controls over the banking system.

VI BANKING IN CONTINENTAL EUROPE

Major central banks in the European Union are France’s Banque de France, Germany’s Bundesbank, and the Bank of Italy. Major commercial banks include Germany’s Deutsche Bank A. G., Dresdner Bank A. G., and Commerzbank A. G.; France’s nationalized Banque Nationale de Paris, Crédit Lyonnais, Crédit Agricole, Groupe Caisse d’Epargne, and Société Générale; the Union Bank of Switzerland and the Swiss Bank Corporation; and ABN-Amro Bank and Rabobank Nederland in the Netherlands. Significant structural differences distinguish the banking system of continental Europe from that of many other developed nations. The main differences are in ownership, scope, and concentration of activities.

One distinguishing aspect of European banking, especially in the Latin countries, is the role of the state. Virtually all banking institutions in the United States, Canada, and the United Kingdom are privately owned. In France and Italy, however, the government has traditionally owned either many of the major commercial banks or the majority of their stock. The role of the government in banking is, therefore, significant, and often controversial. France’s Crédit Lyonnais was the subject of considerable criticism in the early 1990s because of the government assistance extended to it to cover its heavy trading losses. European banks engage in some activities prohibited elsewhere, such as the placement and acquisition of common stock. Commercial banks in Europe tend to limit their lending to shorter-term loans. Long-term loans are handled by bank affiliates. The share of the deposits and loans handled by the major European banks tends to be particularly large. This stems from the absence of restrictions on branching, leading the large European banks to maintain extensive networks of branches in their home countries. The absence of an antitrust tradition also accounts for the greater degree of concentration.

Germany’s Bundesbank was the dominant central bank in the European Union, thanks mainly to its success in controlling inflation and Germany’s economic strength. Its constitution leaves it notably independent from government interference. It was established in 1957, taking over from the Länder (regional states) banks and the Land Central Banks.

The Land Central Banks had been independent but acted together as a central bank and were responsible for the German currency. They then came under the Bundesbank structure and now act as regional/federal offices for the central bank. The Bundesbank became part of the European System of Central Banks (ESCB) to support the Euro and was fully restructured by means of the Seventh Act Amending the Bundesbank Act, which came into effect on April 30, 2002.

There have also been changes to the Länder banks, which acted as house banks to Germany’s states and as clearing and commercial banks for the Sparkasssen, the public sector savings banks. This was because of EU competition rules.

Now known as the Deutsche Bundesbank, it has been de facto superseded by the creation of the European Central Bank (ECB) in 1999. The ECB’s creation was vital to the success of the Euro, the pan-European Union currency that replaced many of the EU-member states’ national currencies.

According to the ECB itself, there had been a need for exchange rate stability since the 1970s, in the wake of the collapse of the Bretton Woods system, and a stable exchange rate would minimize the risk of trade tensions within the European customs union. This led to the creation of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in 1979. As the EU moved towards the creation of the single market for goods, services, capital, and people, the argument for a single currency grew.

As a result, national authorities participating in EMS/ERM had to subordinate monetary and, to a large extent, fiscal policy to the achievement of exchange rate stability. A further development of this concept was the creation of the ECB and the introduction of the Euro. This development has not been without its critics pointing out that, as a supranational institution, the European Central bank has seized financial and fiscal sovereignty from Euro-member states. Levels of a state debt or borrowing are limited by agreement, consequently affecting state expenditure. However, while the rules of Euro membership have been agreed by treaty and are required to manage effectively the currency and attendant interest rates, some of the largest members of the Euro, notably France and Germany, have consistently failed to keep national expenditure within the limits and have ignored penalties imposed by the ECB.

The benefit of the creation of the ECB and Euro, which also had a knock-on effect on national banking institutions, is that it has begun the process of creating a single pan-European capital market. Already the Euro-denominated corporate debt market has exceeded that of the United States.

VII BANKING IN SWITZERLAND

Switzerland is renowned as a centre for world banking because of its political neutrality, its financial stability, and the national tradition of confidentiality in banking, dating from a law of 1934 that made it an offence for banks to disclose details about their customers without express authorization. Subsequent legislative changes and international agreements have not overly compromised this secrecy, especially with regard to non-criminal tax evasion. Private banking is one of the country’s principal sources of income.

The semi-private Swiss National Bank, Switzerland’s central bank, is owned jointly through shares held by the cantons, other banks, and the public. Swiss commercial banking is dominated by the “Big Four”: the Union Bank of Switzerland, the Swiss Bank Corporation, Crédit Suisse, and Swiss Volksbank. Numerous smaller banks and branches of foreign banks also operate in Switzerland. There are also 28 canton banks, funded and controlled by their respective cantons.

VIII BANKING IN RUSSIA

Prior to 1987 and under the Communist rule of the Soviet state, the government owned and managed the banking system. By far the most important institution was the state bank, Gosbank, which acted as the central bank controlling currency and credit and the oversight of transactions among state enterprises.

Three other institutions also existed: Sberbank, the savings bank that offered low interest to those saving wages; the Construction Bank (Stroybank), which provided investment credits to enterprises; and the Foreign Trade Bank (Vneshtorgbank), which handled financial transactions relating to international trade.

By 1988, as part of the liberalization policies of President Gorbachev, commercial banking operations were removed from Gosbank. Both the Construction Bank and the Foreign Trade Bank were replaced by three institutions designed to provide credit specific economic sectors: Agro-Industrial Bank (Agroprombank), the Industry and Construction Bank (Promstroybank), and the Social Investment Bank (Zhilsotsbank).

By 1991 the Russian Central Bank (or Bank of Russia) assumed the functions of Gosbank, which was dissolved soon after. However, its independence from political interference, in particular, the Russian parliament (Duma), was severely limited and it was not until 1993 that it gained more autonomy.

By this stage, a network of commercial banks had been created both privately and under the Bank of Russia’s guidance through commercializing the specialized banks’ branches. Further aid from the World Bank in the mid-1990s helped create a core of institutions that would conform to the strict standards of the Bank for International Settlements (BIS), including the size and interest rates of loans, the size of a bank’s capital base, and the volume of loan reserves.

In 1995 the Law on the Central Bank was enacted, giving the central bank statutory authority for areas such as controlling the country’s money supply, implementing the federal budget, implementing Russian exchange-rate policies, and regulating commercial banks.

By this time Russia had nearly 3,000 commercial banks, most of which were small and had little capitalization.

However, the former state-controlled specialized banks now form the foundation of the current commercial banking system. At the same time as the creation of the Bank of Russia, the Agroprombank (later renamed Rossel’bank), the Promstroybank, and the Zhilsotsbank (now called the Mosbusinessbank) were also reorganized into joint-stock companies and became independent operations.

Similarly, the old savings bank Sberbank was reorganized with the Bank of Russia holding a controlling share block. The Foreign Trade Bank (Rosvneshtorgbank) also remains state-controlled.

As the banking system developed, the 1998 financial crisis raised serious issues of confidence over the stability of many of the banks that held licences. Parts of the banking industry suffered from high levels of criminal and political interference which, in some circumstances, still exist. A strengthened Bank of Russia restructured much of the banking system enforcing regulations on liquidity and standards of corporate governance. Numerous banks lost their dubious licences, including those with solvency issues. The crisis also led to the creation of the Agency for Restructuring Credit Institutions (ARCO) and the Inter-Agency Coordinating Committee for Banking Sector Development in Russia (ICC).

By the end of 2005, the number of banks licensed to operate in Russia had fallen to 1,258, but the state banks continue to dominate the Russian system in terms of assets with 21 falling under state, federal, or regional authorities. Several regions have monopolistic banking services and the former state savings bank Sberbank has about 500 times the number of branches of its closest rival. On top of that, there has been a level of separation in banking systems between Moscow and rural areas.

Banks such as Alfa-Bank and Rosbank dominate the private sector.

Foreign banks have played a crucial role in developing the banking system but have often been met with nationalist political opposition. In spite of this, the number of Russian banks with foreign shareholders stood at 131 in 2004. At the same time, 33 banks were fully foreign-owned.

Both the Bank of Russia and the state continue to follow a policy of developing the regulatory environment and generally raising the professional standards and liquidity of the banks.

IX BANKING IN JAPAN

As one of the world’s richest countries, Japan has a banking sector with considerable influence on the world economy as a whole; it is also home to some of the world’s largest banks in terms of capital holdings. However, the banking system has undergone a massive shake-up since the mid-1990s, in part because of forced regulatory changes but mostly because of huge levels of debt and poor corporate governance.

At the start of the 21st-century Japanese banking structure still has several components, many of which are unique: huge city banks, trust banks, long-term credit banks, credit cooperatives, foreign joint ventures, regional banks (of which the Bank of Yokohama is the largest), and state lending and financing bodies. All of these sorts of institutions have been facing a series of regulatory shake-ups.

The Bank of Japan (BoJ) is the national central bank, and controls the banking system; it has less constitutional autonomy than in many other developed countries. In addition, its role of monitor and regulator of the Japanese system has been severely limited due to law and custom. For example, the BoJ only began tracking lending by Japanese institutions in 1999. Its role in the system was further complicated by several government banks and institutions, although the government has announced its intention to create a single public lender by scrapping one, privatizing two, and integrating the remaining five.

The public institutions include the Japan Bank for International Cooperation, which was created in 1999 with the merger of the Japan Export-Import Bank and the Overseas Economic Cooperation Fund and handles large credits for international trade; the Japan Finance Corporation for Small and Medium Enterprise; the Agriculture, Forestry and Fisheries Finance Corporation; the National Life Finance Corporation; and the Okinawa Development Finance Corporation, all of which are expected to be consolidated by 2007. Other state bodies such as the Housing Loan Corporation and the Japan Finance Corporation for Municipal Enterprises were wound-up in April 2007.

These changes to the overall structure of the state’s involvement in banking were partly as a result of the earlier failure of the state-owned Long-Term Credit Bank of Japan. It, like its private counterpart, Nippon Credit Bank, failed in 1998, and both were acquired by US enterprises. In 2000 the US private equity fund Ripplewood Holdings took on the Long-Term Credit Bank of Japan and it became the Shinsei Bank. Nippon Credit Bank was later reborn as Aozora Bank under the US investment fund Cerberus Group.

The investment by foreign banks in such Japanese institutions has been in itself a major change to the banking system. The operations of foreign banks within Japan have been severely limited until fairly recently.

A new bank re-capitalization law came into effect in August 2004 to help restructure regional banks and others. As a result of legal changes, there has been a flurry of activity across all the financial institutions that have often been separated in function in most unusual ways by comparison with other banking systems.

Consumer lending/leasing companies are being bought by banks to use their expertise in what is known as “retail” banking in other jurisdictions. Many banks had traditionally only operated in business financing. Similar alliances and mergers between banks and insurance firms are progressing with an eye to the liberalization of the sector, also in 2007.

The reform of the financial sector was forced on the Japanese government following the collapse of Japan’s economy in the early 1990s, which left many banks heavily burdened with stock assets of little real value. In part this collapse was due to the structure of the Japanese financial system: some major private banks were tied closely to the government through government investment. Other major commercial banks were part of the great pre-war commercial and industrial conglomerations, the so-called zaibatsu, and maintained close ties with their associated businesses, keiretsu. This often lead to huge bad loan debts as the banking system honoured the traditional links.

However, the realities of international economics and the need for the government to reduce the amount of taxpayers money spent on reviving Japanese banks, has also seen consolidation in the private sector: the once great zaibatsu Mitsubishi Bank, was forced to merge with the Bank of Tokyo (which had specialized in foreign exchange) and UFJ Bank. The changes were necessary in order to clean up balance sheets and gain investor confidence.

X BANKING IN CANADA

The Bank of Canada is the national central bank formed in 1934 during the Great Depression to regulate credit and currency.

Canada has numerous chartered commercial banks. In 1980 Canadian banks were reorganized into two bands: “Schedule I”, with shareholdings by any individual limited to 10 percent; and “Schedule II”, either foreign-owned or in private hands. Further legislation in 1992 freed banks, trust companies, and insurance companies to diversify into each other’s areas of interest, and opened ownership of Schedule II banks to nonbanking institutions. Trust and mortgage loan companies, provincial savings banks, and credit unions are also important components of the banking system.

Private banking is dominated by Toronto-Dominion Bank, Canadian Imperial Bank of Commerce, Bank of Montreal, Bank of Nova Scotia, National Bank of Canada and Royal Bank of Canada (RBC). The latter is by far the best-known Canadian player in the international banking scene.

XI BANKING IN AUSTRALIA

The Commonwealth Bank of Australia was established in 1911, offering a savings and general bank business and supported by the federal guarantee. However, in 1959, with concerns that it was unethical to be both a central bank and a general bank, it was split into the Commonwealth Banking Corporation (which includes the Commonwealth Trading Bank and the Commonwealth Savings Bank) and the Reserve Bank of Australia.

The Reserve Bank of Australia has been tasked by legislation to contribute to the stability of the currency of Australia; the maintenance of full employment in the country; and the economic prosperity and welfare of the people of Australia.

The Commonwealth Banking Corporation was privatized in the 1990s and is currently the second-largest bank in Australia after the National Australia Bank (NAB), and followed by the Westpac Banking Corporation and the Australia and New Zealand Banking Group (ANZ Bank). The Australian banks are considered conservative by nature although highly profitable by global standards, with returns on average capital of more than 28 percent in 2003. With the exception of ANZ Bank, they have few interests in neighbouring Asia-Pacific countries.

Building societies are also common. Banking reform in the 1980s similar to that enacted in Britain freed many building societies to become banks or offer banking services and also opened the domestic market to more foreign competition.

XII BANKING IN NEW ZEALAND

The Reserve Bank of New Zealand is the national central bank. The Reserve Bank is owned and operated by the government. Commercial banks are called trading banks, as in Australia: the Australia and New Zealand Banking Group and the Westpac Banking Corporation are both also represented in Australia. A long tradition of close government regulation and protection of commercial banks ended in 1987 with banking deregulation moves that opened the commercial market and introduced many new and foreign banks. Trustee savings banks are also prevalent, with former savings banks such as ASB Bank and Trust Bank having become important commercial banks following banking deregulation. New Zealand’s small population allows highly sophisticated banking systems, with Electronic Funds Transfer at Point of Sale, integrated nationwide. The government lends money at low interest to farmers, home builders, and small-business owners through the State Advances Corporation.

XIII BANKING IN SINGAPORE

As one of the world’s major financial centres and a regional economic giant, Singapore has an internationally significant banking regime. Central banking functions are exercised by the Monetary Authority of Singapore, though issuing of currency is conducted by a separate government body. The domestic commercial banking industry in Singapore consists of some 13 local banks and is dominated by the leading houses. The Post Office Savings Bank serves as the national savings bank. There are also numerous merchant banks. Singapore is also host to many foreign banks, divided according to the type of licence they are granted: full, restricted, or “offshore”. The Singaporean government operates a compulsory savings scheme for employees, the Central Provident Fund. Singapore’s banking industry continues to grow and mature with the development of the nation’s economy. The reversion of Hong Kong to Chinese sovereignty in July 1997 has also spurred Singapore’s growth as an international financial centre in Asia.

XIV BANKING IN HONG KONG S. A. R.

As a British colony until 1997, Hong Kong S. A. R. benefited from British banking and contractual law and attracted international businesses, boosting a multinational banking presence. Now known as the Hong Kong Special Administrative Region (S. A. R.), it is under Chinese sovereignty but benefits from a large measure of self-rule and a continuing laissez-faire economy.

It is regarded as the most important banking and securities trading centre in Asia Pacific after Japan and has over 200 authorized banks. One of the world’s largest banks based on Tier 1 capitalization, HSBC—previously known as the Hongkong and Shanghai Banking Corporation—was founded here but reincorporated to the United Kingdom in the 1990s. (Tier 1 capitalization is a measure of a bank’s financial strength as used and defined by the Bank for International Settlements. It is used as a measure of a bank’s ability to handle unexpected losses by regulators and financial analysts worldwide. It is based on various types of available capital, primarily equity.)

The Office of the Commissioner of Banking supervises banking in Hong Kong S. A. R. in conjunction with the Hong Kong Monetary Authority (established 1993). Generally, regulatory control is not onerous. The primary aims of the regulatory bodies are to maintain capital adequacy ratios, stop improper lending, and monitor that international banking rules are being followed.

Banking rules were further relaxed in 2001 with the removal of restrictions on foreign banks as to the number of branches they could operate, which benefited Citibank in particular.

There are three banks of issue: HSBC, the Standard Chartered Bank, and the Bank of China. Numerous locally incorporated commercial banks operate alongside branches of foreign banks; there are also many banks operating under restricted licences and numerous deposit-taking companies.

XV BANKING IN CHINA

Scholars argue that they can trace a banking system in China to more than 2,000 years ago. Indeed, both coinage and paper money was pioneered in the country. Coins were often deposited with local or central government institutions in exchange for either paper money or credit certificates. These could be exchanged in provincial treasuries, boosting commerce. The domestic system developed, although the international trade financing of the mid-19th century saw western banks come to dominate the business.

During the first half of the 20th century, while communism destroyed most of the ancient banking system, the old mechanisms tended to survive in certain parts of the nation longer than in Beijing. However, any remnants of traditional systems of banking in China, especially in the international city of Shanghai, were destroyed by either the invasion and occupation by the Japanese army in the 1930s or during the Chinese civil war, which effectively ended in 1949.

With the advent of Communist rule, the People’s Bank of China (PBOC) became the de facto central bank in charge of monetary policy, foreign reserves, deposit-taking, and the financing of development projects. It overlapped in some of these functions with the Ministry of Finance. However, its scope of work and organizational setup has changed frequently over the years. During the Cultural Revolution, for example, the bank lost some of its responsibilities, as did many Chinese institutions, but these were fully restored in the 1970s.

The first steps to modernizing the Chinese banking system may be traced to 1979, when it moved from being a “monobank” financial system (as in other centrally planned economies) with only the PBOC, to a two-tier system. The new second tier created three big state-owned commercial banks, including the Bank of China (BOC), which was assigned the role of handling foreign currency transactions, the China Construction Bank (CCB), and the Agricultural Bank of China (ABC), which had to build-up rural banking. This move was completed in 1984 with the creation of the Industrial and Commercial Bank of China (ICBC), which took on the commercial banking activities of the PBOC.

This was the beginning of the Chinese government’s efforts to transform a planned economy into a market-based one, a process that is continuing today but has not been without its problems.

Today China’s core banking system is regulated by the PBOC and the China Banking Regulatory Commission (CBRC), which was established in 2003. The CBRC took over most of the regulatory and supervisory functions from the PBOC, allowing it to focus on implementing monetary policy matters.

Within the mainstream banking system, the big four commercial banks remain, although the Bank of China is no longer purely state-owned, having floated on the Hong Kong stock exchange in 2002, a policy slowly being encompassed throughout the banking system.

Below the four commercial banks exist the three policy-lending banks, which include the Agricultural Development Bank of China (ADBC), China Development Bank (CDB), and the Export-Import Bank of China (Chexim), all established in 1994. As the four state-owned banks developed greater commercial and market-orientated operations, these new institutions took over the government-directed spending functions.

As part of this redevelopment of the banking system, many of the local branch networks of the big four were replaced by a system of regional commercial banks and a new tier of private joint-stock banks in 1998. More than 100 city commercial banks now exist alongside 11 joint-stock commercial banks. At least 4 of the 11 are listed on the domestic stock markets, for example, the Shanghai Pudong Development Bank, the Shenzhen Development Bank, the China Merchants Bank, and the China Minsheng Bank.

Below this level exists tens of thousands of credit cooperatives and foreign banks with their limited access.

In terms of overseas banking institutions, around 168 foreign banks from 38 countries have opened representative offices in 25 Chinese cities. Out of nearly 200 foreign banks operating in China, 88 have won the approval to do renminbi business.

Hand-in-hand with the development of the banking structure in China, the authorities also began developing other financial services to boost commercial activity. Among these were the creation in the 1980s of international trust and investment corporations that engage in various forms of merchant and investment banking activities. As with the commercial banks, many of the institutions have sought to become listed entities.

The process continued with key moves in 2005, including the sale of equity in China’s largest state banks to foreign investors and refinements in foreign exchange and bond markets.

The Chinese banking sector has been faced with numerous problems. The reform process has involved the restructuring of a number of banks in order to clean up books with high levels of non-performing loans, poor asset quality, and low capitalization levels. These issues continue to be the major problems.

A major part of the liberalization process has been China’s entry into the World Trade Organization (WTO) in 2001. By the end of 2006, the banking system was fully opened to foreign participation, which began with foreign currency transactions. These changes have seen the numbers of branches and representative offices of foreign banks in China increase.

However, the WTO agreement does not deal with foreign banks acquiring stakes in Chinese institutions, although a single entity can hold up to 20 per cent of a domestic bank and up to 25 percent for all foreign investment. The 25 percent limit does not apply to listed banks.

The Chinese authorities are seeking foreign participation mainly on the basis of bringing expertise to the domestic system. In 2003, under the Closer Economic Partnership Agreement, Hong Kong banks received privileged access to do business on the mainland.

XVI BANKING IN INDIA

The central bank of India is the Reserve Bank: most large commercial banks were nationalized in 1969, with more being nationalized in 1980. The Department of Banking at the Ministry of Finance controls all banking. The State Bank of India, the largest and oldest commercial bank, handles some of the Reserve Bank’s roles. The other nationalized banks share the commercial market with non-nationalized and foreign banks. Some of them offer merchant banking services, though there are no independent merchant banks in India. Cooperatives and credit societies are an important supplement to the private banking industry, especially in rural areas.

Foreign banks are keen to tap the opportunity that India’s expanding economy and rising income levels offer, but there remain significant political and regulatory barriers restricting market access. Currently, three-quarters of the nation’s banking assets are held by the 27 state banks.

While the Indian government has been under pressure from other nations to open all areas of its business and industrial infrastructure since the late 1960s, it has refused to liberalize its banking and financial sector until 2009. In 2005 the Reserve Bank ruled that foreign banks would not be allowed to acquire private local banks, although in the case of a weak or failing bank they could buy and hold minority interests in order to save them.

Whether other restrictive rules, such as limiting the number of branches that foreign banks may operate, will also be rescinded in 2009 is unknown. Partly as a response to the restrictive banking practices and unclear future direction of regulation, foreign institutions began investing in the areas of finance in which they were allowed. Towards the end of the 20th century, in particular, there was a flurry of activity with joint venture operations opening to provide consumer finance.

Internal rules also limit the number of branches that foreign banks may operate, effectively ruling them out of offering a nationwide retail banking operation. However, foreign banks have announced their intention to exploit whatever opportunities there are and argue that the domestic system under-provides normal services such as consumer finance compared with relative economies. A number of joint ventures have been announced limited to the area of consumer finance.

XVII OFFSHORE BANKING

Strictly speaking, an offshore bank is one that is outside the legal jurisdiction of the depositor, but since that would apply to every bank, its definition has been modified.

The provision of offshore banking means that the jurisdiction offers regulatory and legal advantages for the depositor, often hand-in-hand with more sophisticated banking services than would normally be found in an average retail bank. In general, these advantages include: low or zero tax rates, strict confidentiality, easy global access to accounts and services, and usually (although not always) political stability.

The term was believed to have been first used in relation to the Channel Islands (offshore to Britain) and tends to be mostly associated with island financial centres. In part this has developed because for a state with few or non-existent natural resources, something common to small islands, the legal and administrative base for a banking industry is relatively easy to set up, bringing enormous financial benefits to the state. Not all offshore banking centres are islands, with Switzerland and Liechtenstein being the most obvious exceptions.

The offshore system is aimed primarily at high-net-worth individuals through private banking, although companies often take advantage of certain features. Often used by the very wealthy to protect assets from high taxation in the jurisdictions in which they live or from insecure civil and political structures. Differing regulations make some offshore centres more attractive than others to individuals with certain circumstances. For example, until recently Swiss banking law ruled that information about individual accounts details could only be released to other state authorities under a breach of law. This breach also had to be categorized as a crime in Switzerland and since there was no crime of tax evasion, it became attractive to those wishing to hide funds. Other jurisdictions have regulations that there may be no requirement to list or release names of company directors, effectively making money transactions anonymous. Inevitably, some of these rules attract those wishing to break the law, as well as those using the services for legitimate money management purposes.

Offshore banking is often used by expatriates, probably offering tax advantages over their home country and possibly providing security of assets compared to their working environment.

According to research company Datamonitor, there was Euro 644.7 billion in offshore retail savings and investments in 2004, a decline of 10 percent in asset value over 2000.

XVIII BANKING IN DEVELOPING COUNTRIES

The type of national economic system that characterizes developing countries plays a crucial role in determining the nature of the banking system. In capitalist countries a system of private enterprise in banking prevails; in a number of socialist countries (for example, Egypt and Sudan) all banks have been nationalized. Other countries have patterned themselves after the liberal socialism of Europe; in Peru and Kenya, for instance, government-owned and privately owned banks coexist. In many countries, the banking system developed under colonialism, with banks owned by institutions in the parent country. In some, such as Zambia and Cameroon, this heritage continued, although modified, after decolonization. In other nations, such as Nigeria and Saudi Arabia, the rise of nationalism led to mandates for majority ownership by the indigenous population.

Banks in developing countries are similar to their counterparts in developed nations. Commercial banks accept and transfer deposits and are active lenders, especially for short-term purposes. Other financial intermediaries, particularly government-owned development banks, arrange long-term loans. Banks are often used to finance government expenditures. The banking system may also play a major role in financing exports.

In the poorer countries, an extensive but primitive non-monetary sector usually continues to exist. It is the special task of the banking community to encourage the use of money and instill banking habits among the population.

XIX ROLE OF CENTRAL BANKING

The foremost monetary institution in a free market economy is the central bank. These are usually government-owned institutions, but even in countries where they are owned by the nation’s banks (such as the United States), the responsibility of the central bank is to the national interest.

Most central banks perform the following functions: they serve as the government’s banker, act as the banker of the banking system, regulate the monetary system for both domestic and international policy goals, and issue the nation’s currency. As banker to the government, the central bank collects and disburses government income and receipts, manages the issue and redemption of government debt, advises the government on all matters pertaining to financial activities, and makes loans to the government. The issuance of debt by the central bank is generally done to finance state budget deficits and takes the form of bonds, although in the United Kingdom the instruments are known as gilts. These are generally issued with differing maturities. As banker to the nation’s banks, the central bank holds and transfers banks’ deposits, supervises their operations, acts as a lender of last resort, and provides technical and advisory services. Monetary policy for both domestic and foreign purposes is implemented and, in many countries, decided by the national banking authorities, using a variety of direct and indirect controls of the financial institutions. Coins and notes that circulate as the national currency are usually the responsibility of the central bank.

The primary ability of the central bank is to control the money supply. Some central banks, such as the Bank of England and US Federal Reserve, also have the power to set interest rates. In both cases, this power can affect the pace of national economic growth. Some economists believe that monetary control is extremely effective in the short run and can be used to influence economic activity. Nevertheless, some hold that discretionary monetary policy should not be used because, in the long run, central banks have been unable to control the economy effectively. Another group of economists believes that the short-term impact of monetary control is less powerful, but that the central banking authorities can play a useful role in mitigating the excesses of inflation and depression. Today there is the general acceptance that the key role of monetarist policy within the central banking systems is its ability to control demand and inflation although this is often at the cost of national growth. A newer school of economists claims that monetary policy cannot affect systematically the pace of national economic activity. All agree that problems related to the supply side of the economy, such as fuel shortages, cannot be resolved by central-bank action.

XX INTERNATIONAL BANKING

The expansion of trade in recent decades has been paralleled by the growth of multinational banking. Banks have historically financed international trade, but the notable recent development has been the expansion of branches and subsidiaries that are physically located in other countries, as well as the increased volume of loans to borrowers internationally. For example, in 1960 only 8 US banks had foreign offices with a total of 131 branches; by 1998, about 82 US banks had a total of 935 foreign branches. Similarly, in 1975, fewer than 80 foreign banks had offices in the United States; by 1998, 243 foreign banks had offices in the United States. Most are business-oriented banks, but some have also engaged in retail banking. Total assets of banking offices representing foreign banks in the United States rose from US$201 billion in 1980 to US$1,228 billion in 1999. Total foreign lending by US banks stood at US$324 billion as of December 1999.

The growth of the Eurodollar market has forced major banks to operate branches worldwide. The world’s banking system played a key role in the recycling of petrodollars, arising from the surpluses of the oil-exporting countries and the deficits of the oil-importing nations. This activity, while it smoothed international financial arrangements, is currently proving awkward as foreign debtors find it more difficult to repay outstanding loans.

The growth in the use of the Internet worldwide and the development of procedures enabling secure transactions online have created the new field of online banking, where customers deal with their banks chiefly or entirely through Internet connections. Such services are not restricted by opening hours or location of branches, unlike the traditional banks. Both existing banks and new groups are already moving into this potentially very important area. Since online banking services can be accessed with equal ease almost anywhere in the developed world, this raises the possibility of banking networks operating without regard to national boundaries, with consequent regulatory problems.

XXI ISLAMIC BANKING

At its simplest, Islamic banking conforms to principles deemed important to religious practice and interpretations of shari’ah (Islamic) law, which are the guiding principles revealed in the Koran. Many of the principles are common to other religions, including Christianity and Judaism.

During the 1990s, in particular, many of the larger Western banking bodies identified the provision of Islamic-compliant financial products as an important market in which to participate. Figures estimate that those who might invest in Islamic financial products have assets worth in excess of US$250 billion, although project finance alone in the Gulf states is expected to soak up to US$80 billion by 2010. Much of this financing will be done by Western banking institutions that have developed products suitable for this market.

Indeed in 2003 at the annual gathering of the Organization of the Islamic Conference (OIC), a group of more than 50 Islamic states, Western banks were praised for spurring the development of Islamic finance, while Islamic institutions were labelled “inward looking”.

While there is much detail to elements of Islamic finance, it broadly adheres to three rules. Firstly, it is forbidden to have any sort of involvement with industries considered sinful, such as gambling, alcohol, or pig meat. Secondly, there is a ban on riba, the payment or receipt of interest on money-lending, and thirdly, there is gharar—avoiding hazardous or excessive ambiguity in transactions.

Examples of riba can include interest on credit cards or gains from bond trading. Under Islam the charging of interest is considered unjust: the lender has assured a secure return while the borrower takes on all risk and the unknown future outcome. It is, however, acceptable to buy, sell, and rent goods, assets, and services.

Should a person not make payment on a car, for example, the seller may take back the car or refuse future credit but he cannot add to the debt. The system encourages trade but limits the amount of debt a person or business can accumulate. In the provision of capital to projects in the Gulf, for example, the providers must have some exposure to the underlying commercial risk.

Gharar can be the selling of anything that is indefinable, for example, futures contracts or be selling the following year’s crop in advance, but it is not fraud or deception. Any agreed transaction that does not describe and value major elements of a deal would involve an unacceptable level of gharar. A small amount of gharar is allowable since it is considered unavoidable, in some form, in most transactions.

As a result of these beliefs, many banking products considered normal in the West would be forbidden, for example, standard mortgages, credit cards, and savings accounts.

Equity investment is encouraged so long as the Islamic investor estimates what percentage of their profits might have come from riba and other prohibited activities. They then must donate the same sum to charitable causes for ‘purification’. However, investment in certain mutual funds and especially hedge funds is forbidden. Dow Jones launched the first of its Dow Jones Islamic Market Indexes with shari’ah-compliant stocks in 1997.

To get around the limitations imposed by Islam, credit transactions are built on concepts of partnerships in which risk and profit are shared. Instead of a savings account, depositors would use an investment account and earn a profit share on their deposits. Rather than loan financing, the banker buys the product on a customer’s behalf and sells it on at a profit. Islamic mortgages are more complicated transactions with rent being paid, not interest.

As a result institutions like CitiGroup, HSBC, Lloyds TSB, and BNP Paribas have “invented” products that comply with the rules, each “product” being overseen by a committee of Islamic scholars to ensure it fulfils the necessary religious requirements.

It must be pointed out that many Islamic financial products are not without their own controversy. While the broad principles are based on the Koran, there are also customary laws laid down by Islamic scholars over the centuries called qiyas, but there is no codification of these rules, in part because there is no formal clergy. As a result, interpretations of the rules vary. In 2002 Malaysia set up the Islamic Financial Services Board in part to resolve disagreements between its own sophisticated Islamic money markets and Arab and Pakistani markets.

Reviewed By:
Gerard O’Kane

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