Regulation of investment portfolio

Dodo (Tata) Kurtanidze Doctoral candidate

Necessity of state regulation of economy in general, including banking system causes divergence of opinions among economists.

Some reckon that state intervention should be minimal1, while others support government’s active participation in the regulation of an economy2. However, majority of scientists agree with the opinion that it is necessary to reasonably merge state and market measures for the regulation of an economy and banking system3.
In the countries with developed economies, mechanism of state’s influence on an economy is represented by the unity of market and non-market methods in accordance with country’s social-economic and political levels of development. Role and importance of these methods is varying in different countries.
There is a variety of models of regulating and supervising financial sector in the world. However, majority of countries prefer to have one regulating institution. In some of the countries, National Bank is bearing the function of regulating organ (Czech Republic, Cyprus), while there is a separate institution established in some of the countries (Great Britain, Bulgaria, China, Japan, Dania, Sweden). Majority of countries is using second model4. National Central Bank is an institution supervising banks’ investment activities and it influences risk of investing in securities by means of economic standards. As a rule, economic norms regulate volumes of investing in securities and risks of their concentration.
Central banks of developed countries influence banking system both by economic (indirect) and economic administrative (direct) methods. Besides direct and indirect methods of carrying out monetary credit policy of the central bank, general and selective methods of regulating banking activities are identified also.
General methods are mostly indirect that mainly influence equity market. Selective methods are regulating specific types of securities. They are connected with solution of the tasks such as limiting equity investment of a bank.
One of the selective methods is direct quantitative limitations that were used by European countries in 1960-70 years, before liberal market reforms. Nowadays, direct limitation of banking credits as one of the means of monetary management, is very popular among developing countries.
Direct limitations of banking credits or restraining in growth pace induce commercial banks to hold part of the deposits as reserves. Negative result of this method of regulation is necessity of establishing strict limitation in the field of capital movement. Otherwise, in case of getting close to the limit banks are “exporting” attracted resources abroad5. The method of direct limiting of credit volumes found a wide application after World War II, in FRG, France and other countries. Limitations covered fixing of limits for promissory notes of separate credit institution or determining growth rates of credit investments in whole economy.
According to the USA law on credit management (was operating up to June 1982) in case of necessity, for avoiding inflation caused by large amounts of supplied credits, president had the right to order Federal Reserve System’s (FRS) managing council to regulate consumer credits or to carry out selective management of real estate credits. Besides this, according to the law on “equities and exchanges” (adopted in 1934) and its further amendments, managing council of FRS is regulating supplies of credit for purchasing and keeping securities. The aims of these limitations were to regulate fluctuations at equity market caused by maximal usage of credits for purchasing securities, and to reduce rate risks of separate investors, avoid financial risks in the process of making deals connected with options. In addition to FRS requirements on limitations of credit volumes that banks were able to offer for purchasing of securities, these limitations were spread onto convertible securities and deals connected with options6.
The level of government’s intervention in market mechanisms of a country’s economy might vary. State intervention should be made by line of conduct of “life cycle” changes. In some of the industrial sectors wide scaled intervention of the state is noticed at initial stage of life-cycle. With the development of the field, state intervention is diminishing. If industrial sector faces complicated problems state intervention increases again.
World-wide practice of investment activity optimization proves that state influences investment process by means of regulating interest rates and cash flows. As a result, industrial field development is achieved by converting cash flows and domestic savings through banks into entrepreneurial investments.
Application of selective methods by central banks in order to influence activities of commercial banks is typical for economic policy at the stage of disturbances in reproduction proportions. Under such conditions economic policy is directed to encouragement of investing in high-priority sectors by means of structural measures and using general macroeconomic instruments of regulating monetary and credit relations.
Therefore, central banks maintain the function of centralized distribution of credit resources, which diminishes to minimum in the periods of cyclic ups and do not operate in such situation limitations distort market prices and distribution of the resources.
In 1995, Regional Group of Transcaucasia and Central Asia (Georgia, Armenia, Azerbaijan, Kazakhstan, Uzbekistan, Kirgizia, Turkmenistan, Tajikistan, afterwards joined by Turkey, Ukraine, Russia, Moldova etc) expressed desire to adopt banking supervision principles of Basel Committee. One of the principles is a capital sufficiency principle. Essence of the principle is the following:
Banking supervision organs should design clever and acceptable requirements on sufficiency of banks’ capital, so that on the one hand it should reflect risks that banks are taking and on the other it should determine capital composition considering abilities to cover loses. This principle is widely approved in international practice in evaluation system of credit organization stability. Given circumstance is coming out from the nature of bank’s capital that is a reserve for covering considered losses and it accumulates risks taken by credit organization, represents reliable sources for bank’s development, maintains creditors’ and partners’ confidence in credit organization, regulates bank’s growth, as it is balancing viability and growth of credit organization in long-term perspective.
Method of calculating capital sufficiency standard divides capital composition into two levels.
First level capital covers bank stock, i.e. issued and totally remunerated equities and preferred stock without cumulative payment of dividends, issued reserves, additional paid up capital, surplus earnings, reserve aggregate for covering unexpected losses and other reserves that are created in accordance with national legislation.
Second level capital includes latent reserves and revaluation provision, some types of securities that cover Debt Instruments and which have gained big importance in the West during recent years.
Sum of first and second capitals creates numerator of formula for coefficient of capital sufficiency. While denominator of the formula is the sum of risk weighted assets and other risks (imbalance operations, interest, fund, currency) excluding reserves.
Application of risk weighted assets enables to exactly calculate minimum of necessary capital or sufficient capital. At the same time, it is worth of noting that “sufficient capital” doesn’t exclude probability of bank’s bankruptcy. Capital and its analysis is an indicator that points tendencies of bank’s financial situation and gives opportunity to make concrete conclusions. Otherwise, even highly capitalized bank might be bankrupted and insolvent just as much as bank with insufficient capital.
Main direction of central bank’s regulating influence on the securities portfolio is determination of the types of securities that banks are allowed to purchase and limitations by the types of securities.
In order to increase accuracy of risk assessment of various categories of assets, banks were given an opportunity to use credit ratings that are being published by specialized financial agencies. It is proved in practice that standard approach is of great interest that implies changes in risk coefficient in accordance with celebrated rating agencies (Standard and Poor’s, Moody’s ratings).
These ratings are already used in many countries for the aims of regulations and correspondingly practice of defining such agencies is designed. According to so-called Basel Agreement, minimal requirements for rating agencies are the following:
Impartiality – rating methodology should be strict, systemic and under specific procedures of checking historical database.
Ratings should be revised periodically and they should reflect changes in financial situation of debtor. Before receiving approval of regulating institutions agency should pass strict checking by statistical data and this period should continue at least for a year, three-year minimum is considered as preferred.
Independence – Methodology as far as possible should be free of any outside political influence or limitations, in addition with pressure made by evaluating organizations.
Transparency – Individual assessments should be available for checking.
Reliability – reliability somehow is based on previous criteria. This criterion must not impede appearing of new player on the market. However, every agency that appeared after changes in regulations system should be checked thoroughly.
International transparency – agencies are not obliged to rate companies in more than one country. However, their results should be available to foreign interested people with the same terms as for the residents.
As we have already mentioned, specialized rating agencies are playing significant role in a new system. In the countries with transition economies and with less developed banking infrastructure usage of given method of risk assessment would be quite difficult.
Actual assessment of bank capital sufficiency in such countries is complicated due to unfinished adoption of international standards of financial accounting. According to independent experts, full adoption of international standards of financial accounting in banking sectors of such countries might reveal insufficient capitalization of many banks. Considering general stability of economy of these countries and dangers of systemic banking crisis, adoption of international standards of financial accounting in evaluating capital sufficiency and banks’ stability other showings should be of evolutional character.
Considering all the above-mentioned factors, measuring of capital sufficiency indicator, taking into account all the risks of banking activity, represent integrated indicator of credit organization’s stability. Moreover, risks are constantly diversified in a modern world and the task of refining risk assessment methods is constant either. Coordination of efforts of supervision organs, banks, consulting firms and rating agencies together with scientific circles is essential in solving this task.
State regulation of banking activities in Georgia is made by National Bank’s influence on commercial banks that is defined by organic law on National Bank of Georgia of 23 July, 1995 and law on Activities of commercial banks of 23 February, 1996, together with other operating legislation, including numerous statutory acts issued by National Bank of Georgia. These laws, decrees and regulations establish such framework of behavior for banking system that encourages its reliability and stability by means of using regulation and control methods.
Essence of banking system regulation is designing of concrete rules and their application that is obligatory for every commercial bank, while the aim of control is protection of operating rules. To be more specific, main aim of banking regulation and supervision is maintaining of stability and transparency of banking system that implies determination of the risks of whole financial system and their reduction; and in this way, maximal protection of interests of commercial banks, depositors and other creditors, and of Agency of Financial Supervision of Georgia7.
National Bank of Georgia is state institution of economy regulation, which is the country’s primary bank that has special functions such as right of emitting national currency and ensuring stability and transparency of financial system. Financial system of Georgia mainly consists of commercial banks, insurance companies and securities market. Commercial banks that are the main ring of Georgian financial system have huge importance for the development of country’s economy, as they are the most effective mediators between creditor and debtor8.
For the aims of regulating financial sector, Agency of Financial Supervision is functioning at National Bank. Agency of Financial Supervision is observing risks of separate financial organization, while National Bank of Georgia studies systemic risks of whole financial system. Once a year National Bank publishes its main study – report on financial stability that in contrast with standard macroeconomic analysis studies events with low probability, but potential negative influences – strongly high (financial crises). As a rule, this report reviews future events in the country on the basis of evaluating current situation.
Up to 2007, three separate regulating units of financial sector were operating in Georgia. National Bank’s Supervision Department was responsible for the activity of commercial banks, micro financial organizations, credit relations and exchange offices. Securities National Committee was supervising securities market, while Insurance State supervision Service – insurance business. As a result of amendments made in corresponding law in 2007-2008 on the basis of mentioned three supervising institutions, has been established one organization for the regulation of financial sector – Agency of Financial Supervision.
Both economic (indirect) and economic-traditional (direct) methods of banking supervision are preferred among the regulations instruments of National Bank of Georgia. These methods might be used with the operations of securities.
Regulating influence of Supervising institutions on investment portfolio of securities is revealed in: shares in assets; types of securities and their limitations; rules of accounting; creating reserves and establishing standards.