Banking practice

What Is Banking Practice?

Banking practice refers to the established methods, procedures, and customs employed by financial institutions in conducting their operations. It encompasses a wide array of activities, from managing customer deposits and extending credit to handling investments and ensuring regulatory compliance. Within the broader Financial Services Industry, sound banking practice is crucial for maintaining public trust, fostering financial stability, and promoting economic growth. These practices are shaped by internal policies, market dynamics, technological advancements, and a complex web of laws and regulations.

History and Origin

The origins of banking practice can be traced back to ancient civilizations, where merchants and moneylenders facilitated trade and safeguarded assets. Modern banking, however, began to take shape in medieval Italy, with institutions performing functions such as currency exchange and credit provision. Significant shifts in banking practice often follow periods of economic upheaval. For instance, in the United States, the Great Depression led to a profound reassessment of banking operations. The Banking Act of 1933, commonly known as the Glass-Steagall Act, was enacted to separate commercial banking from investment banking by prohibiting commercial banks from underwriting or dealing in corporate securities. This legislation fundamentally altered banking practice by restricting the scope of activities for different types of banks, aiming to prevent the speculative excesses believed to have contributed to the crisis.¹²,¹¹,

Key Takeaways

• Banking practice describes the operational methods and customs of financial institutions.
• It covers core functions like deposit-taking, lending, and investment activities.
• These practices are influenced by internal policies, market forces, and regulatory frameworks.
• Adherence to sound banking practice is essential for financial stability and consumer protection.
• Significant historical events and regulatory changes have often reshaped banking practice.

Formula and Calculation

While "banking practice" itself does not have a single mathematical formula, many underlying banking activities involve complex calculations and models. For example, banks use various formulas to assess credit risk for loan origination, manage liquidity risk, and determine appropriate capital requirements. One fundamental concept in risk assessment is Expected Loss (EL), often calculated as:

$EL = PD \times LGD \times EAD$

Where:

• (PD) = Probability of Default
• (LGD) = Loss Given Default
• (EAD) = Exposure At Default

These calculations inform a bank's risk management strategies and contribute to sound banking practice.

Interpreting the Banking Practice

Interpreting banking practice involves understanding how banks manage their daily operations, assess risks, and interact with customers and other financial entities. It means looking beyond just the numbers to the underlying processes and decision-making frameworks. For instance, a bank's approach to risk management will significantly influence its overall stability and profitability. Regulators, such as the Office of the Comptroller of the Currency (OCC) in the U.S., focus on ensuring that national banks and federal savings associations operate in a safe and sound manner, provide fair access to financial services, and comply with applicable laws and regulations.¹⁰,⁹ The OCC supervises and examines banks to assess the effectiveness of their banking practice.⁸

Hypothetical Example

Consider a hypothetical bank, "Prosperity Bank," that is reviewing its loan portfolio. Part of its banking practice involves assessing the creditworthiness of borrowers. For a small business loan application, Prosperity Bank's credit department employs a rigorous underwriting process. This involves analyzing the business's financial statements, historical cash flow, industry outlook, and the owner's personal credit history. The bank's internal guidelines, a key aspect of its banking practice, might stipulate that the business must demonstrate a debt service coverage ratio of at least 1.25x and that the owner's personal credit score should exceed 700. If these criteria are met, the loan proceeds to approval; if not, the bank might request additional collateral or decline the application, adhering to its established procedures to mitigate credit risk.

Practical Applications

Banking practice is observable across all facets of the financial system. In regulatory frameworks, it dictates how banks must operate to ensure stability. For example, the Basel III framework, developed by the Basel Committee on Banking Supervision, sets international standards for capital requirements, liquidity, and leverage, aiming to strengthen bank resilience globally.⁷,⁶ These standards directly influence the internal banking practice of internationally active banks. Furthermore, the supervision conducted by central banks, such as the Federal Reserve in the United States, plays a vital role in overseeing banking institutions to ensure safe and sound operations and compliance with laws and regulations.⁵,⁴ This supervisory function directly impacts the daily banking practice of institutions by setting expectations for corporate governance, risk controls, and consumer protection.³

Limitations and Criticisms

Despite extensive regulation and oversight, banking practices are not immune to limitations or criticisms. One significant challenge lies in the dynamic nature of financial markets and the continuous evolution of new financial products and technologies. Existing banking practices and regulatory frameworks can sometimes lag behind these innovations, potentially creating unforeseen risks. For instance, during the 2008 financial crisis, certain lending practices and the securitization of subprime mortgages were heavily scrutinized, highlighting how prevalent banking practices, even those widely accepted, can lead to systemic vulnerabilities if underlying risks are not adequately understood or managed. Another criticism revolves around the complexity of modern financial institutions, making comprehensive oversight challenging. While international efforts like Basel III aim to standardize practices and enhance bank resilience, differences in implementation and national regulatory approaches can still lead to inconsistencies. Furthermore, the potential for moral hazard, where deposit insurance or government bailouts might encourage excessive risk-taking, remains a recurring point of critique regarding the interaction between regulation and banking practice.²

Banking Practice vs. Financial Regulation

Banking practice refers to the internal operational procedures, methods, and customs that banks employ in their day-to-day business. It encompasses how a bank takes customer deposits, underwrites loans, manages its treasury, and handles its investment activities. These are the actions and processes performed by the bank itself.

In contrast, Financial Regulation refers to the set of rules, laws, and guidelines established by governmental bodies and regulatory authorities to govern the conduct of financial institutions. It dictates what banks can and cannot do, and how they must conduct their operations to ensure safety, soundness, and consumer protection. While banking practice is the "doing," financial regulation is the "rulebook" that shapes and supervises that doing. Banking practices must always adhere to the prevailing financial regulations, and regulatory changes frequently necessitate adjustments in a bank's internal practices.

FAQs

Q: What is the primary goal of sound banking practice?
A: The primary goal of sound banking practice is to ensure the safety and soundness of financial institutions, protect customer deposits, and contribute to overall financial stability within the economy.

Q: How do regulators influence banking practice?
A: Regulators influence banking practice by establishing rules and guidelines, conducting examinations and audits, and enforcing compliance. They set standards for areas such as capital requirements, risk management, and consumer protection, compelling banks to adopt specific operational methods. The Federal Reserve, for example, oversees the banking system to ensure compliance with its monetary policy goals and regulatory standards.¹

Q: Are banking practices the same globally?
A: While there are international frameworks like Basel III that promote common standards for banking practice, specific national laws, economic conditions, and cultural factors mean that banking practices can vary significantly from one country to another. However, there's a trend towards greater harmonization, especially for large, internationally active banks.