Chapter 2: Banking regulation: theory and practice

Chapter 2: Banking regulation: theory and practice

Essential reading
Books
Matthews, K. and J. Thompson The Economics of Banking. (Chichester: Wiley, 2008) Chapter 12. Saunders, A. and M.M. Cornett Financial Institutions Management: A Risk Management Approach. (New York: McGraw Hill, 2006) Chapter 1, pp.10 15; Chapter 10, pp. 27582; Chapter 17, pp.48184; Chapter 19, pp.526 54; Chapter 20, pp.567600, pp.61314.

Journal article
Bhattacharya, S. and A.V Thakor Contemporary banking theory, Journal of . Financial Intermediation, 3(1) 1993, pp.250; Sections 4 and 5.

Further reading
Books
Bessis, J. Risk Management in Banking. (Chichester: Wiley, 2002) Chapters 3 and 7. Koch, T.W. and S.S. MacDonald Bank Management. (London: Thomson Learning, 2006) Chapter entitled The Effective Use of Capital. Sinkey, J.F. Jr. Commercial Bank Financial Management. (Harlow: Prentice Hall, 2002) Chapter entitled Bank Capital Structure: Theory and Regulation. White, L.H. The Theory of Monetary Institutions. (Maiden, Mass.: Blackwell, 1999) Chapter 6.

Journal articles
Diamond, D.W. Banks and liquidity creation: A simple exposition of the Diamond and Dybvig model, Federal Reserve Bank of Richmond Economic Quarterly, 93(2) 2007, pp.189200. Diamond, D.W. and P Dybvig Bank runs, deposit insurance and liquidity, . Journal of Political Economy, 91(3) 1983, pp.40119

Aims
This chapter aims to: build on your understanding of the process of banking regulation gained from the prerequisite 24 Principles of banking and finance or its predecessor 94 Principles of banking. introduce theories of bank regulation, particularly in relation to bank runs, and the costs and benefits of regulation. demonstrate the practice of international regulation of bank capital adequacy.

Learning objectives
After studying this chapter and having completed the essential reading and activities, you should be able to: discuss the problems with liquidity transformation and analyse the theory of bank runs

15

29 Financial intermediation

discuss and evaluate the system of international regulation of bank capital adequacy analyse the arguments in favour of, and against, banking regulation.

Introduction
This chapter sets out theoretical and practical insights on banking regulation. It builds on the foundation in this topic provided in unit 24 Principles of banking and finance (see Chapter 5 of the subject guide for that unit, Regulation of banks). The next section provides a motivation for the chapter by considering aspects of the recent turmoil in international financial markets. Attention then turns to theoretical considerations, with emphasis on the theory of bank runs. The subsequent section addresses the key aspect of capital adequacy regulation in international banking and its development over recent years. The final section addresses the costs and benefits of bank regulation.

The credit crunch 2007

In motivating your study of the theory and practice of banking regulation, we start by considering the credit crunch which has led to considerable turmoil for banks and capital markets from 2007 onwards. At the time of writing (spring 2008), JPMorgan Chase has recently purchased Bear Stearns at a very low valuation (due to the latters difficulties), and financial markets are beset with rumours of which bank or financial institution will be next to report serious problems or even fail. There is no indication of when financial market conditions will return to a normal state. The symptoms of the credit market turmoil started in late 2006 when the default rate on lower quality (termed sub-prime) US mortgages increased. See unit 24 Principles of banking and finance for a discussion of sub-prime lending, and Chapter 4 of this subject guide for a detailed discussion of credit risk. The substantial losses reported by two Bear Stearns hedge funds which had invested in structured securities backed by sub-prime mortgages triggered the squeeze. Market participants drove up interbank interest rates (e.g. Libor) drastically, and money market funds were unwilling to buy commercial paper backed by sub-prime mortgagebacked securities (MBS, see Chapter 6 of this guide) due to the uncertainty in the sub-prime market. This led to a sudden drying up in liquidity as banks found it difficult to make payments on sub-prime MBS by rolling over short-term borrowing in the money market. The subsequent months observed a bank run on the UK bank Northern Rock (see below), and writedowns on structured finance investment related to sub-prime MBS by several large investment banks (see Matthews and Thompson, 2008, pp.14445). Expectations of longer-term fallout 45). . from the credit market squeeze have also been signalled by supranational financial institutions. The credit market turbulence can be traced back to institutional changes in housing finance in industrial countries. The deregulation of housing finance markets led to increased competition and the integration of housing finance into capital markets as different agents in the mortgage market (such as depositary institutions and specialised mortgage banks) sought cheap debt to meet the increasing demand for house ownership financing. Increased use of MBS to finance housing was particularly popular in the USA. Technological changes (such as advancements in IT

16

Chapter 2: Banking regulation: theory and practice

and credit scoring) and development of money market funds also helped ease housing finance. An extended global economic boom and worldwide decreases in interest rates were macroeconomic factors behind the housing market boom in many countries. Financial innovation, especially extensive use of derivatives, facilitated access to cheap debt provided by global capital flows. Easier access to financing home ownership led to increased housing demand and surges in housing prices across industrial countries. An extreme effect of the housing boom was the increased supply of housing finance to sub-prime mortgagers, who were denied home mortgages in the prime market because of the vulnerability of their repayment ability, as investors searched for high yield in an environment of low interest rates. The introduction of sub-prime mortgages into securitisation transactions provided investors with high yield but also brought vulnerability to any shock in the economy (as observed in the later episodes during summer 2007). The bank run on Northern Rock was a dramatic event in the context of this credit crunch (see Matthews and Thompson, 2008, pp.99, 143). This was the first bank run in the UK for 150 years, and naturally led to a highlighting of many questions about the efficacy of regulation. The Bank of England was called on as lender of last resort. Consumers demonstrated a lack of awareness and/or confidence in deposit insurance arrangements, whose provisions were subsequently extended in the UK. Elements of the theory of bank runs (see below) were evident in the behaviour of bank customers during the episode. The UK government had provided so much funding to Northern Rock that they decided to nationalise the bank in early 2008. The tripartite system of regulation in the UK involving the Financial Services Authority (FSA), the Bank of England (BoE) and the Treasury was called into question. In particular, the separation of the responsibilities for bank supervision (FSA) and the role of lender of last resort (BoE) was criticised. Also, Northern Rock was pursuing a somewhat unique business model for a retail bank in its heavy reliance on money-market funding, and the question of whether there should have been earlier regulatory intervention on the basis of this has been posed by many commentators. Activity To gain insight into the long-term effect of the credit market squeeze, visit the following web sites: the International Monetary Fund (www.imf.org) and the Bank for International Settlements (www.bis.org). For extended discussion of the sub-prime mortgage crisis, visit: www.kansascityfed.org, click on Economic Symposium then 2007. Critically analyse the present economic and financial conditions in the global economy and consider the influence of the sub-prime crisis and wider credit squeeze. At the time you are reading this, what effect has the credit squeeze had on your home countrys economy? For a discussion of cases of bank failures, read Matthews and Thompson (2008) p.187. Read the Bank of Englands Financial Stability Reports for 2007 (at www.bankofengland. co.uk). Critically analyse the lessons learnt by bank regulators from past bank failures, and consider what regulatory changes could arise from the Northern Rock case.

Banking regulation
Economists are divided on the question of whether there is a need for banks to be regulated. In the prerequisite unit 24 Principles of banking and finance, you will have studied the basic arguments for and against bank regulation. Here, we extend some of those ideas, and

17

29 Financial intermediation

illustrate some of the most influential theory, particularly on the issue of the threat of bank runs. The case for bank regulation rests on the argument that unregulated private actions create outcomes whereby social marginal costs are greater than private marginal costs. The social marginal costs occur because a bank failure has effects throughout the economy as banks are used to make payments and as a store for savings. In contrast, the private marginal costs are borne by the shareholders and the employees of the firm, and these are likely to be smaller than the social costs. Nevertheless, bank regulation involves real resource costs of a direct nature plus the compliance costs borne by the regulated banks. Further, a hidden cost of excessive regulation is a potential loss of innovation dynamism. Matthews and Thompson (2008, section 12.2) provide the above arguments and offer further detail and examples. A key reason for regulation is that uninsured depositors are likely to cause a bank run when faced with information of an adverse shock to bank balance sheets. This argument has support both in history and in theory. The bank run on Northern Rock (see above) in September 2007 is a recent historical example. Although depositors in this bank had some protection from deposit insurance, they still preferred to run on the bank in the light of uncertainty regarding the banks viability because it had been forced to rely on the lender of last resort facility. There was also a lack of appreciation (or confidence) by depositors that the bank was initially suffering from a liquidity problem rather than a solvency problem. Matthews and Thompson (2008, pp.18990) provide several other historical cases, and note that this evidence appears to support the argument that a deposit insurance scheme reduces the danger of bank runs and the potential systemic effects of a run. The next section considers the theoretical support. Activity a. Read Saunders and Cornett (2006) pp.1015. Explain how the special nature of banks implies a need for regulation. b. Read Saunders and Cornett (2006) pp.52654. Analyse the different means by which deposit insurance could be structured to reduce moral hazard behaviour.

Theory of bank runs

In addition to improving the flow and quality of information, banks provide financial or secondary claims to savers, which often have superior liquidity attributes compared with primary securities such as corporate equity and bonds (see also Chapter 1 of this subject guide). Banks typically offer contracts that are highly liquid and low price-risk to savers on the liability side of the balance sheet while holding relatively illiquid and higher price-risk assets. They achieve this through diversifying some of their portfolio risks. Banks exploit the law of large numbers in this way, whereas savers are constrained to holding relatively undiversified portfolios. The more diversification achieved by the bank, the lower the probability that it will default on its liability obligations and the less risky, and more liquid, its claims. Financing long-term assets (e.g. loans) through short-term deposits is the source of potential fragility of banks, because they are exposed to the possibility that a high number of depositors will decide to withdraw their funds for reasons other than liquidity needs. The liquidity transformation

18

Chapter 2: Banking regulation: theory and practice

function of banks makes them vulnerable to runs (i.e. the possibility that many depositors simultaneously seek to redeem their claims out of concern that the bank will default if they wait). Bank runs would not be a problem if they were confined to banks that were already (pre-run) insolvent. In fact, the threat of a run would act as a discipline in giving banks an incentive to avoid insolvency or the appearance of insolvency. However, bank runs clearly become problematic when depositors with imperfect information run on banks that are not (pre-run) insolvent. In an important theoretical model, Diamond and Dybvig (1983) show that a run can in itself cause a bank to default that would not otherwise have defaulted. If enough other depositors are running, it becomes each depositors best strategy to run themselves. A bank run thus becomes self-reinforcing, or a Nash equilibrium in game-theory terms. A bank attempting to meet demands by more than a certain proportion of its depositors will incur losses so large that its default becomes inevitable. In the above model, any event that causes depositors to anticipate a run also makes them anticipate insolvency. It thus does in fact cause a run and so the outcome validates the anticipation. The possibility of a run makes intermediation more costly in terms of depositors needing to monitor banks more closely and banks needing to maintain more reserves. Whereas a bank run relates to an individual bank, a panic refers to a simultaneous run on several banks. If runs are contagious, they will lead to a panic. Activity You should now read Saunders and Cornett (2006) pp.48184 and Bhattacharya and Thakor (1993) Section 4, pp.2226. Explain how a bank run could become self-reinforcing. More formally, Diamond and Dybvigs (1983) model consists of a large number of identical agents considered for three periods (0, 1, 2). Liquidity insurance (see Chapter 1 of this guide, where we previously mentioned this model) is also relevant to the notion of fragility of banks (see also unit 24 Principles of banking and finance). Each agent is endowed with one unit of a good and makes a storage or investment decision in period 0. In period 1, some agents face an unpredictable liquidity demand and are forced to consume in period 1 and receive one unit of goods. These are labelled as type 1 agents. The remaining agents consume in period 2 and they receive R units of goods, where R > 1. These are labelled as type 2 agents. One solution is that there will be trades in claims for consumption in periods 1 and 2. The limitation to this is that neither type of agent knows ex ante the probability that funds will be required in period 1. However, they can opt for a type of insurance contract, which could be in the form of a demand deposit. This would give each agent the right either to withdraw funds in period 1 or to hold them to the end of period 2, which provides a superior outcome. An alternative scenario would be that both types of agents withdraw funds in period 1, that is, there is a run on the bank. Two policy initiatives can prevent this outcome: suspension of convertibility, which prevents the withdrawal of deposits provision by regulatory authorities of a deposit insurance scheme which removes the incentive for participation in a bank run because the deposits are safe. The regulator can finance the scheme by levying charges on the banks. Given that no bank runs occur, the charges will be minor after the initial levy to finance the required compensation fund.

19

29 Financial intermediation

The model thus supports a form of deposit insurance to remove the incentive to run. Activity Read Matthews and Thompson (2008) pp.19192 for an alternative presentation of the model based on utility functions.

The deposit contract

In the context of bank runs, a possibly problematic feature of deposit contracts is that assets are distributed preferentially to those who are first in line to redeem their claims. In other words, funds are given to depositors on a first-come, first-served basis (also termed a sequential service constraint, SSC). Some authors argue that this type of contract is run-prone and would not exist in this form under a free banking system (see unit 24 Principles of banking and finance and the final section of this chapter). A further dimension of banks ability to reduce risk through diversification is that they are more able to bear the risk of mismatching the maturities of their typically long-term assets and short-term liabilities. Such mismatches will often result in a bank being faced with interest rate risk, but it is able to manage this risk through its superior access to markets and instruments for hedging (see Chapters 3, 5 and 8 of this guide). Maturity mismatching also provides incentives for a bank to conduct both screening prior to issuing loans and post-lending monitoring of its borrowers. Problems with the deposit contract are also relevant here. In the context of bank runs, it is rational for a depositor to withdraw funds if the deposit contract is structured in such a way that there is a greater pay-off to arriving sooner, rather than later, to redeem. This will prevail when deposits are: debt claims (i.e. claims to fixed amounts regardless of the performance of the banks assets) redeemable on demand, with a first-come, first-served rule for redemption requests (the sequential service constraint, SSC) subject to likely default on the last redemption claim serviced; this will be probable when either the bank is insolvent before a run begins, or a run itself causes insolvency. It is argued that some of the problems associated with the deposit contract can be solved through securitisation of assets, that is, the re-packaging of loans to create a security which is liquid, marketable and attractive to investors (see the detailed discussion in Chapter 6 of this subject guide). A securitised loan can be viewed as a loan sold to investors with recourse to the bank (or a collateralised deposit). In other words, the bank sells new depositors a secured claim on the incremental loans financed with their deposits. Banks are often prevented from prioritising ordinary deposit claims (e.g. in the USA). The process of securitisation enables a bank to prioritise the claims of depositors by issuing deposit-type claims of different seniorities. Holders of a securitised asset have first claim on the asset in the case of bank insolvency. Risk-averse investors may therefore choose to invest in securitised claims, which improves risk sharing. A bank can thus choose between deposit financing and capital market financing via securitisation. The banks choice in this matter, especially the extent to which the loan buyer has recourse to the originating bank in a securitisation transaction (see Chapter 6 of this subject guide), can signal private information to the market and thus alleviate the informational problem encountered with a standard deposit contract. It is

20

Chapter 2: Banking regulation: theory and practice

thus argued that securitisation provides the benefits of liquidity and risk sharing, but removes the drawback of the sequential service constraint discussed above. Activity You should now read Bhattacharya and Thakor (1993) Section 5, pp.2931. Identify any weaknesses of the deposit contract in the context of liquidity and maturity transformation.

Capital adequacy regulation

The argument that deposit insurance eliminates bank runs has validity, though it is questioned by the proponents of free banking (see the final section of this chapter). An important side effect of a system of complete (i.e. 100 per cent) insurance of deposit is that it creates a moral hazard problem. (You should recall this point from unit 24 Principles of banking and finance.) Under full insurance, depositors lack incentives to monitor a banks activities, because they will suffer no losses if the bank fails. With depositors not monitoring the bank, its managers will have an incentive to take greater risks than they would otherwise have done (hence bank behaviour is distorted by the complete deposit insurance). Two possible solutions are co-insurance (where deposits are less than 100 per cent insured) or requiring riskier banks to pay higher deposit insurance premiums (see unit 24 Principles of banking and finance for details). Activity Study the illustrations by Matthews and Thompson (2008) pp.19094 based on balance sheets. It has been argued that due to the existence of deposit insurance, banks are tempted to take on excessive asset risk and to hold fewer reserves. This provides support for regulation based on reserve ratios and capital adequacy. An important manner in which excess asset risk can be regulated is by linking banks shareholder capital to the risk held by the bank in its assets. Central banks and other regulatory agencies have typically utilised two measures of capital adequacy, namely the gearing ratio and the risk assets ratio. The gearing ratio is based on bank deposits relative to bank capital. It is an indicator of how much of the deposit base is covered if a given proportion of the banks borrowers default. Let the balance sheet be described as: A=D+E where A is total assets, D is deposits and E is equity. The gearing ratio, g = D / E , hence D = g E , and: A=gE+E A = E (g + 1) If is the rate of default on assets, and max A = E, then: max A = A / (1 + g) max = 1 / (1 + g) If A of assets is lost due to default, it can be absorbed by bank capital (E) and deposits are covered. In other words, the maximum default rate which can be absorbed without affecting deposits is equal to 1 divided by (1 + gearing ratio). See Matthews and Thompson (2008, pp.19495) for further discussion.

21

29 Financial intermediation

The other common measure used is the riskassets ratio. It is important to begin by defining our understanding of the term capital. However, we may find alternative definitions arising from the differing perspectives of accounting, economics and regulation. The economists definition of a financial institutions capital (or owners equity stake) is the difference between the market values of its assets and liabilities (also termed the net worth). Regulators have found it necessary to adopt definitions of capital that depart to some extent from this concept of a banks economic net worth. While net worth is a market value accounting concept, regulatory definitions of capital tend to be based in whole or in part on historical or book value accounting concepts. The degree to which the book value of a financial institutions capital deviates from its economic market value depends on a number of factors. The higher the interest rate volatility, the greater the discrepancy. In general, the greater the level of rigour applied by regulators in supervising the bank, the smaller the discrepancy. Activity You should now read Saunders and Cornett (2006) pp.57375. Refer to Chapter 7 of this subject guide for further discussion of comparing market and book values in analysing performance. There are several factors which contribute to the importance of capital management in banking: Capital is at the centre of the regulatory framework, and as such provides confidence for depositors and other creditors. Capital provides a buffer intended to absorb losses while permitting the bank to continue operating, and thus preventing default. Capital management has implications for profitability and capital availability. Our interest is primarily in the first two of the above issues, which are addressed in detail in this section. Only equity capital, the banks own funds, which has no fixed maturity and no fixed financing cost, can fully perform these functions. As long as capital is sufficiently large, it can be used to absorb losses without depositors or other claimants on the bank suffering. Banks do have other means of raising long-term funds (e.g. through issuing fixed-interest bonds or floating rate notes (FRNs)). However, although these activities can improve liquidity and reduce mismatching problems on the balance sheet, they do not fulfil other functions of capital (a major attribute of capital being that it has no fixed maturity and is therefore the best means of financing long-term assets). Activity Now read Saunders and Cornett (2006) Chapter 20, pp.56775. Identify and briefly discuss the importance of the functions performed by bank capital. Banks would generally prefer to maintain a relatively low amount of capital in order to boost their return on equity (see Chapter 7 of this guide). However, even for the best-managed bank which has effective risk management procedures, there always remains the possibility of risks materialising that produce losses. Therefore, it is essential for banks to have adequate capital backing. As banking risks have grown, supervisory authorities have demanded tough requirements for capital adequacy. The need to generate more capital acts as a vital constraint on a banks asset and liability management (see Chapter 5 of this guide).

22

Chapter 2: Banking regulation: theory and practice

Because capital is so important to the banking firm, capital adequacy has become a primary concern of bank supervision. Historically, various countries regulators had alternative approaches to capital adequacy, some relying on quantitative (balance sheet ratio) approaches, with others adopting qualitative procedures. They also had different views as to what was adequate and what constituted capital. This raised issues concerning the potential for banks in a given country to enjoy competitive advantages over banks in other countries because of regulatory and/or accounting differences. The increased integration of financial markets internationally along with the need to create a level playing field for banks in different countries led to the June 1988 Capital Adequacy Accord of the Basle Committee on Banking Supervision, which was implemented from 1 January 1993. This has become known as Basle I. The agreement explicitly incorporated the different credit risks of assets (both on and off the balance sheet) into capital adequacy measures. Following a revision to the accord in 1998, market risk was incorporated into risk-based capital in the form of an add-on to the minimum required ratio for credit risk (see below). Regulations imposing a capital charge against risks are a strong incentive for banks to improve risk measures and controls. Basle I was based on employing the riskassets ratio to determine the adequacy of a banks capital. The risk assets ratio is equal to the capital divided by the credit risk-adjusted assets, with two versions defined as follows: Total risk-based capital ratio = Total capital (Tier I + Tier II) / Credit risk-adjusted assets Tier I (core) capital ratio = Core capital (Tier I) / Credit risk-adjusted assets (2.2) To be adequately capitalised, a bank must hold a minimum total capital (Tier I core capital plus Tier II supplementary capital) to credit risk-adjusted assets ratio (equation 2.1) of 8 per cent. Bessis (2002), Matthews and Thompson (2008) and others refer to this as the Cooke ratio. In addition, the ratio of the Tier I core capital to risk-adjusted assets (equation 2.2) must be at least 4 per cent. For regulators to classify a bank as well capitalised, it must have a minimum total capital to risk-adjusted assets ratio of 10 per cent and a minimum Tier I capital to risk-adjusted assets ratio of 6 per cent. Tier 1 capital includes common stockholders equity, non-cumulative perpetual preferred stock and minority interest in equity accounts of consolidated subsidiaries. Tier II capital includes loan loss reserves (up to a specified maximum), perpetual preferred stock, hybrid debt/equity instruments, subordinated debt, and revaluation reserves (see Saunders and Cornett, 2006, Table 20-8 for further details). A credit risk-adjusted asset is calculated as the value of the asset multiplied by an appropriate credit risk weight. Four risk categories are used and examples of credit risk weights assigned to various assets are presented in Table 2.1. Asset Cash and equivalents Claims on, or guaranteed by, OECD depository institutions Mortgages Commercial loans Rsk weght (%) 0 20 50 100 (2.1)

Table.2.1:.Credit.risk.weights.under.the.1988.Capital.Adequacy.Accord.of.the. Basle.Committee.on.Banking.Supervision..
Source: www.bis.org

23

29 Financial intermediation

The higher the default risk associated with an asset, the higher the risk weight assigned. Off-balance sheet items are treated similarly by assigning a credit equivalent percentage that converts them to on-balance sheet items and then the appropriate credit risk weight applies (e.g. see Bessis, 2002, p.33). Refer to Saunders and Cornett (2006, Table 20-10) for further details. See Matthews and Thompson (2008, pp.19697) for a useful alternative representation of the risk-weighted assets and solvency requirements under Basle I, and an illustrative calculation. With regard to the add-on for market risk, banks in the countries that are members of the Bank for International Settlements (BIS) can calculate market risk exposure using either a standardised framework (the regulatory model) or their own internal models (if approved by the regulators). Under the latter approach, if an internal model is approved, it is still subject to regulatory audit and certain constraints. Examples of typical approaches to internal models for market risk are discussed in Chapter 3 of this subject guide. Activity Now read Saunders and Cornett (2006) Chapter 10, pp.27582, and Bessis (2002) Chapter 3, pp.2540. Explain the BIS standardised framework for measuring market risk. Basle I attracted some criticism during the 1990s. Most importantly, it was argued that the risk weights were rather unsophisticated and inadequately related to default risk. The most serious objection related to the uniform 100 per cent weighting applied to commercial loans (see above). Based on its corporate database, Moodys Investors Service estimates that the default probability of a B3-rated corporate borrower is almost 200 times greater than the default probability of an Aaa-rated issuer over a five-year time horizon. Generally, the average default probability of sub-investment grade issuers is at least 20 times that of investment grade borrowers (see Chapter 4, Table 4.3 of this subject guide for supporting data). Despite these observations, under Basle I, all corporate borrowers received the same 100 per cent risk weighting irrespective of underlying risk. Another criticism is that the capital requirement is additive across loans. This means that there is no reduction in capital requirements arising from greater diversification of a banks loan portfolio (see Bessis, 2002, p.34). Further, differences in taxes and accounting rules could mean that measurement of capital varies widely across countries. The information required to calculate capital adequacy also lags behind the market value of assets. However, the Basle conditions are only a minimum, and regulatory agencies in some countries expect a higher capital adequacy standard in order for a bank to be considered well capitalised (see Matthews and Thompson, 2008, p.197). A revised capital adequacy framework was initially proposed by the Basle Committee in June 1999 and, following an extensive consultation process, the framework was finalised in June 2004 ready for implementation in stages, commencing at the end of 2006. This agreement has become known as Basle II. The framework contains a degree of flexibility in its application, and there is scope for adjustments in future years. Bessis (2002) Table 3.1 provides a useful summary of the differences in approach between Basle I and Basle II. Briefly, Basle I focused on a single risk measure and a one size fits all approach, whereas Basle II places more emphasis on banks own internal methods, supervisory review, market discipline and a menu of possible approaches for banks to follow.

24

Chapter 2: Banking regulation: theory and practice

Basle II consists of three mutually reinforcing pillars which contribute to the safety and soundness of the financial system: Pillar 1: minimum capital requirements, seeking to refine the framework established under Basle I. Pillar 2: supervisory review of an institutions capital adequacy and internal assessment process. Pillar 3: market discipline through effective disclosure to encourage safe and sound banking practices. Under Pillar 1, regulatory capital requirements for credit, market and operational risk are addressed. The credit risk capital requirement remains the core of the framework, with market risk and operational risk capital requirements featuring as add-ons. The measurement of market risk has not changed from that adopted in 1998 (see above). The BIS developed capital requirements proposals for interest rate risk in 1993 and 2001, but no formal add-on has subsequently been agreed for interest rate risk. A banks capital requirement for interest rate risk is a question to be addressed within the supervision process (under Pillar 2). To facilitate this, banks should provide the results from their internal measurement systems, using standardised interest rate shocks. The ultimate aim of international regulators is a comprehensive capital adequacy standard which incorporates all banking risks (see Chapter 3 of this subject guide). The incorporation of operational risk is a new element, arising from the increased importance of this type of risk in recent years (see Chapter 3 of this subject guide, and Saunders and Cornett, 2006, Chapter 14). Basle II proposes three methods by which banks can calculate the capital required to protect against operational risk: the Basic Indicator Approach the Standardised Approach the Advanced Measurement Approach. The first of these is structured so that banks, on average, will hold 12 per cent of their total regulatory capital for operational risk, where the 12 per cent figure arises from a wide-ranging BIS survey of large banks practices. The second approach aims to provide a finer differentiation by dividing bank activities into eight major business units and lines, and the banks total operational risk capital requirement is calculated as the sum of the operational risk capital requirements for each of the eight business lines. The business lines are corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services and custody, retail brokerage and asset management. The capital allocation for operational risk can thus differ across these business lines. The third approach allows banks to rely on their own internal data to calculate the operational risk capital requirement, which is based primarily on the probability that a loss event occurs and the losses given such an event. Refer to Saunders and Cornett (2006, pp.59598) for further details on these three methods. Two options are available to banks for the measurement of credit risk. First, the standardised approach, which is conceptually the same as under Basle I, but more risk-sensitive. Secondly, the internal ratings-based (IRB) approach, whereby banks are allowed to use their internal estimates of borrower creditworthiness, subject to strict methodological and disclosure standards. We now discuss each of these approaches in more detail.

25

29 Financial intermediation

The standardised approach

The basic formulation is the same as for Basle I. The key difference under this approach arises from the greater sensitivity of the risk categories. Risk weights are refined by reference to ratings by External Credit Assessment Institutions (ECAIs) that meet strict standards set by the BIS. The term ECAIs mainly refers to credit rating agencies (see Chapter 4 of this subject guide), but ratings by Export Credit Agencies (ECAs) are also permitted for sovereign risks. Note how the approach places a greater reliance on these external credit assessments, compared with the internal assessments applicable under IRB below. Table 2.2 identifies the proposed risk weighting under this approach. Issuer Credit Rating AAA to AASovereigns Banks Option 11 Option 22 0% 20% 20% AAA to AACorporates 20% AAA to AASecuritised 20% A+ to A20% 50% 20%3 A+ to A50% A+ to A50% BBB+ to BBB50% 100% 50%3 BBB+ to BBB100% BBB+ to BBB100% BB+ to B100% 100% 100% BB+ to BB100% BB+ to BB150% Below B150% 150% 150% Below BB150% Below BBDeducted from capital Unrated 100% 100% 50%3 Unrated 100% Unrated

Table.2.2:.Credit.risk.weighting.in.the.Basle.II.capital.adequacy.framework.
Source: Bank for International Settlements A new capital adequacy framework, June 1999. Also, see Saunders and Cornett (2006) Table 20-12 and Bessis (2002) Tables 3.2 and 3.3.
1 2 3

Risk weighting based on risk weighting of sovereign in which the bank is incorporated. Risk weighting based on assessment of the individual bank.

Claims on banks of short original maturity, for example less than six months, receive a weighting that is one category more favourable than the usual risk weight on the banks claim. Activity Access the web site of the Bank for International Settlements at www.bis.org and explore the latest relevant publications produced by the Basle Committee on Banking Supervision. Critically evaluate the design of the existing regulatory regime.

The IRB approach

The development of an approach to regulatory capital based on internal ratings (see Chapter 4 of this subject guide) is a key element in the revised framework under the Basle II Accord. Under the IRB approach, credit risk models (see Chapter 4) are used to formally determine credit risk-adjusted capital requirements. Generally speaking, a bank estimates each borrowers creditworthiness, and the results are translated into estimates of potential future losses, which then form the basis of capital requirements. Key features of the internal models include the probability of default by each borrower within one year ahead and a history of satisfactory model validation by the bank (which needs to be approved

26

Chapter 2: Banking regulation: theory and practice

by the regulator). There are incentives for banks to use the IRB approach the Basle Committees aim is that risk weights will be lower, on average, if using this approach instead of the standardised approach. The range of risk weights is far more diverse than in the standardised approach, resulting in greater sensitivity. There are distinct analytical frameworks for different types of loan exposures, for example corporate and retail lending, where loss characteristics are different. Banks with a sufficient number of internal credit risk rating grades for loans, and whose borrowers are largely unrated by the major credit rating agencies (see Chapter 4 of this subject guide), may (subject to regulatory approval) adopt one of two IRB approaches to calculating credit risk-adjusted assets for capital requirements. Under the Foundations Approach, a bank estimates the one-year probability of default (PD) associated with each of its internal rating grades, while relying on supervisory rules for the estimation of other risk components. The methods for mapping internal ratings and PD include the use of the banks own default experience, the use of external data from credit rating agencies (as in Chapter 4, Table 4.3) and the use of statistical default models. The PD estimate must represent a conservative view of a long-run average PD, through the economic cycle, rather than a short-term assessment of risk. Under the Advanced Approach, a bank may use its own estimates of three additional risk components: loss given default (LGD), exposure at default (EAD) (see Chapter 4) and maturity. With regard to the latter, note that (with the exceptions stated in note 3 to Table 2.2) the standardised approach does not allow weights to vary with maturity (see Bessis, 2002, p.43). Under both approaches, benchmark risk weights (BRW) are calculated for different loans. Under the Foundations Approach, the bank calculates the expected (mean) PD for each of its rating classes based on historical experience in order to generate the BRW. Then, given an LGD for the loan, it calculates an individualised risk weight for each of its corporate loans. Here, the BIS assumes LGD to be 50 per cent for unsecured loans, 45 per cent for loans secured by physical non-real-estate collateral, and 40 per cent if secured by receivables (see Saunders and Cornett, 2006, p.613 for further details of the calculation). The 8 per cent capital requirement on all loans under Basle I translates into a one-year PD of 1 per cent. Thus, under Basle I, loans with PDs of less than 1 per cent generally charged too much capital and loans with PDs greater than 1 per cent generally charged too little capital (see Saunders and Cornett, 2006, Table 20-A1). Bessis (2002, p.31) notes that investment grade borrowers have one-year PD of between 0 per cent and 0.1 per cent, while small corporate borrowers have one-year PD ranging from 3 per cent to 16 per cent or more across the economic cycle. Basle II stops short of permitting banks to calculate their capital requirements based on their own portfolio credit risk models. This is because of the need to improve the reliability of inputs to such models and the difficulty of demonstrating the reliability of the capital estimates generated by the models. Bessis (2002, p.46) notes that by imposing the need for banks to build comprehensive credit risk databases, Basle II paves the way for a later implementation of such an approach. A major impediment to model validation is the small number of forecasts available with which to evaluate a models forecast accuracy. Due to the relative infrequency of defaults, it takes a long time to produce sufficient observations for reasonable tests of forecast accuracy for these models. These data limitations create a serious difficulty for users own validation

27

29 Financial intermediation

of credit risk models and for validation by third parties, such as external auditors or bank regulators. Bessis (2002, p.42) notes that data gathering on all credit risk drivers is a major priority for banks, and Basle II provides an incentive for solving the incompleteness of credit risk data currently available. Activity Now read Saunders and Cornett (2006) Chapter 20, pp.598600. Critically analyse the strengths and weaknesses of the revised regulatory regime for minimum capital requirements. Pillar 2 of the framework is focused on supervisory review of banks capital adequacy and internal assessment process, which the BIS views as a vital complement to Pillar 1. This pillar involves procedures through which regulators will ensure that each bank has sound internal processes in place to assess its capital adequacy and will set targets for capital that are commensurate with the banks specific risk profile and control environment. This pillar also implies that bank supervisors will have some discretion to overcome any anomalies produced by the formulas applied under Pillar 1. The four basic principles that supervisors should follow are stated in Bessis (2002) pp.4950. Pillar 3 of the framework seeks to encourage safe and sound banking practices by focusing on the role of market discipline, which it is hoped will be achieved through effective disclosure by banks. Specifically, the BIS provides detailed guidance to banks on the disclosure of capital structure, risk exposures and capital adequacy. In order to be granted permission to adopt internal models in the calculation of its capital requirements, a bank must ensure appropriate disclosure of information. The aim of such requirements is that market participants will be able to assess critical information about a banks risk profile and capital adequacy, and that market reaction to such information will act as a discipline on banks activities. Note that if there were no implicit or explicit guarantees in bank regulation (e.g. deposit insurance and lender of last resort), Pillar 3 might be the only element that was required. This ties in with the notion of free banking (see the next section of this chapter), and proponents of such an approach would argue that the Basle framework should ultimately be moving towards such an environment. Activity Read Bessis (2002) Chapter 3 and Saunders and Cornett (2006) Chapter 20, pp.567600 and pp.61314. Now answer the questions on pp.60506 of Saunders and Cornett (2006).

Arguments against regulation

From unit 24 Principles of banking and finance, you will be aware of some arguments against banking regulation, termed the free banking school of thought. Here, we extend some of those arguments, and conclude this chapter by conducting a costbenefit analysis of regulation. It is argued that the moral hazard created by deposit insurance (see above) will drive even conservative banks to take on extra risk when faced with competition from poorly managed banks taking excessive risks (see Matthews and Thompson, 2008, pp.20106). Under the free banking view, the negative effect of deposit insurance (i.e. moral hazard) creates the need for regulation. When a government (or its agency) has created a

28

Chapter 2: Banking regulation: theory and practice

deposit insurance system, it is politically impossible for it to be withdrawn or restricted to a subset of (e.g. well-managed, low risk) banks. In the presence of deposit insurance, it is argued that the following types of regulation should be considered: prohibition of bank activities that are considered to be excessively risky monitoring and controlling the risky activity of banks requiring banks to hold sufficient capital to absorb potential losses. The first two are viewed as impractical for reasons of being overprescriptive, bringing regulation into disrepute and stifling innovation. The last is the only one which is operational (see details of Basle II above). Some economists argue for reform of the current system of banking regulation in order to allow market discipline to counteract the moral hazard problems and resultant underpriced risk created by deposit insurance. A popular suggestion is the use of subordinated debt in bank capital regulation, with the aim of creating a banking environment that functions as if deposit insurance were absent. Specific proposals have suggested that banks issue and maintain puttable subordinated debt of 45 of risk-weighted assets. If debt holders exercise the put option by 5 5 redeeming the debt, the bank would have a short time period to make an appropriate adjustment to continue to meet the regulatory capital requirement. The benefit of the put characteristic (see Chapter 8 of this subject guide for discussion of put options) would be that the bank would be forced to continuously satisfy the market of the soundness of its balance sheet. Holders of subordinated debt are not depositors and are not underwritten by deposit insurance, hence they have strong incentives to monitor the bank. Subordinated debt holders cannot cause a run on the bank. They have an asymmetric payoff structure: when the bank performs well, they can expect the premium interest promised but when the bank performs badly they will absorb any losses that exceed the equity capital. The risk premium on the subordinated debt yield will be indicative of the risk-adjusted deposit insurance premium. Any excess risk taking by the bank will be reflected in rising yields on the subordinate debt and/or difficulty for the bank in reissuing new debt to replace maturing subordinate issues. Matthews and Thompson (2008, pp.20405) identify that the choice between the current regulated banking system and free banking is ultimately a costbenefit analysis, as we now highlight. With free banking and the absence of a lender of last resort, one can anticipate that individual banks reserves and capital ratios would be higher than under regulated banking. Also, interest rate spreads would be wider under free banking than under a regulated banking system with central banks, which we now demonstrate. The bank balance sheet was given above by: A=D+E If L denotes loans and R denotes reserves, then: L+R=D+E Let the capitalasset ratio (E / L) be given by e and the reservedeposit ratio (R / D) be given by k. L-E=DR Since E = eL and R = kD, this can be re-expressed as: L - eL = D - kD L(1 - e) = D(1 - k)

29

29 Financial intermediation

The objective function of the bank (ignoring costs) is described by the profit function: P = rL L rE E rD D This is because the revenues are generated from the use of funds (loans) attracting the interest rate rL, while the sources of funds are equity and deposits, which have required rates of return of rE and rD respectively. Given that D = (L(1 e)) / (1 k) and E = eL, the objective function becomes: P = rL L - rE eL rD (L(1 - e))/(1 - k) Differentiating this function with respect to L gives: dP/ dL = rL rE e rD (1 e) / (1 k) and setting this to zero gives: rL rE e rD (1 e) / (1 k) = 0 Multiply through with (1 k): rL (1 k) rE e (1 k) rD (1 e) = 0 rL rL k rE e (1 k) rD + rD e = 0 rL rD = rL k + rE e (1 k) rD e The spread (difference between loan interest rate and deposit interest rate) is given by: s = rL rD Then: s = rL k + rE e (1 k) rD e and finally: ds/de = rE (1 k) rD This expression is greater than zero provided that the required return on equity (adjusted for the reserve ratio, k) is greater than the deposit rate. This condition will always prevail in the steady state, otherwise no investor would hold bank shares in preference to bank deposits. The inference is that the spread will increase when the capitalasset ratio increases, and vice versa. Hence, if free banking implies that banks will maintain higher capitalasset ratios, then spreads will be wider. Free banking delivers higher levels of e, leading to larger s and larger rL . These higher interest rates under free banking would entail a welfare loss (as demonstrated in Figure 12.2 in Matthews and Thompson, 2008). With a regulated banking system (entailing deposit insurance and the existence of a lender of last resort), reserves and capital ratios would be lower than under free banking, and the level and spread of interest rates would also be lower. These lower interest rates would have the benefit of liquidity creation, but at the cost of increased risk and potential for bank crisis.

A reminder of your learning outcomes

After studying this chapter and having completed the essential reading and activities, you should be able to: discuss the problems with liquidity transformation and analyse the theory of bank runs

30

Chapter 2: Banking regulation: theory and practice

discuss and evaluate the system of international regulation of bank capital adequacy analyse the arguments in favour of, and against, banking regulation.

Sample examination questions

1. With reference to the Diamond and Dybvig (1983) model, critically analyse whether funding through short-term deposits results in inherently fragile banks. 2. Explain why capital adequacy is such an important consideration for the banking sector, and critically analyse the capital requirements imposed by regulators.

31