ASB 3201: International Banking

Lecture 9: The Theory of International Banking Regulation

Bangor Business School 2012/2013

Dr Ru Xie r.xie@bangor.ac.uk
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Readings
Goodhart, C. (2010), How should we regulate bank capital and financial products? What role for living wills? in: The Future of Finance (The LSE report), chapter 5

Aims of Financial Regulation

Two critical explanations:
Regulation is an instrument for financial institutions to secure their comparative advantages that originates in their role in the process of money creation (Greenbaum./Thakor) Regulation is the best protection from competitions (Stigler, Kane)

A more friendly explanation (Terberger, HdF):

Regulation is the counterbalance to the problem of the moral hazard-effects which result from the inevitable fact that central banks, governments and deposit insurance institutions assume systemic risk

A more common explanation (e.g. Dale/Wolfe):

Financial markets and institutions function in a way which can be improved by suitable forms of regulation and supervision

Why we regulate banks

1. consumers lack market power and are prone to exploitation from the monopolistic behavior of banks There are strong economic incentives of financial institutions/their employees for moral hazard: excessive risks and outright fraud Individual investors cannot control financial institutions and therefore need to be protected 2. depositors are uninformed and unable to monitor banks, and therefore needs protection No incentive: requires both technical sophistication and resources, free-rider problem

Why we regulate banks

3. we need regulation to ensure the safety and stability of the banking system Intense competition lowers the franchise value of financial institutions and thereby increases the incentives to take excessive risks Market failure requires public intervention

Banks are fragile because of its asset transformation functions: size, maturity, liquidity, and risk transformations
Financial sector is too important to the economy to not provide external control and insurance against systemic risks

4. To maximize economic efficiency Maintain competition Protect investors against fraud and similar abuses Prevent externalities

Correct other market failures

Cost of regulation
Direct regulatory costs: hiring government employees and associated monitoring and compliance cost. Indirect costs: unintended consequences of regulation
Moral hazard (greater risk taking and maintenance of weaker capital positions) Loss of economic welfare caused by banks performing fewer transactions Reduces competition (limiting portfolio choices or restricting branches)

May disrupt the efficient evolution of markets The movement of the activity to financial centers with lighter regulation

Instruments of Banking Regulation

Authorization / Market entry (structural regulation): minimum size, qualification of bank managers, legal forms, possibly nationality, etc. Conduct Regulation especially important: Restrictions of authorized businesses Minimum equity requirement as bank reserves, and as a means to counteract moral hazard Liquidities requirements or exposure restrictions Diversification rules: credit restrictions, FX exposure restrictions Restrictions concerning how banks (and other FIs) may conduct their businesses : interest rate restrictions, credit limits, asset restrictions

Structural Banking Regulation ...

Structural regulation determines who is allowed to undertake what kinds of banking/financial activities Which institutions are regulated? Which institutions are allowed to undertake banking activities? Which transactions are banks allowed to undertake? (universal banks, specialised banks, see Germany and US) What are the requirements to get a banking license? Which institutions get (keep) a license? What are the requirements to get a license as a bank manager? Who gets a license as a bank manager?
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Conduct regulation with the main purpose of preventing banks from incurring too much risk
Conduct regulation for banks Objectives

Capital requirements Absolute capital requirements Relative capital requirements (risk weighted assets to equity) according to Basle II
Diversification rules (risk management) Maximum credit amounts to single borrowers (compared to equity) Maximum open positions in fin. assets Maximum co-variance of portfolio returns Internal risk management and control systems Restrictions on risky activities Information requirements as a means to secure solvency

Assure that banks can bear the risks of their business themselves

Assure that banks are not exposed to excessive risks they cannot bear with their equity

Assure that any deviation from standards is reported instantly 9

Basel I
Basle Committee consisting of the 12 most important central banks governors and chief supervisors (since 1974 located at the BIS in Basel, where the name comes from) The reasons of regulatory cooperation and coordination Basle Agreement (Basel I): Uniform regulations of solvency requirements (equity requirements) for internationally active banks Two kinds of equity (Tier 1 und Tier 2), at least 8% of RWA Emphasis on the possibility of a credit default No consideration of diversification, price risk, and market forces A questionable political compromise . and a solution which relies too much on administrative competences

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Basel II International Convergence of Capital Measurement and Capital Standards

Basel Capital Accord (Basel I): Minimum capital requirement was fixed at 8% of the risk weighted credit positions
1996 Market risk amendment of Basel I: market prices of risks in banks were incorporated into capital requirements 1999 First consultative paper on Basel II

Operational risk incorporated into capital requirements Better differentiation of credit risk Treatment of credit risk mitigation (collateral, derivatives) 2004 Completion of the documentation of Basel II
2005/06 National processes: Further testing / impact studies to guide national discretion choices Legislation and national rule-making Banks plan for implementation

2007/08 G10 implementation of simpler methodologies / advanced methods

Future Internal credit portfolio models & Implementation in non-G10 countries

What is the intention of Basel II?

Improve the safety and stability of the financial system and keep the equity reserves of banks at least at the same level Increase the level of (sound and fair) competition among banks in different countries Assure an adequate treatment of risks Deliver approaches for the calculation of the adequate bank equity that takes into account a banks current operations and risks Main focus (as originally in Basel I) should be on internationally active banks Consequence: the three pillar approach
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The three pillar approach

Basel II
Minimum Reserves
More exact quantification of credit risk, market risk and operational risk

Banking Supervision
Individualization of banking supervision and continuous s.

Strengthening Market Discipline

More & better disclosure

Risks: Classification and Definitions

Credit risk
the risk that loans and interest on the loans can not be repaid at all or not entirely Applies to direct (bank) loans to private persons, corporations, public authorities Applies also when corporations issue public debt (bonds) If the debtor defaults the creditors will be paid with the remaining assets depending on the seniority of the debt

Market risk
Can occur if a FI actively or passively trades or holds shares, bonds or financial derivatives that are traded on public markets An FI is exposed to market risk if it has an open (non-hedged) position With open positions traders bet on rising/falling share prices, interest rates, exchange rates etc. In case of an adverse development, the FI will loose money

Operational risk
Operational risk refers to (technical) systems or internal processes not working adequately or not at all (thus theres a strong relationship between technology and operational risk) Also: fraud, personal mistakes, catastrophes (external effects) etc. Examples: Front-Office Trading Systems do not work due to technical problems, earthquakes, bank robberies and fraud cases
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Risk Management
Credit risk management probability of default - Internal ratings of banks (typically), KMV loss given default (LGD) exposure at default (EAD) maturity (M) Market risk management Asset Liability Management - Banks face interest rate risk when their assets and liabilities are maturity mismatched Market Risk Measurement - Value at Risk Capital Allocation & Risk Adjusted Performance Measurement Operational risk management Indicators of human risk Indicators of process risk Indicators of technological risk Indicators of product risk

Basel-II Equity Requirement

Bank Equity 8% RAA (Market risk operational risk) *12,5
RAA = risk adjusted activity (calculated from the individual debtor) Credit risk Standard approach (with different risk weights compared with Basel I) Internal rating based (IRB) approach only individual PD advanced IRB-approach (for all the large banks) besides individual PD also individual LGD Market risk Standard approach Internal model approach (VaR, etc.) Operational Risk Basis indicator approach Standard approach Internal measurement approach

Basel II Pillar 2 Supervision

Principles for supervisory review: 1. Each bank should assess its internal capital adequacy in light of its risk profile 2. Supervisors should review internal assessments Models Stress-Tests Interest Rate Risk in the Banking Book 3. Recommendation that banks hold capital above regulatory minimums 4. Supervisors should intervene at an early stage

Basel II Pillar 3 Market Discipline

- Promote market discipline through greater transparency and improved public disclosure - Disclosure recommendations and requirements particularly important given increased reliance on internal assessments - IRB disclosure requirements include: PDs, LGDs, and EADs within portfolios Composition and assessment of risk Performance of internal assessments

The problems of Basel I

On balance sheet prime mortgage had 50% risk weight On balance sheet subprime mortgage had 100% risk weight Off balance sheet line of credit had 0% risk weight if less than 1 year Following post-Enron reforms, could easily create SPE to remove assets from balance sheet and largely from scrutiny of creditors, regulators & analysts

Source: Richard Herring: Regulation: What May Lie Ahead?, Frankfurt 2009

The problems of the three pillars

Pillar 1: Standardized Approach relies heavily on external ratings Adds to officially induced-pressures for institutions to demand high ratings Internal Ratings Based Approaches rely on internal models But even the most sophisticated players have found their internal models unreliable

Internal VaR-like models proved inadequate to deal with credit events in trading book

Pillar 2: No quantitative treatment of liquidity risk Pillar 3 would enhance disclosure and market discipline But most SPEs would remain opaque Creditors and counterparties were bailed out a IKB, Northern Rock & Bear Stearns undermining market discipline Inadequate disclosure to help external investors understand exposure to structured debt or SPEs Increased difficulty in comparing capital adequacy across countries Differences in permissible implementation choices Differences in risk management systems, Differences in accounting standards In January 2006 Deutsche Bank had trading assets under US GAAP of 448 vs. 1,010 under IFRS
What May Lie Ahead?, Frankfurt 2009

2 Source: Richard Herring: Regulation: 0

Reaction of bank regulators to the lack of bank capital

Imposition of new, higher capital requirements -Basel III Consultative document from December 2009 published by BIS Strengthen the resilience of the financial system Builds on the existing Basel II framework Core elements : raising the quality, consistency and transparency of the capital base Enhancing risk coverage Supplementing the risk-based capital requirement with a leverage ratio Reducing procyclicality and promoting counter cyclical buffers

From Basel II to Basel III

All banks will need to calculate the enhanced capital, new liquidity ratios, and new leverage ratios Stress testing receives greater significance under Basel III Stress testing: to analyse the impact of significant market events on the key ratios

The core elements of Basel (III)

Enhancing risk coverage Raise of capital requirements for the trading book and complex securitization exposures Higher capital requirements for resecuritizations Less reliance on external ratings for securitized products Supplementing the risk-based capital requirement with a leverage ratio Introduction of a leverage ratio that puts a floor under the build-up of leverage in the banking sector Reducing procyclicality and promoting counter cyclical buffers Most important point: banks should be required to build up capital buffers in good times which can then be used in bad times

Basel III and capital requirements

Expanding the risk-weight and minimum ratio approach: Two types of capital buffer are being introduced Capital conservation buffer to offset losses and be large enough to enable banks to maintain capital levels above the minimum requirement throughout a significant sectorwide downturn retaining their profits and retained earnings, reducing dividend payments, and staff bonus payments.

Countercyclical buffer to achieve the broader macro-prudential goal of protecting the banking sector from the period of excessive credit growth the objective is different from that of conservation buffer, which focuses on individual banks' financial conditions.

Basel III and Liquidity: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
LCR: addresses the sufficiency of a stock of high quality liquid assets to meet short-term liquidity needs under a specified acute stress scenario Stock of high-quality liquid assets/total net cash outflows over the next 30 days under stress scenario NSFR: addresses longerterm structural liquidity mismatches Stock of available amount of stable funding/Required amount of stable funding Stable Funding includes: customer deposits, long-term wholesale funding and equity Stable Funding excludes short-term wholesale funding

Phase-in Arrangements of Basel III

Financial Supervision Model in EU (I)

The Centralized Model This single supervisor model dominated the early stage of financial systems when the central bank was, in several countries, the only supervisory institution, given the importance of banks in developed countries Currently, many EU States (Scandinavian countries, United Kingdom, Germany, Austria, Ireland, Belgium) have adopted the centralized model

Nowadays, the single supervisor usually differs from the central bank, and is responsible for supervising and regulating all the segments of the financial sector (banking, securities markets, insurance) having regard to all the regulatory objectives: micro and macro stability, transparency and competition

Financial Supervision Model in EU (II)

The Vertical Model The institutional supervision or vertical model, developed as response to the great crises of 1930s, follows the traditional segmentation of the financial markets in three basic sectors: banking, insurance, securities markets This vertical approach facilitates the practical implementation of supervisory powers, it avoids useless duplications of controls and can reduce regulatory costs; conversely, it is not able to ensure a stabilizing system of controls in a context characterized by a fast growth of financial conglomerates, progressive integration of financial markets, blurred borders of the financial sectors In Europe, Greece is the only example of pure application of the vertical model, with three authorities that have responsibilities over, respectively, the banking sector, the securities market and the insurance segment: the Central Bank, the Hellenic Capital Market Commission and the Directorate of Insurance Enterprises and Actuaries of the Ministry of Development, General Secretariat of Commerce.

Bank supervision in Germany

Bank Supervision in Germany

Bundesbank
Operational supervision Regular supervision Onsite inspection in medium and large size banks are conducted annually

Bafin
Uniform government regulatory Authority for all financial institutions 2.277 banks 844 financial service institute and brokerage 607 insurance company und 24 Pension funds 78 investment company

The academic positions

Hart & Zingales propose that equity holders either inject additional equity when the price fluctuations in the underlying assets, or they lose their equity Problem: price of assets can not be easily determined (because not all of them are traded) and debt holders may not be able to coordinate Hart & Zingales suggest to rely on the CDS market instead If the CDS spreads of a certain bank exceeds a threshold, then new equity has to be issued to push the CDS spread below the critical value again or the regulator intervenes/takes the bank over and wipes out equity holders