7. Micro-Prudential Banking Regulation

Question 1

Regulatory Capital

Answer 1

is the sum of these two types of capital (Tier 1 - equity capital and highly subordinated bonds and Tier 2 - other subordinated liabilities under the Basel approach) and minimum requirements are set for how much of this capital an institution must have

Question 2

What are the two tiers of loss-absorbing classes of liabilities under the Basel approach?

Answer 2

Tier 1 Capital: Equity capital and highly subordinated bonds
Tier 2 capital: Other subordinated liabilities
- Tier 1 capital is more “at risk” than Tier 2 capital

Question 3

How are risk weighted assets measured?

Answer 3

by multiplying each asset’s value by its corresponding risk weight and then summing up the results for all assets

Question 4

What were the main differences between Basel 1 and Basel 2?

Answer 4

• a much larger selection of “risk buckets” using ratings agencies risk assessments to better assess the risk of various types of assets
• the option-taken up by many big banks - of using an in-house Internal Ratings Based (IRB) approach to assessing the riskiness of assets
• mortgages deemed to be less risky than assumed under Basel 1

Question 5

What is Value at Risk (VaR)?

Answer 5

• used to measure market risk, estimating potential losses due to changes in market prices
• used to quantify the market risk of a bank’s portfolio
• VaR estimates the maximum potential loss over a specified time period (e.g., one day or one month) with a given confidence level (e.g., 95% or 99% - i.e., there’s a 95% chance that the loss will not exceed the calculated VaR amount over the specified time period)

Question 6

Internal Ratings-Based approach

Answer 6

is a method to calculate a bank’s credit risk exposure

Question 7

Value at Risk (VaR) is described as a statistical distribution for a bank’s credit losses.

Answer 7

• the average of the distribution is the “expected loss”
• the extreme tail at the right hand side of the distribution: it describes a level of losses such that there is only a 1% chance that your losses will be larger than this
• this figure is usually called the banks Value at Risk.
  e.g. if you have $50 million of weekly VaR, that means that over the course of the next week, there is only a 1% chance that your portfolio will lose more than $50 million

Question 8

The IRB apporach required banks to have of what?

Answer 8

• a minimum level of regulatory capital equal to some multiple (usually three) of the unexpected losses indicated by the VaR
  Once VaR has bee calculated the bank can then set
  Capital Required = 3 * VaR
• given that the Basel approach requires banks to have capital that is at least equal to 8 percent of risk weighted assets, this means that VaR is used to indirectly back out the value of risk weighted assets as
  RWA = 3 * VaR/0.08

Question 9

What else is added to get the final figure for RWA? (From Value at Risk to Risk-Weighted Assets)

Answer 9

Market Risk: An upward adjustment is made for risks “pertaining to interest rate related instruments, equities, foreign exchange risk and commodities risk”
Operational Risk: An adjustment is made for “inadequate or failed internal processes, people and systems or from external events”

Question 10

A bank’s VaR figure is usually arrived at by using a distribution of past returns of the assets held. What are the potential problems with using this approach?

Answer 10

• Estimation Sample: You never really know the “true” distribution but can only estimate it from historical data
• Tail Risk: How much do you lose in the 1% case? What about extreme unknowns? Financial markets generate extreme losses more often than predicted by normal distributions (they have “fat tails”). However, the VaR methodology doesn’t factor in what happens in very bad outcomes when generating its capital requirement

Question 11

What problems are raised by Risk Modelling?

Answer 11

According to Philipp Hildebrand, former Chairman of the Swiss National Bank (i.e. Swiss Central Bank):
- banks and supervisors alike incur significant operational costs to implement the new, highly complex regulation
- Basel II creates new risks: Risks about risk assessments
- Under Basel II, we increase our dependence on risk models
- to view the model outputs as a true representation of reality has proven to be a grave mistake
- the increased reliance on banks’ internal models has rendered the job of supervisors extremely difficult.
1. supervisors have to examine banks’ exposures
2. they have to evaluate highly complex models
3. they have to gauge the quality of the data that goes into the computation of these models

Question 12

What are the Basel 3 Agreements?

Answer 12

• a common equity requirement of 7% in normal times
• a common equity buffer of 2.5% “that can be used to absorb losses during periods of financial and economic stress” meaning a minimum allowable common equity requirement of 4.5% (up from 2%)
• an additional cyclical buffer for the common equity requirement with a range of 0-2.5% that would “be in effect when there is excess credit growth that is resulting in a system wide build up of risk”
• stricter definitions of capital (e.g. requiring more deductions for things like staff pension fund shortfalls)
• a maximum leverage ratio: a limit on the ratio of unweighted assets to capital which addressed some of the problems due to over-reliance on risk modelling

Question 13

What were Other Post-Crisis Regulations?

Answer 13

• Liquidity Reforms: Basel 3 introduced a “liquidity coverage ratio” designed to ensure that banks can survive for 30 days in a stress scenario when large amounts of funding is being withdrawn and a “net stable funding requirement” which “establishes a minimum acceptable amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one year horizon
• Too big to Fail: The Basel Committee identified 28 global systemically important banks (G-SIBs) “whose failure could threaten the world’s economy” and proposed higher Tier One capital ratios ranging between 1% and 2.5%

Question 14

what does TLAC stand for and what is it?

Answer 14

In 2015, the Financial Stability Board issued a recommendation for a new standard for Total Loss-Absorbing Capacity (TLAC) to be applied to all G-SIBs
TLAC is defined as “a minimum requirement for the instruments and liabilities that should be readily available for bail-in within resolution at G-SIBs
G-SIBs cannot use common equity that is already used to meet regulatory capital requirements as part of TLAC

Question 15

The Basel committee agreed a further round of reforms to capital regulation (sometimes informally referred to as Basel 4 ) to be introduced from 2022 onwards. What did these include?

Answer 15

1. Revisions to the “standardised approach” to improve “granularity” and risk sensitivity. Example: In the revised standardised approach mortgage risk weights depend on the loan-to-value (LTV) ratio of the mortgage.
2. Limiting the use of more advanced IRB approaches for certain asset classes such as exposures to large and mid-sized corporates, and exposures to banks and other financial institutions
3. “Output floors” for calculating risk-weighted assets. Banks’ risk-weighted assets must be calculated as the higher of the total risk-weighted assets calculated using the approaches that the bank has supervisory approval to use in accordance or 72.5% of the total risk-weighted assets calculated using only the standardised approaches.
4. A higher requirement for capital to deal with operational risk
   - For a given level of capital, these reforms will reduce capital ratios relative to risk-weighted assets and thus will increase pressure on banks to raise capital. Banks often now report their ratios under both current and future regulations

Question 16

Arguments Against More Bank Capital

Answer 16

Equity Funding is Costly: Bankers argue that equity funding is inherently riskier than debt funding (such as customer deposits or borrowing), so equity investors demand higher returns (e.g. in the form of dividends or capital gains) to compensate for that risk). e.g. the need to pay additional dividends to new equity investors could require banks to raise interest rates on their loans to cover these costs
- (bankers believe that more equity funding increases their costs (due to the higher returns demanded by equity investors) and could lead to higher loan interest rates)

Question 17

Arguments for More Bank Capital

Answer 17

Increased Stability: Higher capital requirements reduce a bank’s risk of failure, since more equity provides a larger buffer against losses. This could lead to lower risk premiums for borrowing and potentially lower interest rates in the long run, as creditors and depositors would demand less compensation for risk
Lower Funding Costs in the Long Term - If a bank is safer because it holds more capital, it might be able to borrow more cheaply in the future, as bondholders and depositors perceive it as less risky
Less likelihood of a bailout - Higher capital reduces the likelihood that a bank will need a government bailout in the event of a financial crisis, which ultimately protects taxpayers and the broader economy
- (supporters of higher capital requirements argue that these costs are offset by the benefit of a more stable banking system, which reduces the chances of financial crises and long-term funding costs)

Question 18

What is the Basel Approach?

Answer 18

requires banks with riskier assets to have more regulatory capital

Question 19

Basel I

Answer 19

assigned assets risk wrights of zero, 10%, 20%, 50% or 100% to different classes of assets
OECD country government debt had a weight of zero, mortgages had a weight of 50%, while most corporate bonds had a weight of 100%
Bank capital requirements were then set as a fraction of risk weighted assets:
1. Total regulatory capital had to be a minimum of 8% of RWA
2. At least half this capital had to be Tier One capital
3. At least half of the Tier One capital had to be common equity (i.e. the equity stake of regular shareholders) or so-called “core tier one”.