Bank capital and liquidity Flashcards
Banks balance sheets are
highly leveraged, hence they have more debt than equity
What incentivizes bankers to maximize leverage
Limited liability and short-term compensation structure
What was the problem with many banks when the 2007 crisis hit
They were undercapitalized and highly leveraged
Balance sheet of a bank
What are the assets / liabilities?
- Assets: Loans, investments, cash, real estate, equipment etc.
- Liabilities: Debt (deposits, bonds etc.) and very little Capital
Regulatory capital is
what a bank is required to hold against potential unexpected losses
Bank capital has
a higher cost (less profit) than other non-capital funds, because capital holders have a higher risk of suffering a loss than debt holders in insolvency
Purposes of regulatory capital
- Buffer: loss absorption as a going (while still in business) and gone concern (bankrupt) to pay creditor claims
- Risk charge: Disincentivizing the high risk-taking and internalizing the social costs of it
Who is the last one to get something when bank goes bankrupt
the shareholders
Basel I in short
From 1988 conducted by the Basel Committee on Bank Supervision (BCBS)
It established an international capital adequacy standard
a) defines capital as equity and subordinated debt
b) defines a measure of credit risk (RWAs)
c) requires banks to hold a minimum ratio of capital to RWAs of 8%
Basel II in short
From 2005
Introduced the 3 pillar concept
Pillar 1: Minimum capital (everything from Basel I)
Pillar 2: Supervisory review
Pillar 3: Market discipline - transparency of risk appetite, risk exposure
Basel III in short
From 2010
Corrected for the lessons learned in the fc of 2007-2009
Introduced:
a) Leverage ratio as a supplementary measure to RWAs
b) Reduction of procyclicality
c) Liquidity requirements
What is directive
regulation that needs to be transposed by the national law of the member
What is a regulation
regulation that directly applies to all members
Basel III -> EU legalisation
Capital Requirements Directive (CRD IV)
Capital Requirements Regulation (CRR) (includes Liquidity coverage ratio, Net stable funding ratio)
not yet finalized (will be in 2023?)
Basel I - basic principle
The higher the risk taking of the bank, the higher the capital it should hold
Basel I - Risk-based approach was meant to increase
a) comparability between banks and banking groups with different business model
b) risk-sensitivity and promotion of low-risk assets/investments
Basel I was primarily focused on
credit risk
Basel I fundamental principle
Risk weighting of assets:
Each asset of the bank is assigned to risk weight representing the risk attached to it
For instance : Asset worth 10 mln * risk weight of 50% = 5 mln
Basel I - the capital ratio sets
the amount of capital a bank needs to hold for a given amount of RWAs:
8% of RWAs !
Basel I risk weights
0 % - OECD countries, US treasuries, cash, gold
20% - OECD banks, public institutions
50% - Residential mortgages
100% - all other claims (corporates, non-OECD countries etc.)
Basel I - Regulatory capital can be sourced from different Tiers
Tier 1 (core capital) - includes shareholder equity (the capital that absorbs losses first)
Tier 2 (supplementary capital) - includes long-term debt and is limited to 100% of Tier 1
Shortcomings of Basel I
- Regulatory capital requirements applied only to loans on banks’ balance sheets (only to credit risk, and not market risk) -> massive growth of securitization and credit derivatives markets
- Favoring of short-term lending to banks (less than 1y) -> especially in developing countries (Asian fin crisis)
- Initially applied only to banks’ loan books, not other risky areas such as trading securities or derivatives for clients or for their own books
Market Risk Amendment 1996
- Expanded regulatory capital requirements to include a banks market risk (trading book)
- Allowed banks for the first time to use their own data and models as a basis for calculating their regulatory capital for the trading book
Banks loan book
Contains traditional bank loans and equivalents during maturity
-> longer-term risk, valuation based on the book value
Banks trading book
Contains assets considered to be liquid -> incentive to shift assets from loan to trading book (securitization)
-> During turbulent times, trading book assets must be marked to market
Why market risk needs to be backed by capital requirements?
Because it is marked to market and there is a higher risk of losses
Basel II:
Pillar 1
Rules - based
-> Minimum capital requirements (independent of the idiosyncratic risk, so transposed to CRR)
a) 3 Tiers of capital
b) calculates regulatory capital differently depending on the type of risk being assessed (credit, market or operational risk)
c) results are additive (c+m+o)
Basel II:
Pillar 2
Principles-based
-> Supervisory review process
(includes idiosyncratic risk, so in EU its directive)
It has correcting nature to Pillar 1 (capital add-ons)
Basel II:
Pillar 3
Market-based
-> Market discipline (through increased transparency)
Basel II:
Pillar 1: Minimum capital requirements (the Tiers)
Tier 1: shareholder’s equity, disclosed reserves, retained earnings, certain innovative capital instruments
Tier 2: Other bank reserves, hybrid instruments, medium- and long term subordinated loans
Tier 3: Short-term subordinated loans (that wasn’t loss absorbent at all so they removed it from Basel III)
Basel II:
Pillar 1: Credit risk
2 approaches:
A) Standardized - standardized regulatory weights and external ratings
B) Internal risk-based - use of complex internal risk models to create firm-specific risk weights
Not every bank get to which to use, since small banks can’t deliver enough data for the supervisor to be satisfied, hence only big banks usually use the internal approach
- > B II extended the use of RW, with other parameters (maturity, probability of default, bank’s loss and exposure given default)
- > meant to be neutral for risk-taking
Basel II:
Pillar 1: Market risk
- > Clear documentation for all positions in trading book
- > Guidelines for valuation and stress testing programs
- > Standardized or Internal Models approach
- > Typically value-at-risk (VaR) models, looking at historical variations in asset prices over a certain period of time
- > 5 market RW categories * 12,5 % = RWA equivalent
Basel II:
Pillar 1: Market risk - 5 market RW categories
- Foreign exchange risk
- Commodities risk
- Treatment of options
- Equity position risk
- Interest rate risk
Basel II:
Pillar 1: Operational risk
3 Approaches:
a) Basic Indicator approach - based on 15% of average gross income over the last 3 years
b) Standardized approach - Based on weighted percentage (12-18%) of gross income per business line
c) Advanced Measurement Approach - Based on complex internal statistical models
- > 7 loss types
Basel II:
Pillar 1: Operational risk 7 loss types
- Internal fraud
- External fraud
- Employment practices/ workplace safety
- Clients, product, business practices
- Damage to physical assets
- Business disruption/ system failures
- Execution, delivery, process management
Basel II:
Pillar 2: Supervisory review
Framework dealing with systematic, concentration, strategic, reputational, liquidity, and legal risks.
Introduced the Internal Capital Adequacy Assessment Process (ICAAP) -> bank internal process is subject to supervisory review and intervention
Basel II:
Pillar 2: 4 important elements in any ICAAP
- Assessment (identification and measurement) of actual and potential risks
- Application of risk mitigation techniques
- Stress-testing techniques
- Role of the board of directors and management
Basel II:
Pillar 3: Market discipline
Covers external communication of risk and capital information by banks
- > Defines a set of disclosure requirements allowing market participants to assess the capital adequacy of a bank
- > Most disclosures are required to be made at least twice a year and must be inline with the assessment of the board and senior management
Basel III main lessons form the financial crisis
- Removed the Tier 3 capital
- Dependency on external ratings led to increased procyclicality of capital requirements
- 3. Large financial institutions were heavily leveraged (led to the intro of leverage ratio)
- 4. Even well-capitalized banks got into trouble due to liquidity shocks and the collapse of the inter-bank market
- 5. Previous capital requirements didn’t take into account systematic risks posed by large, complex and highly interconnected banks
What still remains in Basel III
Use of internal models
RWA
Total capital ratio of 8%
3 pillars concept
Basel III:
Pillar 1: Regulatory capital
Tier 1:
a) Common Equity Tier 1 (CET1): ordinary shares, retained earnings, and certain reserves;
- > has no redemption cost or mandatory payments
- > It ranks below Creditors in insolvency
b) Additional Tier 1 (AT1) - perpetual instruments (no fixed maturity)
- > May have a call option for bank after 5 years of issue date
- > Subordinate to senior creditors and depositors in insolvency
Tier 2 - hybrid instruments with a maturity of not less than 5ys (typically bonds)
- > Issuer can call the instruments after 5ys, but no incentive to redeem
- > ranks above Tier 1, but subordinate to senior creditors and depositors in insolvency
Basel II vs Basel III capital requirements
Basel II:
Core Tier 1 - fully absorbs loss in going concern - 2%
AT1 - limited loss absorption in going concern - 2%
Tier 2 - Absorbs losses in gone concern - 4%
Basel III:
CET 1 - fully absorbs in going concern - 4.5%
AT1 - Absorbs at point of non-viability - 1.5%
Tier 2 - absorbs losses at point of non-viability - 2 %
-> Hence, quality increased!!
Basel III - Mandatory capital buffers
Outside periods of stress, banks should build up and operate with some capital in excess of the regulatory minimum to maintain a buffer against the impact of loss
- > These buffers can be drawn down in case of unexpected losses or times of stress
- > Once they are drawn down, there are constraints on the distribution of capital, dividends, and discretionary bonus payments to bank employees until the buffers replenished
- > Aim to ensure that shareholders, not depositors, bear the risk
Basel III / CRR & CRD IV buffer requirements
On top of the mandatory cr,
there are
1. Capital conservation buffer (mandatory) - 2.5%
2. Countercyclical Buffer (discretionary) - 0-2.5%
3. G-SIFI Surcharge (mandatory for the G-SIB banks) - 1- 3.5%
Basel III - Determining G-SIBs
Indicator-base measurement approach: 12 indicators in 5 categories:
- Size
- Interconnectedness
- Substitutability
- Cross-jurisdictional activities
- Complexity
Basel III - Leverage ratio
Irrespective of the risk level of the bank
LR = capital measure (tier 1 capital) / exposure measure
3 % minimum requirement
Acts as a backstop to the risk-based cr
Banks are required to regularly disclose the level and composition of their leverage ratio
Basel III Liquidity requirements
1) Liquidity Coverage Ratio (LCR) - enhances banks resilience in the short term (if a shock occurs, the banks must have capital to survive at least 30 calendar days) - It is costly for the banks and they have lobbied hard
High quality Liquid Assets / Total net cash outflows over 30 days > 100%
2) Net Stable Funding Ratio (NSFR) (relatively new)- promotes banks long-term stability by requiring a min amount of stable funding sources over 1yr
Available amount of stable funding / Required amount of stable funding > 100%
Basel III LCR and NSFR aim to
reduce the excessive reliance of banks on short-term sources of funding
Basel III Governance dimension
- > new regulatory focus on risk management and corp governance
- > Banks can be subject to Pillar 2 capital add-ons
- > Stress-testing as a core part of the capital framework - provides an integrated forward-looking assessment of resilience, ensuring that banks can continue to support the real economy under difficult economic confitions
Overview of Basel III reforms and additions
Pillar 1: Quality and level of capital Leverage ratio LCR & NSFR Capital conservation Buffer, Countercyclical Buffer G-SIFI Surcharge
Pillar 2:
ICAAP
Internal Liquidity adequacy assessment process (ILAAP)
Supervisory Review and Evaluation Process (SREP)
Pillar 3:
Enhanced and more granular disclosure of exposures, capital and liquidity components and risk management
Basel III.5 reforms?
- > revision of standardized approach for credit risk
- > revisions to the measurement of the leverage ratio
- > G-SIB leverage ratio buffer higher
- > Into of an aggregate output floor
