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FinReg > Bank capital and liquidity > Flashcards

Bank capital and liquidity Flashcards

1
Q

Banks balance sheets are

A

highly leveraged, hence they have more debt than equity

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2
Q

What incentivizes bankers to maximize leverage

A

Limited liability and short-term compensation structure

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3
Q

What was the problem with many banks when the 2007 crisis hit

A

They were undercapitalized and highly leveraged

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4
Q

Balance sheet of a bank

What are the assets / liabilities?

A
  1. Assets: Loans, investments, cash, real estate, equipment etc.
  2. Liabilities: Debt (deposits, bonds etc.) and very little Capital
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5
Q

Regulatory capital is

A

what a bank is required to hold against potential unexpected losses

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6
Q

Bank capital has

A

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

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7
Q

Purposes of regulatory capital

A
  1. Buffer: loss absorption as a going (while still in business) and gone concern (bankrupt) to pay creditor claims
  2. Risk charge: Disincentivizing the high risk-taking and internalizing the social costs of it
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8
Q

Who is the last one to get something when bank goes bankrupt

A

the shareholders

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9
Q

Basel I in short

A

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%

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10
Q

Basel II in short

A

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

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11
Q

Basel III in short

A

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

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12
Q

What is directive

A

regulation that needs to be transposed by the national law of the member

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13
Q

What is a regulation

A

regulation that directly applies to all members

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14
Q

Basel III -> EU legalisation

A

Capital Requirements Directive (CRD IV)

Capital Requirements Regulation (CRR) (includes Liquidity coverage ratio, Net stable funding ratio)

not yet finalized (will be in 2023?)

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15
Q

Basel I - basic principle

A

The higher the risk taking of the bank, the higher the capital it should hold

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16
Q

Basel I - Risk-based approach was meant to increase

A

a) comparability between banks and banking groups with different business model
b) risk-sensitivity and promotion of low-risk assets/investments

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17
Q

Basel I was primarily focused on

A

credit risk

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18
Q

Basel I fundamental principle

A

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

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19
Q

Basel I - the capital ratio sets

A

the amount of capital a bank needs to hold for a given amount of RWAs:

8% of RWAs !

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20
Q

Basel I risk weights

A

0 % - OECD countries, US treasuries, cash, gold
20% - OECD banks, public institutions
50% - Residential mortgages
100% - all other claims (corporates, non-OECD countries etc.)

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21
Q

Basel I - Regulatory capital can be sourced from different Tiers

A

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

22
Q

Shortcomings of Basel I

A
  1. 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
  2. Favoring of short-term lending to banks (less than 1y) -> especially in developing countries (Asian fin crisis)
  3. Initially applied only to banks’ loan books, not other risky areas such as trading securities or derivatives for clients or for their own books
23
Q

Market Risk Amendment 1996

A
  1. Expanded regulatory capital requirements to include a banks market risk (trading book)
  2. 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
24
Q

Banks loan book

A

Contains traditional bank loans and equivalents during maturity

-> longer-term risk, valuation based on the book value

25
Q

Banks trading book

A

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

26
Q

Why market risk needs to be backed by capital requirements?

A

Because it is marked to market and there is a higher risk of losses

27
Q

Basel II:

Pillar 1

A

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)

28
Q

Basel II:

Pillar 2

A

Principles-based
-> Supervisory review process
(includes idiosyncratic risk, so in EU its directive)

It has correcting nature to Pillar 1 (capital add-ons)

29
Q

Basel II:

Pillar 3

A

Market-based

-> Market discipline (through increased transparency)

30
Q

Basel II:

Pillar 1: Minimum capital requirements (the Tiers)

A

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)

31
Q

Basel II:

Pillar 1: Credit risk

A

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
32
Q

Basel II:

Pillar 1: Market risk

A
  • > 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
33
Q

Basel II:

Pillar 1: Market risk - 5 market RW categories

A
  1. Foreign exchange risk
  2. Commodities risk
  3. Treatment of options
  4. Equity position risk
  5. Interest rate risk
34
Q

Basel II:

Pillar 1: Operational risk

A

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

35
Q

Basel II:

Pillar 1: Operational risk 7 loss types

A
  1. Internal fraud
  2. External fraud
  3. Employment practices/ workplace safety
  4. Clients, product, business practices
  5. Damage to physical assets
  6. Business disruption/ system failures
  7. Execution, delivery, process management
36
Q

Basel II:

Pillar 2: Supervisory review

A

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

37
Q

Basel II:

Pillar 2: 4 important elements in any ICAAP

A
  1. Assessment (identification and measurement) of actual and potential risks
  2. Application of risk mitigation techniques
  3. Stress-testing techniques
  4. Role of the board of directors and management
38
Q

Basel II:

Pillar 3: Market discipline

A

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
39
Q

Basel III main lessons form the financial crisis

A
  1. Removed the Tier 3 capital
  2. 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
40
Q

What still remains in Basel III

A

Use of internal models
RWA
Total capital ratio of 8%
3 pillars concept

41
Q

Basel III:

Pillar 1: Regulatory capital

A

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
42
Q

Basel II vs Basel III capital requirements

A

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!!

43
Q

Basel III - Mandatory capital buffers

A

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
44
Q

Basel III / CRR & CRD IV buffer requirements

A

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%

45
Q

Basel III - Determining G-SIBs

A

Indicator-base measurement approach: 12 indicators in 5 categories:

  1. Size
  2. Interconnectedness
  3. Substitutability
  4. Cross-jurisdictional activities
  5. Complexity
46
Q

Basel III - Leverage ratio

A

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

47
Q

Basel III Liquidity requirements

A

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%

48
Q

Basel III LCR and NSFR aim to

A

reduce the excessive reliance of banks on short-term sources of funding

49
Q

Basel III Governance dimension

A
  • > 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
50
Q

Overview of Basel III reforms and additions

A 
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

51
Q

Basel III.5 reforms?

A
  • > 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

FinReg (12 decks)

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