Banking Regulation Flashcards
Why do banks need to be regulated?
Protection of the public. Banks are special in that most of the liabilities come from depositors not investors.
Self regulation isn’t possible before of conflicts of interest. Between shareholders and depositors, and bank managers and investors (myopia)
Basel decides on standards for…
bank capital, liquidity and dunding
What happens if you don’t abide by Basel regulation?
Nothing really, they aren’t binding. Investors may lose confidence though.
What are the aims of Basel 1?
- require banks to have enough capital to absorb losses without causing systemic problems
- create a level playing field for banks internationally. Have all banks play by the same rules - foster competition
What was the Basel 1 capital requirements?
Capital/risk-weighted assets >= 8% (Cooke Ratio)
Effectively, credit risk was divided into buckets according to riskiness. This determined the capital a bank had to hold.
What did Basel 1 define as capital?
Capital = Core Capital + Supplementary Capital - Deductions
What were the critiques of Basel 1?
The approach to setting credit weights was too simplistic. Of course not all corporate bonds have the same risk.
It also ignored all other types of risk.
What was the amendment to the Basel 1 accord?
Banks could now use internal models to differentiate risk within loan categories
How did this accord lead to bad results?
(Talk about capital arbitrage)
Banks discovered that there was a wide variation in credit quality within risk-weighted categories. Banks would securitise loans to classify them into a lower regulatory risk category with a lower capital charge.
What are the 3 Pillars of Basel II?
- Introduced capital requirements for credit risk, market risk and operational risk
- Supervision of internal systems
- Market Discipline
Talk about Basel II’s capital requirements.
Introduced Minimum Capital Requirement (MCR). This is capital/(credit risk + market risk + operational risk) >=8%
This used tier 3 capital as well
Talk about how Basel II identified market, credit and operational risk.
Market Risk: VaR
Credit risk: Had to use ratings from external ratings agencies, could use internal models to calculate chance of default
Operational risk: based on annual revenues
Talk about Basel II’s supervisory review process.
Banks could create internal models to gauge levels of capital. The supervisory authority can assess their capital adequacy.
Talk about Basel II’s market discipline.
Enhances disclosure by banks. This means the market can discipline banks if they are taking excessive risk.
Aims for a bail-in process rather than bail-out.
What were the problems with Basel II?
There’s still the possibility of regulatory arbitrage.
Pro-cyclicality isn’t accounted for
Still incentive to understate credit risk
How does regulatory arbitrage occur with Basel II?
A bank gives out a loan to a company. The bank they buys a CDS (insurance) from another bank. This means the capital charge is reduced because banks carry a lower capital weight.
The other bank can also get insurance from a company outside the financial system and so BIS rules don’t apply.
In what 5 areas did Basel III revise Basel II?
- Strengthen capital framework
- Capital conservations and countercyclical buffers
- Leverage ratio
- Global liquidity standard
- Risk coverage
Basel III framework is a set of international standards whose objective is to…
determine how much capital the bank needs to hold.
What was the main aim of the Basel III reform?
Ensure that governments never have to bail out banks again.
How were the Basel III capital requirements changed?
They got rid of tier 3 capital.
Each tier has to represent a certain percent of risk weighted assets.
What was the capital conservation buffer?
Losses for banks can be even larger if a downturn is preceded by a period of excess growth.
As a result, countercyclical buffers aim to further hedge risk.
What was the leverage ratio in Basel III?
Banks are supposed to keep a minimum leverage ratio
Leverage ratio = Tier 1 capital/total exposure >=3%
How was liquidity risk managed in Basel III?
Introduced LCR >=100%
Also introduced Net Stable Funding Ratio
What were the implications of Basel III?
-LCR. Risk if bank runs should be reduced thus improving the stability of the financial sector
-Banks’ profitability is worse off because they have to hold more liquid, low yielding assets
-Weaker banks crowded out
-Reduced chance of systemic banking crisis
-Reduced lending capacity
-Reduced investor appetite for bank debt and equity
