Banking Regulation

Question 1

Why do banks need to be regulated?

Answer 1

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)

Question 2

Basel decides on standards for…

Answer 2

bank capital, liquidity and dunding

Question 3

What happens if you don’t abide by Basel regulation?

Answer 3

Nothing really, they aren’t binding. Investors may lose confidence though.

Question 4

What are the aims of Basel 1?

Answer 4

• 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

Question 5

What was the Basel 1 capital requirements?

Answer 5

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.

Question 6

What did Basel 1 define as capital?

Answer 6

Capital = Core Capital + Supplementary Capital - Deductions

Question 7

What were the critiques of Basel 1?

Answer 7

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.

Question 8

What was the amendment to the Basel 1 accord?

Answer 8

Banks could now use internal models to differentiate risk within loan categories

Question 9

How did this accord lead to bad results?
(Talk about capital arbitrage)

Answer 9

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.

Question 10

What are the 3 Pillars of Basel II?

Answer 10

• Introduced capital requirements for credit risk, market risk and operational risk
• Supervision of internal systems
• Market Discipline

Question 11

Talk about Basel II’s capital requirements.

Answer 11

Introduced Minimum Capital Requirement (MCR). This is capital/(credit risk + market risk + operational risk) >=8%

This used tier 3 capital as well

Question 12

Talk about how Basel II identified market, credit and operational risk.

Answer 12

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

Question 13

Talk about Basel II’s supervisory review process.

Answer 13

Banks could create internal models to gauge levels of capital. The supervisory authority can assess their capital adequacy.

Question 14

Talk about Basel II’s market discipline.

Answer 14

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.

Question 15

What were the problems with Basel II?

Answer 15

There’s still the possibility of regulatory arbitrage.
Pro-cyclicality isn’t accounted for
Still incentive to understate credit risk

Question 16

How does regulatory arbitrage occur with Basel II?

Answer 16

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.

Question 17

In what 5 areas did Basel III revise Basel II?

Answer 17

• Strengthen capital framework
• Capital conservations and countercyclical buffers
• Leverage ratio
• Global liquidity standard
• Risk coverage

Question 18

Basel III framework is a set of international standards whose objective is to…

Answer 18

determine how much capital the bank needs to hold.

Question 19

What was the main aim of the Basel III reform?

Answer 19

Ensure that governments never have to bail out banks again.

Question 20

How were the Basel III capital requirements changed?

Answer 20

They got rid of tier 3 capital.

Each tier has to represent a certain percent of risk weighted assets.

Question 21

What was the capital conservation buffer?

Answer 21

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.

Question 22

What was the leverage ratio in Basel III?

Answer 22

Banks are supposed to keep a minimum leverage ratio

Leverage ratio = Tier 1 capital/total exposure >=3%

Question 23

How was liquidity risk managed in Basel III?

Answer 23

Introduced LCR >=100%

Also introduced Net Stable Funding Ratio

Question 24

What were the implications of Basel III?

Answer 24

-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