L8

Question 1

what is Credit Ratings?

Answer 1

represents the forward looking opinions of the credit rating agencies (CRAs) about the creditworthiness of a debt issuer or the risk of debt securities going default
-conveyed by alpha-numerical letters: Aaa, Aa1

-highly competitive market, high barries (S&P: 48.9% OR Moody’s 34.2% 2017)
-emerging (DBRS 1.8%)

Question 2

types of credit ratings

Answer 2

issuers- governments, corporations
specific debt issues- sovereign bonds, ABS
LT VS ST CR
Foreign vs local currency CR (foreign either lower or equal to local CR)
solicited vs Unsolicited

Question 3

S&P long-term issuer credit broad rating scale

Answer 3

investment grade, ranges from AAA to BBB with all A being able to various degrees of strongly, to meet their financial obligations.

-BBB should be able to repay, but adverse shocks will weaken the capacity to pay and willingness

Speculative Grade: ranges from BBB-CC,R,SD and . BB being the comp will be exposed to shocks easier. CCC being currently venerable. D default

Question 4

Outlooks and Watches

Answer 4

outlook shows how the cra thinks how cr is going to be
watch is generally shorter

rating “through-the-cycle” updates are slow
ratings often come with:
-outlook (stable/positive/negative)
-watch (positive/negative/developing)

outlook and watch don’t imply that the rating changes are going to happen

Question 5

rating change annoucements

Answer 5

the change is usually made in a public announcement, shortly after consulting with the issuers

CRAs are abided by law to:
-make available the factors determining the assignment of ratings
-justify the reason for the rating change

a righting might be:
-downgrade
-upgrade
-outlook/ watch revision

Question 6

why are there regulations on banks and CRA

Answer 6

-due to frequency of banking crises during 1970- 2007

124 systemic banking crisis in 101 countries
-occur regularly in same countries, 19 countries experiencing more than 1 crisis
-large fiscal cost: south Korea 31% of GDP

Question 7

Economic theory for Regulation of banks

Answer 7

limit monopoly power
-prevent distorting competition
-protects consumers

safeguarding welfare
-protect people when market fails (info limited or costly to obtain)
-done primary through provisions of deposit insurance- regulators require banks to hold some minimum capital

externalities: individual bank risk is the respon of managers ,owners, debtholder

Question 8

how do externalities happen in banks?

Answer 8

-information contagion (one bank fail, doubt for banks in similar business)
-no access for funding for customers
-greater interconnectedness of banks
-forced sales of banks assets (fire sales), force down the price of similar assets held by solvent banks
-credit rationing by banks to rebuild balance sheets, adversely affects output and prices

Question 9

information asymmetry in bank consequences:

Answer 9

adverse selection- solution: government-info disclosure, private collection of info, pledging of collateral to insure against the borrowers default. need borrower to use own resources
moral hazard- solution: need managers to report to owners, to invest their own resources, covenants restricting borrowers actions with funds

Question 10

rational for regulation: Fragility of banks

Answer 10

liquidity mismatch- between assets and liabilities: st borrowing i.e. deposits used to finance profitable but illiquid investments

risk for bank: inability to roll over st borrwoing

• run on the banks

-borrow st, banks pledge a collateral (the security they own)

-cant borrow entire collateral value

Question 11

Rational for regulation: systemic risk

Answer 11

-events capable of threating the stability of the banking and financial system
-shift of regulation from the individual institution to systemic context
-liquidity and solvency problems
liquidity: speed at which the asset can be sold or bought without effecting the market value
-funding liquidity risk
because of size of changes, st interest rates rise or depositors withdraw funds
-domino effect because of interbank linkages

Question 12

Rational for regulation: protection of depositors

Answer 12

protection of public and safety of payment systems represents good reasons for regulations for banks

-lack of expertise and knowledge of individual depositor to asses the quality of the bank
- differentiated degree of regulation imposed on retail and wholesale banks
-challenging because many banks are universal banks

US: volcker rule: prohibits commercial banks from engaging in proprietary trading
UK: Ring-fence retail operations from investment banking ops within the same group

Question 13

Rational for Regulation: social cost of bank failures

Answer 13

wide impact on the economy
systematically important financial institutions SIFIs
-large no of borrowers and depositors, and wider geographic distri than with a firm
-bank fail= disrupt payment mechanism with wider consequence on econ
-source of systemic risk
-adverse selection and moral hazard associated with LOLR and other safety net arrangements are more severe for large banks

Question 14

rational for regulation: control of entry into banking industry

Answer 14

prevent undesirable individuals and firms to enter industry
eu single passport policy is from home bank but is supervised by the central bank
new rules from Basel Committee: a central bank may refuse a licence if it believes that a bank is not properly supervised by its home authority
e.g., BOE 86s quietly revoked 16 banking licences and obliged 35 banks to recapitalise, change management or merge
later in 98, supervisory powers were passed to the FSA restricting BOE from acting rapidly and saving banks form liquidity problems
-now new laws, passed allowing BOE faster support in event of failure of banks

Question 15

Bank capital Regulation

Answer 15

key functions of bank capital:
- provide a cushion to absorb unexpected losses- inspires confidence
- reduce moral hazard- protection for uninsured depostiors and tax payers
- reserve for additional expansion

minimum capital requirements ensure banks have enough to make risks

Question 16

Basel 1 Accord

Answer 16

The Basle Committee on Banking Supervision introduced the first Capital Accord (Basel 1) in 1988, which required international banks to have a risk asset ratio of 8% (tier 1 capital of 4% at minimum) to cover credit risk. Banks’ capital was divided into two parts: tier 1 (core) and tier 2 (supplementary) capital.

Question 17

Basel 1 critics

Answer 17

problem with ratio:
- risk independency assumption permits simple addition of risk weighted assets, but risks maybe interdependent in some case
only focus on credit risk from lending activity
ignoring diversification
treats all commercial loans the same- some risker than other
makes banks want to sell risker assets
some forms of capital omitted: OBS assets, derivatives

Question 18

Basel 1 adjustments

Answer 18

in 98, added market risk into risk-based capital
minimum market risk capital requirement was set for any open position in debt, equity and derivatives, held in banks trading books
subject to supervisory approval, banks may use internal models to calculate tier market risk (usually called VAR model)

Question 19

Basel II Capital Accord

Answer 19

effective from 2007, reflects growing complexity of banking risks
updated ways to handle credit risk:
-separating commerical loans into diff risk classes
- large inernational banks would be allowed to use their own internally generated credit rating to determine the riskiness of each loan
both were effective of reducing the capital requirement
extended coverage of capital to operational risks

Question 20

Basel II 3 pillars

Answer 20

1.minimum capital requirement- measurement of risk-asset ratio included credit, market and operational
2. supervisory review- supervisors were respon for evaluating how well banks are assessing their capital competency needs relative to risk- encouraged internal assessment methods
3. market discipline- encourage effective disclosure about: risk exposure, capital adequacy and risk management techniques

Question 21

Advan and dis for Basel II

Answer 21

+ more precise segmentation of risk and consider diff types of risk
+ better evaluation of risk
+reduce requirement of capital and induce better capital allocation

-only covers “internationally active” banks
-EU mandated Basel II should apply to all banks
-India and china opt out
-implemented in stages from end of 06
-potentially flawed framework: during 2008 crisis, forcing banks to cut lending and rise capital reserves when economy was in a recession
-not addressing systemic/ liquidity risk

Question 22

why was Basel III created

Answer 22

financial crisis revealed the problems of 1 and 2
-VAR models failed to estimate true levels of market risk
-failed to capture major on and off b/s risks
-failed to reduce the degree of pro-cyclicality (financial variables fluctuating) in regulatory framework
-ignored liquidity risk within frame work

Question 23

Basel III accord

Answer 23

10, fully implemented in 19
greater emphasis on common equity to protect banks during crisis
-minimum common equity tier 1 (CET1) to risk weighted assets ratio 4.5% up from 2% in previous
-ordinary shares plus retained earnings

tier 1 minimum capital to risk-weighted asset must be 6% (4% under 2)
-comprised of CET1 and an extra 1.5% of additional tier
-common equity plus preferred stock

tier 2: 2%
total of 8%, bet quality than Basel 2

Question 24

Basel III: capital Buffer

Answer 24

introduced 2 additional capital buffers to address macroeconomic concerns.
-mandatory capital conservation buffer- to be built up outside periods of stress and used to cushion it when it came
+2.5% of risk weighted assets
+with 4.5% CET1 capital ratio, banks told to hold a 7% CET1 capital ratio
+cant distribute dividend or bonuses when close to 7%

-discretionary counter-cyclical buffer: national regulators can ask up to 2.5% more capital during periods of high credit growth, which must be met by CET1 capital

Question 25

Basel III: systemic risk

Answer 25

identification of the SIFIs (identify systemic financial institutions) to tackle systemic risk:
- from 1% to 2.5% of the RWA
-up to 3.5% for even higher risk

Question 26

Basel III: liquidity and leverage requirement

Answer 26

Liquidity coverage ratio
-st ratio, enough liquid assets over one month to cover Liquid liabilities
-should be higher than 100%
Net Stable Funding Ratio (NSFR)
-looks at LT capital requirements to limit reliance on ST assets
Leverage ratio: to refrain use of leverage to limit banks risk exposure
-tier 1 capital/total exposure >3%
bank cant borrow more than 33 times its equity
in july 2013, US federal reserve announced minimum Basel III leverage ratio would be 6% for 8 SIFI banks

Question 27

shortcomings of basel III

Answer 27

relates to liquidity risk-
-failure to factor in role of central banks as LOLR
-runs happening in case of banks with a high % of liabilities in deposits still exists because of limited deposit insurance or irrational depositors

avoid tax shifting risky assets and liabilities of b/s

Question 28

CRA purpose

Answer 28

purpose of credit rating agencies to help reduce asymmetric info

Question 29

how has CRA’s evolved ?

Answer 29

free-rider issue because of photocopy machine-rating firms afraid sales fall, cause of it. free rider problem: burden on shared resource by use or overuse, by people who aren’t paying their fair share

-need to assure low risk debt issuers

access to portfolios of financial institutions
common rule info can be paid for by issuers of debt and buyers

Question 30

role of CRA in securitization process

Answer 30

securitization: process of taking illiquid assets or group of and transforming it into a security

-RA boosted attractiveness of some
-use complex models to assess the prob of default of securitized assets and advised issuers to structure these to minimize funding cost

Question 31

regulations imposed on CRA since crisis in EU and USA

Answer 31

EU:
reduced fm overreliance on CR
improve quality of ratings of sovereign debt of EU member states
CRA more accountable
reduce conflicts of interest due to issue pays for work model
publication of ratings on euro rating platforms

USA
-consumer protection act 2010- introduced more requirements on CRA
-Office credit ratings in 2012 provided greater regulator oversight
-no of recent rules, annual reports on internal control, conflict of interest
-2014, SEC adopted new rules on internal controls over rating process and transparency