Microprudential Regulation: Basel and Capital Adequacy Flashcards
What is Microprudential Regulation?
The pursuit of health and stability in the banking sector, with the ultimate goal of avoiding bank failure.
What is Capital Adequacy Regulation?
The imposition of minimum levels of adequate capital to chill reckless risk-taking and limit the potential losses thereof.
What is the Intended Effect of Capital Adequacy Regulation?
To hamstring, “the moral hazard of excessive risk taking,” which is exacerbated by the LOLR Function and Despoit Insurance Schemes.
Razeen Sappideen, The Regulation of Credit, Market, and Operational Risk Management under the Basel Accords (2004) 59 Journal of Business Law 72.
What is Capital Adequacy Regulation’s main Weakness?
Inexactness. Such rules tend only to be edcuated estimations, because regulators don’t want to suffocate bank activity.
What was the Purpose of Basel I in 1988?
To harmonize the capital adequacy rules governing international banks.
As laid out in Basel I, what were its Fundamental Objectives?
- To strengthen the soundness and stability of the international banking system through harmonization; and in doing so,
- Decrease regulatory arbitrage.
What were the Achievements of Basel I?
- Defined and Calibrated the notion of Credit Risk for banks.
- Harmonized minimum capital adequacy requirements.
- Defined the notion of Capital.
What is Credit Risk?
The risk that a Borrower will default on its payment obligations.
How was Credit Risk measured under Basel I?
Through the Risk-Weighting Methodology.
Why is standardized Risk-Weighting a prudential good?
- Increases the consistency and accuracy of credit risk analysis.
- Chills banks’ incentive to lend to riskier borrowers for profit.
Under Basel I, what were the Five Categories of Risk-Weight?
- 0%.
- 10%.
- 20%.
- 50%.
- 100%.
How did the Risk-Weighting Methodology operate?
Asset Value × Risk-Weighting = Risk-Weighted Asset Value.
Gross Risk-Weighted Asset Value × 8% (Minimum Capital Buffer) = Minimum Capital Requirement.
What were the Advantages of the Risk-Weighted Methodology under Basel I?
- Fairer standard of comparison for international banking systems.
- Accounted for off-balance-sheet risk exposure.
- Incentivized banks to hold low-risk liquid assets.
What were the Disadvantages of the Risk-Weighted Methodology under Basel I?
- Blunt and tactless at times, e.g. private-sector risk analysis.
- Arguably disincentivized corporate borrowing.
- Did not incorporate diversification of lending into risk analysis.
Northern Rock and Lehman Brothers had Risk-Asset Ratios of 11.2% and 16.1%, respectively. How does this undermine the 8% prescription?
It shows that either:
- 8% is an insufficient floor;
- The quality of minimum capital held was low; and/or that
- Additional factors need be incorporated into risk analysis.
What were the Two Tiers of Capital under Basel I?
Tier One, which comprised:
- Equity reserves; and
- Disclosed reserves, i.e. retained earnings.
Tier Two, which comprised:
- Undisclosed reserves;
- Revaluation reserves;
- General loan-loss reserves;
- Hybrid debt instrumets; and
- Subordinated term debt.
What was mandatory minimum ratio of Tier One : Tier Two Capital?
50% : 50%.
Why distinguished Tier One Capital from Tier Two Capital?
Visibility, Permanence, and Stability.
What are Undisclosed Reserves?
Unpublished reserves which have nevertheless passed through the Bank’s profit and loss account.
What are Revaluation Reserves?
The sum value of the positive discrepancies between a Bank’s assets’ real value and previously-recorded book value.
What are General Loan-Loss Reserves?
Reserves guarding against losses from any potential asset.
How was Basel I implemented in the EU and UK?
Through the now-obsolete Own Funds Directive and repealed Solvency Ratio Directive.
Why did the Basel Committee introduce the Market Risk Amendment in 1996?
To address the evolving shortcomings of Basel I, namely the:
- Universalization of banks;
- Normalization of the insufficient 8%; and
- New prominence of interest rate, currency, and market risk.
What was the Central Objective of the Market Risk Amendment 1996?
To introduce a Non-Standard Risk Assessment Methodology which incorporated Market Risk.
Under the Amendment, How would Market Risk be calculated?
Using either a Standardized or Internal Model.
What did the Standardized Approach to Measuring Market Risk pertain to?
The measurement of:
- Interest rate risk;
- Foreign Exchange risk;
- Trading risk; and
- Commodities risk.
Was the Standardized Approach intended to be Harmonizing?
No. It was purposed as a rough guideline, thus stressing the importance of developing precise and bespoke risk-measurement models.
What is Interest Rate Risk?
The risk of interest rate fluctuations over a facility’s term decreasing profits or causing losses.
How was Interest Rate Risk addressed under the Standardized Model?
Loans were to be weighted against their Specific and General Risk. The former is borrower creditworthiness, and the latter is term duration.
What is Foreign Exchange Risk?
The risk that fluctuations in the foreign exchange markets will render a given position unprofitable or losing.
How was Foreign Exchange Risk addressed under the Standardized Model?
It was weighted at 8% against net long and short currency positions and net gold positions.
What are Trading and Commodities Risk?
The risk that market fluctuations, volatility, or illiquidty will render a position unprofitable or losing.
How was Trading Risk addressed under the Standardized Model?
It was weighted at either 4% or 8% (based on diversification) against net long and short equity and derivatives positions + 8% general market risk.
How was Commodities Risk addressed under the Standardized Model?
It was weighted at 15% against net long and short commodities positions + 3% capital charge on all gross positions.
What permitted Deviation from the Standardized Model by Banks?
Approval by the National Regulator.
To seek approval of an Internal Model, what would a Bank have satisfy?
The National Regulator’s Qualitative and Quantitative Criteria.
What did the Regulator’s Qualitative Criteria pertain to?
The quality of a bank’s internal risk management systems, as verified by rigorous and regular stress-testing.
How would a Bank go about satisfying the Qualitative Criteria?
Through the creation of a dedicated risk management department, which oversaw prudential policy design, execution, enforcement, and review (preferably by external audit).
What did the Regulator’s Quantitative Criteria pertain to?
The credibility of the risk factors used in measuring and weighting the Amendment’s outlined market risks.