Prudential requirements for credit institutions Flashcards
Function of capital
1) buffer to absorb unexpected losses to protect firm AND counterparties
2) funding for ongoing activities
Rationale for bank capital regulation
1) Asymmetric info (all stakeholders have info on financial condition, not just mgmt)
2) depositor and creditor protection (protection for depositors if bank is helped to remain solvent)
3) borrower protection
4) externalities s.a. other banks, depositors, other (whole system)
5) regulation necessary since markets fail
6) financial stability is a public good (as also other firms, their creditors and whole economy can be impacted)
Basel 1 pros and cons
No risk sensitivity
Not much attention to risk types other than credit risk
diversification benefits of credit risk not taken into account
no accoutn of credit risk mitigation techniques
promoted o´convergence in capital measurement
increased the level of capital for banks
Basel II changes
Pillar 1: minimum capital requirements, now including market and op risk. internal ratings based (IRB) models now allowed. credit mitigation techniques etc. now considered
Pillar 2: Supevisory oversight for capital adequacy (ICAAP)
Pillar 3: Enhanced disclosure to enable third parties to see.
BUT: IRB led banks to reduce capital
Basel III changes
more and better capital. leverage ratio introduced. More Tier 1 capital.
CET1: capital instruments, share premium accounts, retained earnings, reserves. have to be perpetual and principal may not be reduced.
AT1: second best Tier 1, made up of hybrid instruments
Basel III (CRD IV) liquidity requirements
1) Liquidity Coverage ratio (LCR), liquid assets must be there to cover during 30 day stress tests
2) Net Stable Funding Ratio (NSFR): monitor and reduce funding risk
Leverage ratio
non-risk-based backstop to risk-based capital rules that limits excessive build-up in leverage. Tier1Capital / OnAndOff balance sheet exposures > 3%
Basel IV
Changes mainly focus on RWA calculation as banks relied too much on IRB.
Basel IV changes regarding credit risk
more granular approach for unrated exposures, recalibration of risk weighting for rated exposures. More risk sensitivity, reduce reliance on ratings.
Basel IV IRB shortomings and what was done about it
Shortcomings: complexity, no comparavility, lack of robustness
How approached: removed option for A-IRB for certain assets, adopted input floors for e.g. PD and LGD (->minimum conservatism), greater specification of parameter estimation practices to reduce RWAs variability
Output floor
RWAs generated bei internal model cannot be below 72.5% of RWA computed with standard approach
