Regulation I

Question 1

Reserve Requirements
* Banks are required to … or deposits at the central bank (reserves).
* Reserve requirements …
* Other forms of borrowing that do not have reserve requirements became more common (..).
* Some countries (Canada, UK, New Zealand, Australia and Sweden) do not have reserve requirements and requirements vary quite a bit among countries (Eurozone 1%, Switzerland 2.5%, Turkey 8.5%, China 20.5%)

Answer 1

hold a fraction of their deposits as cash

lost their effectiveness over time.

time deposits, wholesale funding (what are those?)

Question 2

Capital
* Capital acts as ….
* This can help …
* Capital can increase banks’ skin in the game.
* Now banks have something to lose so they invest more prudently.

Answer 2

a buffer against losses.

absorb losses and prevent costly bank failures.

Question 3

Basel I

• A group of central bankers come together to set capital requirements internationally. Rules were enforced by law in G-10 countries in 1992.
• Sets minimum capital requirements for banks.
• Banks are required to hold a minimum of 8% of their risk-weighted assets (RWA) as capital.
• Tier 1 (Core) and Tier 2 (Supplementary) Capital. Total capital = Tier 1 + Tier 2 capital.
• Tier 1 has to be at least 4% of RWAs.

Which ones are T1 and which ones are T2 capital?

Answer 3

• Tier 1 (Core):
  – Commonstock
  – Retainedearnings
• Tier 2 (Supplementary) Capital:
  – Loan loss allowances
  – Preferred stock with maturity of at least 20 years
  – Subordinated obligations (both stock and debt) an original average maturity of at least 7 years
  – Hybrid capital instruments

Question 4

Capital requirements and deleveraging
* When capital requirements bind the bank has to: …
* During stress periods it may be …
* Sell assets (deleveraging)
* …
* Amplifies downward pressures.

Answer 4

– Raise new capital or
– Sell assets

very difficult to raise fresh capital.

Depresses asset prices, contagion through falling asset prices.

Question 5

Shortcomings of Basel I

How does it create incentives for exploitation? Exemplify.

How does it reward diversification? What else?

Answer 5

Too coarse risk categories –> risk classes do not actually reflect actual credit risk exposure–> example is mortgages require half of the capital of business loans

It does not as each investment is looked at in isolation.

Rules assume the banking risk is the same across countries.

Capital ratios are expressed in book-values and they fail to adjust to changing market conditions. (mark-to-market)

Question 6

Basel II: designed to address the shortcomings of Basel I. How?

Risk categories, IRB approach, risks involved, main pillars

Answer 6

• Finer risk categories in calculating risk weighted assets.
• Account for risk mitigation efforts of banks and make greater use of banks’internal risk assesments (IRB approach).
• Credit risk, operational risk and market risk (liquidity risk?).
• Three pillars:
  – Minimum capital requirements
  – Supervisory review process
  – Market discipline

Question 7

Explain the IRB approach.

Answer 7

– Allow some banks to rely on their own estimates of risk
– Disclosure requirements
– Probability of default (PD), loss given default (LGD), exposure at default (EAD) and effective maturity (M)

(check slide 14)

Question 8

Shortcomings of Basel II

It amplifies cycles (procyclical). What does that mean?

Answer 8

• Good times: Perceived risks are low resulting in low capital requirements
  – Events of the 2007-09 crisis or the pandemic are n-stdev, n being a large number!
• Bad times: Perceived risks are high resulting in high capital requirements and can fuel a credit crunch.

We need something less model sensitive.

Question 9

• 2007-09 crisis exposed short comings of the regulatory framework.
• Some institutions had… How?
• Liquidity risk: …
• Almost safe assets had …
• ….

Answer 9

1% equity ratio yet satisfied the capital requirements.

Market liquidity risk, funding liquidity risk

0 debt capacity

Freeze in markets

Question 10

Basel III
* Agreed by Basel Comittee on Banking Supervision in 2010-11.
* Basel I and Basel II mainly focused to …
* Basel III recognizes…
* Introduces new measures :
…x3
* Designation of …
* Stress testing

Answer 10

bank loss reserves (capital).

market and funding liquidity.

– Minimum “leverage ratio”
– Voluntary counter cyclical capital requirements
– Liquidity requirements in the form of Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).

global systemically important banks (G-SIBs)

Question 11

Basel III: Increase in capital requirements
* …
* Tier 1 (Core Tier 1 + Additional Tier 1) to 6%
* …

Answer 11

Core Tier 1 ratio to 4.5%

Discretionary counter-cyclical buffer of up to 2.5%.

Question 12

Basel III: Leverage Ratio
* …
* Leverage ratio = …
* Not risk-weighted assets!!!
* Maintain a…
* Federal Reserve minimum leverage ratio will be:
….insured bank holding companies
SIFIs

Answer 12

Minimum leverage ratio. Mandatory requirement in 2018.

Tier 1 capital / Average total consolidated assets

leverage ratio of at least 3%.

• 5% for insured bank holding companies
• 6% for Systemically Important Financial Institutions (SIFIs)

Question 13

Basel III: Liquidity Requirements
* Liquidity Coverage Ratio (LCR)
* LCR requires banks to … to …
– UK and Netherlands had similar requirements before Basel III
* Net Stable Funding Ratio (NSFR)
* NSFR requires… to …

Answer 13

hold sufficient high-quality liquid assets ; cover its net cash outflows over 30 days under a stress scenario.

banks to have available stable funding; exceed the required amount over a one-year period of extended stress.

Question 14

Liquidity Coverage Ratio
* Assets have …
* Stock of high quality liquid assets (HQLA).
* Liabilities have …
* LCR is the ratio.

Answer 14

weights according to their liquidity.

weights according to their withdrawal risk.