The Banking Environment Flashcards
What key factors led to the financial crisis 2001 to 2007?
1. Imbalance of savings
Global imbalance of savings and investments developed. The surpluses of creditor countries (China, Japan, Germany etc.) were reinvested in low risk assets of debtor countries (US, UK, Ireland, Greece etc.) thus lowering real interest rates.
2. A developing asset bubble
With real, and nominal interest rates falling, investors sought higher yielding riskier assets. Asset prices, including property, were rising at this time due to:
- High demand
- Low discount rate; and
- Higher collateral values encouraging borrowing and spending
3. Increased reliance on wholesale funding and leverage
Global financial markets played a greater role in intermediation process leading to growth in shadow banking and increased direct use of bond markets rather than using banks as intermediaries (especially in US). Household savings ratios fell leading to banks increasingly relying on wholesale borrowing to lend.
4. Securitisation
Securitisation involves the packaging of loans and selling them on to wholesale investors. This often included:
- Companies with BB ratings but with AAA cash flows were able to borrow at AAA rates
- Liabilities were taken off balance sheet and risks were transferred
- Assets and liabilities were better matched, by eliminating funding exposure in relation to pricing and duration
- Financial innovation has led to complex financial products being developed such as credit derivatives
5. Globalisation of financial markets
- Rapid growth in cross-border borrowing made UK banks more vulnerable to volatility in these markets
- Inter-linkages between financial institutions increased
- Complexity and opacity (including for regulators) increased, contributing to greater vulnerability in the global financial system
6. The onset of the global financial crisis
- Two Bear Sterns hedge funds (effectively) collapsed in July 2007
- Interbank lending fell significantly
- Funding for second tier banks dried up – Northern Rock sought emergency liquidity assistance (ELA) from BOE in Sept 2007
- Banks with significant mortgage exposure experienced major drop in share price
Who failed in the Financial Crisis?
Name one country heavily affected by it and one only mildly affected.
Many banks began to experience significant funding problems
- Lehman Brothers failed and ended confidence in institutions thought to be ‘too big to fail’
- AIG insurance conglomerate rescued in US
- Retail bank runs led to bank failures (Northern Rock, Bradford and Bingley and some Icelandic banks)
- UK commercial property prices fell significantly, while residential property prices only had small falls
Ireland
- Ireland had experienced a pre-crisis period of strong economic growth primarily built on the financial sector, construction and a property boom
- Low Euro-area interest rates supported growth
- GDP fell, unemployment rose, property values and construction fell and concerns grew about the stability of the Irish banks
Australia
- Australian economy grew strongly prior to the financial crisis benefiting from emerging economies’ demand for commodities
- The impact of the crisis on Australian property prices was varied but banks had low sub-prime exposure and strong balance sheets meaning that the impact on them was ‘mild’
What is Value at Risk (VaR)?
VaR measures the adverse impact that potential changes in markets and prices could have on the value of a business over a specified period of time and is often used by banks to determine regulatory capital usage.
Three variables are considered:
- Potential loss
- Probability of this loss occurring; and
- Time in which this loss could occur
Note: VaR is modelled upon past market behaviour, and assumes that markets are trading normally. VaR cannot precisely model the true VaR during times of market chaos. In May 2003, the Basel Committee on Banking Supervision published a consultative document that concluded: ‘…a number of weaknesses have been identified with using VaR for determining regulatory capital requirements, including its inability to capture tail risk’. A key element of the proposal is moving the quantitative risk metrics system from VaR to expected shortfall (ES).
What is Basel I?
What did the FSA add and why?
In 1988: The Basel Committee on Banking Supervision (BCBS) published the Basel I with the aim of:
- Making capital requirements more risk sensitive and commensurate with the risk posed by a bank’s balance sheet
- Minimum capital requirements 8% of risk weighted balance sheet asset
The Financial Services Authority (FSA) required additional capital charges (firm specific trigger ratios) to compensate for perceived shortfalls in Basel I including:
- Interest rate risk
- Legal risk
- Reputational risk
- Operational risk
What is Basel II?
In 2004 the BCBS published the second Basel Accord with the aim of creating an international standard for banking regulators to control the capital that banks need to put aside to guard against financial and operational risks. In simple terms, the greater the risk posed by a bank the greater the level of capital it must hold. The three pillars of the Basel II framework:
- Pillar 1: Minimal capital requirements
- Pillar 2: Supervisory review (Supervisors required to review processes and strategies – Supervisory Review and Evaluation Process (SREP))
- Pillar 3: Market discipline (Sets out the public disclosures that banks must make that provide greater insight into the adequacy of their capitalisation)
What is Basel III?
In 2010, Basel III was endorsed by G20. The Accord updates Basel II (still has 3 pillars) in the following key ways:
-
Tighter definitions of common equity:
- Banks to hold 4.5% by Jan 2015 (compared with 2.0% previously); plus
- A further capital conservation buffer of 2.5% totalling 7%
- Introduction of a framework for counter-cyclical capital buffers. Banks having a capital ratio below 2.5% face restrictions on dividends, buybacks and bonuses
- Measures to limit counterparty credit risk
- Short and medium-term quantitative liquidity ratios
- The introduction of an internationally harmonised leverage ratio
Stress Testing: Under Basel III banks must have a comprehensive stress testing programme for counterparty risk.
Wrong Way Risk: arises when default risk and credit exposure increase together. Basel III requires that banks should identify exposures which generate wrong way risk. This can be done by stress testing scenarios in order to identify any possibility of severe shocks.
What was the UK Pre-Crisis Regulatory landscape?
The UK Tripartite regulatory regime (1997 – 2007)
- The Financial Services Authority (FSA) – prudential and conduct of business regulation of all financial services including banks and building societies
- The Bank of England – core purpose was to ensure monetary and financial stability
- The Treasury – responsible for the institutional structure of financial regulation and legislation (in event of a crisis, responsible for authorising certain types of financial interventions)
Prior to the 2007 crisis, there was intentionally, limited capacity on financial stability issues. The strong global consensus at the time, believed that the regulatory approach and new methods of securitising debt had substantially reduced systemic risk in the financial sector.
What was the UK Pre-Crisis Corporate Governance landscape?
The Basel Committee
In 2006: The Basel Committee on Banking Supervision provided guidance to assist regulators and to provide a reference point for promoting the adoption of sound corporate governance:
- The board should be involved in approving the bank’s strategy
- Clear lines of responsibility should be set and enforced throughout the organisation
- Compensation (reward) policies should be consistent with the bank’s long-term objectives
- Operational risks should be adequately managed
- The board should also provide effective oversight of senior management
Organisation for Economic Co-operation and Development (OECD)
The OECD identified 5 areas that are critical in its principles of corporate goverenance:
- Shareholder rights – the corporate governance framework should protect shareholders and facilitate their rights
- Equitable shareholder treatment – all shareholders should be treated equitably
- Stakeholders – the corporate governance framework should recognise the legal rights of all stakeholders
- Disclosure and transparency – organisations should make relevant and timely disclosures
- Board of directors – the board of directors is responsible for setting the direction of the organisation
What are the role of directors?
The Companies Act 2006 requires directors of limited companies to ‘exercise independent judgement’, irrespective of whether they are executive directors or non-executive directors.
Executive Directors: Full time company employees working in senior capacity. The Basel Committee identified a number of key issues:
- The board should be involved in approving the bank strategy
- Clear lines of responsibility should be set and enforced
- Compensation policy consistent with long-term objectives
- Operational risks should be adequately managed
- The board should also provide effective oversight of senior management
Non-Executive Directors (NEDs): NEDs are not full time employees, and are not involved in the day to day running of the company. The 2003 Higgs Report identified 4 roles for NEDs:
- Strategy
- Scrutiny
- Risk
- People
What reports / councils shaped Corporate Governance today?
The Financial Reporting Council (FRC) publishes The UK Corporate Governance Code which has 5 sections:
- Leadership
- Effectiveness
- Accountability
- Remuneration
- Relations with shareholders
The Cadbury Report 1992 also made corporate governance recommendations.
In the US Sarbanes–Oxley 2002 has had a significant impact on US corporate governance.
