Topic 19

Question 1

What is the purpose of prudential management?

Answer 1

Prudential management ensures that firms have adequate risk management systems in place, particularly concerning financial risks.

Question 2

Which regulators are responsible for prudential management?

Answer 2

The Prudential Regulation Authority (PRA) is responsible for the prudential regulation of deposit-takers, insurers, and significant investment firms, while the Financial Conduct Authority (FCA) regulates smaller firms.

Question 3

What is the FCA’s approach to prudential regulation?

Answer 3

The FCA’s approach is to manage failure when it happens, rather than focusing on reducing its probability. It is primarily concerned with smaller firms, where failure is less likely to impact the entire financial system.

Question 4

How does the FCA handle situations where the failure of a firm may have a wider impact?

Answer 4

If the failure of a firm is likely to have a broader impact, the FCA focuses on reducing the impact on customers and the financial system’s integrity.

Question 5

What is the role of international prudential regulation?

Answer 5

International prudential regulation ensures that regulatory frameworks are aligned globally due to the interconnectedness of economies, where issues in one economy can affect others.

Question 6

What is the Basel Committee on Banking Supervision?

Answer 6

The Basel Committee is a multinational body that strengthens the regulation, supervision, and activities of banks to enhance financial stability. It sets international standards for the prudential regulation of banks.

Question 7

What was the Basel Accord, and what is its significance?

Answer 7

The Basel Accord, established in 1988, set out minimum capital requirements for banks. It was the first international framework for regulating deposit-takers and was later superseded by Basel II and Basel III.

Question 8

What is capital adequacy in financial institutions?

Answer 8

Capital adequacy ensures that a business has sufficient capital to make it very unlikely that deposits will be at risk in case the business runs into difficulties.

Question 9

What is the meaning of “own funds” in the context of capital adequacy?

Answer 9

“Own funds” refers to capital obtained from shareholders and related sources, distinct from funds deposited by customers.

Question 10

Who is expected to bear the risks in the pursuit of financial reward for a business?

Answer 10

The shareholders are expected to bear the risks, not the depositors.

Question 11

What is the minimum capital that a business must hold called?

Answer 11

The minimum capital that a business must hold is expressed as a solvency ratio.

Question 12

What is a solvency ratio?

Answer 12

A solvency ratio is capital as a proportion of the value of the business’s assets, mainly its loans, adjusted for the perceived risk level of different assets.

Question 13

What is the significance of the solvency ratio in capital adequacy?

Answer 13

The solvency ratio ensures that the bank holds sufficient capital in proportion to the risk of its assets, protecting depositors in case of losses.

Question 14

What is liquidity?

Answer 14

The ease and speed at which an asset can be converted to cash.

Question 15

How does liquidity differ from capital adequacy?

Answer 15

Liquidity refers to a bank’s ability to access cash quickly, while capital adequacy relates to a bank’s ability to absorb losses and remain solvent.

Question 16

What is liquidity risk?

Answer 16

Liquidity risk occurs when a bank does not have sufficient funds readily available to meet its financial obligations, despite having assets.

Question 17

What is an example of liquidity risk?

Answer 17

A bank with large amounts of mortgage loans but few liquid assets may struggle to meet sudden customer withdrawals, leading to a ‘run on the bank.’

Question 18

What led to the liquidity crisis at Northern Rock?

Answer 18

Economic problems in the USA led to a lack of funding for Northern Rock’s business model, which relied on short-term borrowing. When customers rushed to withdraw their savings, the bank’s liquidity was quickly exhausted, requiring government intervention.

Question 19

How can banks manage liquidity risk?

Answer 19

Banks can manage liquidity risk by diversifying asset maturity dates and funding sources to prevent large withdrawals from depleting liquidity.

Question 20

What role did the Bank of England play in the Northern Rock crisis?

Answer 20

The Bank of England stepped in to guarantee deposits when Northern Rock faced a run on the bank, which helped restore confidence and halted the bank run.

Question 21

What is operational risk?

Answer 21

Operational risk is the risk of loss resulting from failed or inadequate internal processes, people, systems, or external events.

Question 22

What are some common causes of operational risk?

Answer 22

Operational risk can arise from failed or inadequate internal processes, human errors, system failures, or external events.

Question 23

How do regulations address operational risk in financial institutions?

Answer 23

Prudential regulations require financial institutions to maintain capital adequacy to cover potential operational losses and to manage operational risks effectively.

Question 24

How is the capital adequacy requirement calculated for operational risk?

Answer 24

It is calculated by applying a 0.15 multiplying factor to a firm’s gross income under the basic indicator approach in the Basel framework.

Question 25

Can insurance be used to offset operational risk capital requirements?

Answer 25

No, financial institutions cannot offset their operational risk capital requirements by holding insurance.

Question 26

What are the Basel II accords?

Answer 26

Basel II is a set of international banking regulations published in 2004, replacing the original Basel Accord. It requires banks to hold capital appropriate to the risks they take and introduced three ‘pillars’ to ensure financial stability.

Question 27

What are the three pillars of Basel II?

Answer 27

Pillar 1: Minimum Capital Requirements – Sets the minimum capital banks must hold relative to their risk exposure. Pillar 2 – Supervision: Ensures banks are appropriately assessing and managing their risks. Pillar 3: Introduced disclosure requirements so that the public and investors can assess a bank’s capital adequacy and risk management.

Question 28

What is Basel III?

Answer 28

Basel III is a set of international banking regulations introduced by the Basel Committee on Banking Supervision (BCBS) in 2010–11, with implementation phased in until 31 March 2019. It was developed in response to the 2008 global financial crisis to strengthen the regulation, supervision, and risk management of banks.

Question 29

What are the two main areas covered by Basel III?

Answer 29

Regulatory Capital: Defines the minimum amount of capital a bank must hold and introduces capital adequacy requirements. Asset and Liability Management: Establishes new rules for managing the liquidity and leverage of banks.

Question 30

What are the two types of regulatory capital in Basel III?

Answer 30

Tier 1 Capital: Comprises core capital, including common equity (e.g., retained earnings and shareholder equity) and certain preferred stocks. Tier 2 Capital: Also known as supplementary capital, which includes items such as subordinated debt and revaluation reserves.

Question 31

How does Basel III adjust asset values?

Answer 31

The value of a bank’s assets is adjusted according to the level of risk they present. Higher-risk assets require more capital to be held against them to ensure financial stability.

Question 32

What is the minimum solvency ratio required under Basel III?

Answer 32

A bank must hold a minimum capital (regulatory capital) to ensure that its assets exceed liabilities. This minimum solvency ratio is set to ensure depositors do not lose money in the event of a bank failure.

Question 33

What is the leverage ratio introduced in Basel III?

Answer 33

Basel III introduced a minimum leverage ratio of more than 3%, calculated as: Leverage Ratio = Tier 1 Capital/Total Assets This limits excessive borrowing and ensures banks maintain a minimum amount of capital relative to their total assets.

Question 34

What is asset and liability management under Basel III?

Answer 34

Basel III introduced stricter liquidity and funding requirements to ensure that banks manage their assets and liabilities in a way that reduces risks and improves financial stability.

Question 35

What are the two key ratios introduced in Basel III for asset and liability management?

Answer 35

Liquidity Coverage Ratio (LCR): Requires a bank’s high-quality liquid assets to exceed its expected net cash outflows over the next 30 days to ensure short-term stability. Leverage Ratio: A bank’s Tier 1 capital divided by its total exposure, which must be more than 3% to limit excessive risk-taking.

Question 36

What is the Capital Requirements Directive (CRD)?

Answer 36

The Capital Requirements Directive (CRD) is the European Union's implementation of the Basel I, II, and III regulations. It sets out rules for capital adequacy and risk management for financial institutions, ensuring they maintain sufficient capital to cover risks and avoid financial instability.

Question 37

What is CRD IV?

Answer 37

CRD IV is the fourth version of the Capital Requirements Directive, which implements Basel III in the European Union. It strengthens capital requirements and introduces new capital buffers for certain financial institutions.

Question 38

Who does CRD IV apply to?

Answer 38

CRD IV applies to: Banks Building societies Investment firms

Question 39

What changes were introduced by CRD IV?

Answer 39

Improved quality of capital: Requires banks to hold higher-quality capital (e.g., more common equity). Capital Buffers: New buffers introduced to enhance financial resilience, such as: Capital conservation buffer: Extra capital to absorb losses in times of stress. Countercyclical buffer: Ensures banks build up capital during economic growth to be used in downturns.

Question 40

What is CRD V?

Answer 40

CRD V is the latest version of the Capital Requirements Directive, which introduced additional prudential requirements, especially in areas like capital buffers and rules for investment firms.

Question 41

What are TLAC requirements?

Answer 41

Total Loss-Absorbing Capacity (TLAC) is an additional capital requirement for banks that are global systemically important banks (G-SIBs) (those considered "too big to fail"). Implemented by the Basel Committee on Banking Supervision (BCBS), it applies to 30 major banks worldwide. Minimum TLAC requirement (since 2019): TLAC ≥ 18% of the bank’s risk-weighted assets (RWAs) The goal is to ensure that large financial institutions have enough capital to absorb losses without requiring a government bailout.

Question 42

What is Solvency II?

Answer 42

Solvency II is a regulatory framework introduced in the European Union (EU) on 1 January 2016 to ensure the financial stability of insurance companies. It replaced the older Solvency I regime, which was first introduced in the 1970s.

Question 43

What are the objectives of Solvency II?

Answer 43

Ensuring Capital Adequacy: Insurers must hold sufficient capital to cover their financial risks. Minimising policyholder risk: Reduces the likelihood of insurers failing to meet their obligations. Early risk detection: Regulators must identify financial issues before they become critical. Enhancing market confidence in the financial stability of insurers.

Question 44

What are the three pillars of Solvency II?

Answer 44

Three-Pillar System (Similar to Basel II & III in Banking) Pillar 1 – Solvency Capital Requirements (SCR): Determines the minimum amount of capital that insurers must hold to cover potential risks. Pillar 2: Regulatory Supervision Requires Own Risk & Solvency Assessments (ORSA) to ensure that insurers have enough capital and risk management processes in place. Pillar 3: Market Discipline and Disclosure Insurers must be transparent in their risk management and financial standing to help regulators identify risks early.