Topic 19: Prudential Supervision Flashcards
What is Capital Adequacy?
The concept that a business (mainly banks) must have sufficient capital of its own to minimise the risk to customer deposits if it ran into financial difficulty. Capital is the firm’s own funds – money from shareholders, the firm’s cash holdings and money from other business sources, but not customer deposits. The theory is that the business should bear the risk of its activities, not the customer.
What is Solvency Ratio?
The minimum capital a business must hold, calculated as its capital as a proportion of the value of the bank’s assets. In this context, assets are generally loans made by the firm, and are weighted in relation to the risk posed by the type of loan. For example, secured loans are less risky than unsecured loans.
What is Total Loss-Absorbing Capacity (TLAC)?
Applies to ‘global systemically important’ banks (G-Sibs) – those whose failure would create major problems in the international system. Standards are set by the Financial Stability Board (FSB), an international body, and apply in addition to the bank’s regulatory capital requirements.
What is prudential management?
A vital element of the work of the industry regulators is to ensure that firms
have adequate risk management systems in place, particularly in relation to financial risks. This is referred to as prudential management. Prudential standards operate at various levels:
- The market as a
whole, to ensure the
continuation of a safe,
efficient and stable
market
- Individual firms, to
minimise the risk
of business failure
on the market as
a whole and on individual consumers
- Individual consumers,
to ensure that
providers they use
are able to continue
to operate or,
should they fail, any
individual impact is
minimised
WHAT IS THE BASEL COMMITTEE ON BANKING
SUPERVISION?
The Basel Committee is a multinational body acting under the auspices of the Bank for International Settlements, and
is based in Basel, Switzerland. Its role is to strengthen the regulation, supervision and activities of banks to enhance
financial stability; many of the people who work for it are on secondment from central banks and national regulatory bodies. It first established an international framework for deposit-takers (ie principally banks) in 1988. This framework,
which – among other things – set out minimum capital requirements for banks, was known as the Basel Accord. It was superseded by the expanded Basel II, itself superseded by Basel III in 2010.
What is Solvency?
The extent to which a business’s assets exceed its liabilities. An example
from the financial services industry would be mortgage lenders whose
assets are the loans made to consumers; liabilities are the funds borrowed
to facilitate those loans, from deposit-taking or from the money markets.
What is Liquidity?
Liquidity can be defined as the ease and speed with which an asset can be
converted into cash – and thus into real goods and services – without significant loss of capital value.
What is Liquidity risk?
The regulators define liquidity risk as the risk that a firm, though solvent, does not have sufficient financial resources available to enable it to meet its
obligations as they fall due.
What is Operational Risk?
The way in which a business is run and managed is another area in which prudential risk can arise. Operational risk is the risk of loss as a result of failed or inadequate internal processes, people and systems (eg staff fraud, or a computer failure), or as a result of external events, such as a natural disaster.
Summarise Basel II?
Basel II was published in 2004 and superseded the original Basel Accord. It
requires banks to hold levels of capital appropriate to the risk presented by
their lending and investment practices: as risk increases, so do the associated capital requirements.
In relation to supervision and disclosure, Basel II introduced a requirement
for banks to carry out ‘stress tests’, ie the use of computer simulations to
understand the effect of particular events on the firm. Stress tests ascertain
the extent to which a firm would have sufficient capital in certain adverse
economic conditions.
Basel III covers two main areas?
- regulatory capital;
- asset and liability management.
Explain Regulatory Capital?
Basel III requires banks to reach a minimum solvency ratio of 10.5 per cent.
Regulatory capital is the amount of capital that a bank is required to hold in
order to meet regulatory requirements. There are precise definitions as to what can be counted as regulatory capital and there are two broad classes of capital:
- Tier 1 capital, which includes share capital and disclosed reserves (ie
profits retained in the business rather than being paid as dividends);
- Tier 2 capital, which is known as supplementary capital.
The value of a bank’s assets is adjusted to take account of the risk that those assets present. So, for example, loans to governments (such as a bank holding UK government gilts) have a risk weighting of zero as they are considered to
be very secure; personal loans, conversely, are unsecured lending so carry a risk weighting of 100 per cent. A general theme is that the higher the risk presented by the business a bank is carrying out, the higher the level of capital it is required to hold. In practice, institutions normally keep more than the
minimum solvency ratio required by Basel III.
Basel III also introduced a minimum leverage ratio, which is a bank’s Tier 1
capital divided by its average total consolidated assets. Banks are expected to maintain a leverage ratio in excess of 3 per cent.
Explain Asset and Liability Management?
Basel III introduced two new ratios that banks must comply with in respect of asset and liability management:
- liquidity coverage ratio (LCR);
- net stable funding ratio (NSFR).
The LCR requires that high-quality liquid assets available to the bank exceed the net cash outflows expected over the next 30 days. In assessing a bank’s
ability to meet the LCR, different weightings are attached to different types
of asset according to their liquidity. The LCR was phased in between January 2015 and January 2019.
While the LCR is aimed at ensuring a bank’s short-term liquidity, the NSFR aims to protect its longer-term position. The NSFR requires that long-term financial resources exceed long-term commitments; long term in this context is taken as being more than one year. NSFR requirements had to be met from 2018.
What is the Capital Requirements Directive?
In the EU the requirements of Basel I, II and III are implemented by the Capital Requirements Directives (CRDs). CRD IV, which implements Basel III, came into effect on 1 January 2014, with the capital requirements being phased in over a number of years. The CRDs establish a supervisory framework that
aims to minimise the effects of a firm failing. They do this by ensuring that firms hold sufficient financial resources to cover the risks that their business activities present.
CRD IV builds on existing rules and introduces new prudential requirements.
Notably, the quality of capital that firms are required to hold has been improved and new capital buffers have been introduced for some firms. CRD IV applies to banks, building societies and investment firms.
Explain CRD V?
CRD V came into effect on 28 December 2020 and introduced new rules
governing the remuneration of staff, including the basis for identifying so-
called ‘material risk takers’ – staff who are subject to the strictest remuneration
rules. The reforms to the rules governing remuneration in CRD V include changes to deferral periods for performance-related pay and proportionality
thresholds above which the requirements apply. As CRD V came into effect
just before the end of the Brexit transition period, under the terms of the UK’s Withdrawal Agreement with the EU the UK was required to ‘onshore’ the CRD V rules.
