Introduction to Banking & Finance Bank regulation & supervision

Today’s objectives To understand bank capital regulation To evaluate strategies to identify problem banks and successful bank restructuring procedures To identify the main causes of banking crises To understand the different approaches taken to resolve a banking crisis To identify the key regulatory initiatives to reduce systemic risk

The financial safety net

Deposit insurance

Deposit insurance Paybox Model narrow settlement scope Paybox plus settlement and also responsible for resolution role Cost reducer model settlement managing insolvency and externality occurrence Resolution facilitator model additional support powers to facilitate restructuring of banks including merging Supervisor model: broadest mandate not independent of the supervisory system Move towards a “cost minimiser” approach: includes selling off bank assets to help funding

Deposit insurance: who pays and how? The banks! Ex ante Bank levy with additional funds available from centre Ex-post No extant fund: members of the DIS fund on an ad hoc basis Which is better? ֎ Ex ante: depositors like it! Fosters confidence, should manage moral hazard if includes risk adjusted premiums BUT Difficult to manage, how do you set premiums, how do you price in systemic risk? Ex-post: fosters market discipline (supposedly), may be delays in getting the funds from banks and if lots of failures, can cause domino effect

DIS country comparison

Lender of last resort (LOLR) Main function of most central banking models Provides liquidity to banks at times of financial crisis Individual banks can borrow when no one else will lend Can be problematic when goes cross border: e.g. EU Has been linked with moral hazard Not supported as a function by the free banking lobby Cite Northern rock ֎

Special resolution regimes (SRR) Bankruptcy / insolvency legislation specifically for banks Highly political Many different approaches UK: Banking Act 2009. Permanent framework Bank of England, Prudential Regulation Authority USA: Fed Dep. Insurance Corp. Canada: Canada Deposit Ins. Corp. EU: Single Resolution Mechanism 2013 Hong Kong specifies a public interest objective NZ, same as HK but has no DIS Financial stability board (BIS) Key attributes for SRRs Most have a cost minimisation focus and a stability / systemic risk management requirement Have a look at pp200-201: summary

Limitations of regulation Moral Hazard Too Big To Fail (TBTF) Regulatory forbearance Time inconsistency Agency capture Costs limitations At the start of the financial crisis: SEC had 3,000 employees, FSA had 39 Regulatory forbearance may be caused by Time inconsistency; regulations that may have helped before the crisis may not be appropriate after it happens. May ahve to wait for things to calm down before implementation. Agency capture: regulation used by banks for their own ends: too much big bank influence, focus on small banks, movement of funds from bank to trading book etc ֎

Bank regulation: key concepts

The three pillars of Basel ֎

Why is capital important? Remember: banking is all about risk management The reason for holding capital is that it should provide protection against unexpected losses. NB; this is not the same as expected losses which are covered by provisions, reserves and current year profits. ֎

CREDIT RISK + MARKET RISK Capital adequacy and Basel II: the logic (the ratio of a bank's core capital to its total risk-weighted assets) TIER 2 CAPITAL TIER 1 CAPITAL CAPITAL BASE CREDIT RISK + MARKET RISK Undisclosed Reserves Revaluation Reserves General Provisions Hybrid Instruments Subordinated Term Debt Equity Reserves (disclosed) Preference shares MINIMUM 4% > 8%

CREDIT RISK + MARKET RISK Capital adequacy and Basel II: the logic > 8% TIER 1 CAPITAL TIER 2 CAPITAL CAPITAL BASE CREDIT RISK + MARKET RISK RISK WEIGHTED ON-BALANCE - SHEET ASSETS OFF- BALANCE SHEET ITEMS Credit Conversion as if on-balance sheet RISK WEIGHTED

Current proposals: Basel III Talking about a leverage ration: Tier 1capital / exposure to on and off balance sheet items ֎

Basel III: phase in arrangements Liquidity cover ratio (LCR) High quality liquid assets/total net outflows (next 30 days) > 100 www.bis.org/press/p130106.pdf Net stable funding ration (NSFR) Talking about a leverage ratio: Tier 1 capital / exposure to on and off balance sheet items

What Basel III means to banks The estimated medium-term impact of Basel III implementation on GDP growth is in the range of -0.05 to -0.15 percentage point per annum. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. Slovik, P. and B. Cournède (2016), “Macroeconomic Impact of Basel III”, OECD

SIFIs, G-SIFIs & G-SIBs SIFI = Systemically Important Financial Institution G-SIFI = Global Systemically Important Financial Institution G-SIB = Global Systemically Important Bank Subject to higher capital requirements: Greater supervision / scrutiny ֎

Additional capital requirements