1. Introduction to Banking and Finance
Thomas Alexy
ACE-102

2. Recap of yesterday Key risks managed by banks
Tools used to manage bank balance sheet risks
Pros and cons of regulations for balance sheet risk management

3. Bank regulation and the future

4. Today’s goals Appreciate the reasons for strong bank regulation
Understand the history of bank regulation
Describe the typical types of financial crises
Discuss the causes and effects of the GFC
Appreciate the impacts of financial crises on the real economy
Review current and future proposed bank regulation

5. Why do we need bank regulation?
Financial systems suffer periods of instability
Business cycle, fundamental changes, technology can all cause instability
The banking sector is vulnerable to this instability due to its in-built high leverage
An unstable banking system can cause “bank runs” when depositors lose confidence
Central bank regulation of banks and the banking system is vital to minimise the chances of banking system instability and to protect bank customers

6. Types of bank regulation
Bank regulations come in the form of either Systemic Regulation of Prudential Regulation
Systemic regulation is usually:
Government deposit insurance
Lender of last resort
Prudential regulation is usually:
Capital rules
Liquidity rules
Code of conduct

7. History of bank regulation
Each local financial system has its own history of bank regulation
Globally a number of major regulatory milestones have had widespread impact:
1933 Glass-Steagall – separation of Investment and Corporate Banking in the US (largely repealed in 1999)
1988 first Basel Capital Accord “BIS I”. Concept of Tier 1 (Equity) and Tier 2 (sub debt, hybrids, other) and Risk Weighted Assets (RWAs). Tier 1 + Tier 2 capital = 8% * RWA
1996 second Basel Capital Accord “BIS II”. Three “Pillars” – 1: capital, 2: supervisory review, 3: disclosure

8. BIS II
Currently the “global” banking system is supposed to be operating under BIS II
Pillar 1:
Risk Weightings aligned to actual expected credit risk
Credit risk calculation could be “Standardised” or “Internal Ratings Based”
Market and Operational risk also included
Pillar 2:
Boosting regulatory powers to review and supervise banks
Pillar 3:
More disclosure of risk, capital adequacy and risk management

9. Financial Crises There are many types of financial crises, including:
Banking crises
Currency crises
Speculative asset price bubbles
Economic crises
GFC was mostly a banking crisis but it came from a speculative asset bubble
Economic crises are usually deep recessions or depressions where GDP falls sharply

10. Banking Crises
Loss of confidence in a bank or number of banks leading to bank run where depositors withdraw funds rapidly
Often associated with periods of poor lending decisions leading to high loan portfolio loss provisions
High leverage in the banking system means confidence is fragile
Small loan losses can quickly turn into a banking crisis

11. Currency Crises
A large increase in country risk can cause foreign investors to lose confidence in the country
Country risk might come from a local economic crisis or perhaps political change
Foreign investors will sell a currency quickly if they lose confidence
25%+ fall on relevant FX rate
Often the Central Bank will try to support the currency by increasing local interest rates
1997 Asian Currency Crisis is classic example of currency crisis – began in Thailand and flowed across the region

12. Currency Crises - IDR
Indonesian Rupiah – USD FX rate:

13. Speculative Asset Price Bubbles
A speculative asset price bubble is a large increase in the price of an asset, often over longer periods, which leaves the asset valuation out of line with underlying fundamental valuations
Dutch tulip bubble of 1637
1929 Wall St crash
1980s Japan property bubble
Late 1990’s “dot-com” bubble
US housing price bubble
Bubbles usually end with a large price crash!

14. 2007-9 Global Financial Crisis
GFC had its roots in US property prices

15. 2007-9 Global Financial Crisis
US property prices from 1987:

16. Over-investment in property
Both US Agency lenders (Fannie Mae and Freddie Mac) lent aggressively to US home buyers in
Securitised lenders also lent aggressively over this time – Investment Banks arranged funding of their using securitisation
Loans for “sub-prime” borrowers were made at 100% LVR!
By 2006 the US property market was a bubble financed by lenders and investors all over the world, often using large amounts of leverage

17. The property bubble bursts
In 2006 the US property market bubble burst and mortgage borrowers started defaulting in large numbers
Banks had massive exposure to the mortgage loan business through loans and securitised products
By 2007 banks around the world were reporting huge losses and confidence in the global banking system had collapsed
Extraordinary measures were taken by 2009 to rescue the system
USD 700m TARP recapitalised the US banking system
USD short term interest rates were lowered to near 0%
Banks and insurers were forced into mergers or government ownership
Etc etc!

18. Fed Funds
Fed Funds lowered to historic levels:

19. Impact on the “real economy”
US GDP growth collapses during the crisis:

20. Impact on the “real economy”
US unemployment rises sharply from 2008:

21. Impact on the “real economy”
US automobile industry goes bankrupt and needs government bailout
AIG – large international insurer - nationalised
Bank of America forced to buy Merrill Lynch
Property market collapse worsens
US government injects USD2 billion+ into the economy through fiscal measures
Etc etc!

22. Conclusion: improve bank regulation
The wasn’t just a US crisis – Europe has had enormous problems as well
Result was fast track Basel / BIS III
US passed “Dodd Frank” law
Reduce bank trading
Increase derivative transparency through clearing
Allow for orderly bank closures
Rid system of “too big to fail”
Reform mortgage market
Toughen consumer finance protection laws

23. BIS III
Required Capital – increase required capital – Tier 1 up from 4% to 6%
Introduce Leverage Ratio – ratio of Tier 1 capital divided by “total exposure” to be a minimum of 3%
Introduce Liquidity Cover Ratio – High quality liquid assets divided by net cash outflow over the next 30 days >100%
Introduce Net Stable Funding Ratio – Long Term Stable Funding divided by Long Term Assets (> 1-year) > 100%

24. BIS III
Introduce counter-cyclical capital buffers – increase capital in good times so banks have more protection for bad times
Strengthen risk frameworks across a lot of areas of the banks eg:
Credit Valuation Adjustment (CVA) for swap counterparty risk management
OTC derivative clearing through centralised exchanges
BIS III is costly for banks and will be less efficient (ie a burden for the global economy) - but should strengthen the banking system
Timetable for introduction

25. Banking of the future?
Banking in the future may look nothing like the past!
Same basic functions of financial intermediation and direct finance will probably exist
“Fintech” or Financial Technology is changing the banking landscape dramatically
2000: 300M internet users mostly on dial-up
2015: 3,000M internet users mostly on 4G smartphones
Cryptocurrencies – what if Bitcoin is the future?
P2P decentralised “trustless” “currency”
No Central Bank can control supply of cryptocurrencies
The “Blockchain” may change banking forever!

26. Fintech at a glance

27. Fintech is the place to be!
Retail branch banking will die out with our parents!
Everyone has a smartphone and can use it to bank
Banking has been slow to change and adopt technology in the past 20 years
Disruption is the BIG economic theme of the 2010s and probably the next two decades
Think Uber, Paypal, iTunes Store, Amazon, Alibaba, Tencent