1. Prudential regulation Commercial banks regulation in G-10 countries
Market entry controls
Controls on the organization and activity of the banking enterprise
Crisis management procedures

2. Prudential regulation Commercial banks regulation in G-10 countries
Market entry controls
Authorization to take up the business of a credit institutions
Acquisition of qualifying holdings
Controls on the network of branches

3. Prudential regulation Commercial banks regulation in G-10 countries
Controls on the organization and activity of the banking enterprise from the early thirties to the mid-nineties
Specialization
In the U.S. separation between commercial banks and investment banks
In Italy specialization by maturity with depository institutions limited to short term lending
In Italy separation between banking and industry (i.e non financial activities)

4. Prudential regulation Commercial banks regulation in G-10 countries
Controls on the organization and activity of the banking enterprise from the early thirties to the mid-nineties
Monetary policy tools
Minimum reserves: requires credit institutions established in the euro area to hold deposits on accounts with their national central bank
Borrowing ceiling: consisting of setting a ceiling on the expansion of bank loans
Portfolio constraints: obligation imposed by the central bank on banks to purchase certain amounts of securities in relation to the increase in their deposit collection over a given period
Are these tools useful for prudential purposes?

5. Prudential regulation Commercial banks regulation in G-10 countries
In a large part of developed countries, in the last decades of Nineteen century, the limits on banks' portfolio choices or activities (e.g. strict separation between commercial banking and investment banking established by Glass Steagall Act in 1933 in the U.S.A.) were canceled
Since the Eighty's, common standards of prudential regulation apply to commercial banks of G-10 countries1 . Basel Committee, established by the central-bank Governors at the end of 1974, formulates supervisory standards and guidelines and recommends statements of best practice
The Committee does not possess any formal supranational supervisory authority, and its conclusions do not have legal force. The standards have been implemented in legal system of many countries because of the reputation of the Committee and of the member’s activity (national central banks).
1Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States

6. Prudential regulation Commercial banks regulation in G-10 countries
In 1988, the Committee decided to introduce a capital measurement system, commonly referred to as the “Basel Capital Accord”.
The Accord established a credit risk measurement framework with a minimum capital standard of 8%.
In January 1996 the Basel Committee amended the Capital Accord of July 1988 to introduce capital requirements for market risks.
In June 1999, the Committee issued a proposal for a revised Capital Adequacy Framework (2004) consisting of three pillars:
minimum capital requirements, refine the standardized rules set in the 1988 Accord;
supervisory review of an institution's internal assessment process and capital adequacy;
effective use of disclosure to strengthen market discipline as a complement to supervisory efforts.

7. Prudential regulation Commercial banks regulation in G-10 countries
Solvency ratio: how does it works?
Equity Capital, Reserves (Tier 1) + Hybrid debt capital instruments, Subordinated term debt (Tier 2)
Risk weighted assets

8. Prudential regulation Commercial banks regulation in G-10 countries
A total amount of capital that banks and investment firms are required to hold should be equal to at least 8% of risk-weighted assets.
Tier 1 capital is considered to be the going concern capital. The going concern capital allows a bank to continue its activities and keeps it solvent.
Tier 2 capital is considered to be gone concern capital. The gone concern capital allows an institution to repay depositors and senior creditors if a bank became insolvent.
The risk-weighted assets concept in essence means that safer assets are attributed a lower allocation of capital, while riskier assets are given a higher risk-weight. In other words, the riskier the assets, the more capital the bank has to set aside.
Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100% (Commercial loans, for example, were assigned to the 100% risk weight category)

9. Prudential regulation Commercial banks regulation in G-10 countries
Capital adequacy requirements
provide a buffer against bank losses
protects creditors in the event of bank fails
creates disincentive for excessive risk taking

10. Prudential regulation Commercial banks regulation in G-10 countries
Other capital requirements
Market risk: Market risk can be defined as the risk of losses in on and off-balance sheet positions arising from adverse movements in market prices. From a regulatory perspective, market risk stems from all the positions included in banks' trading book as well as from commodity and foreign exchange risk positions in the whole balance sheet
Operational risk: is “the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events (including legal risk), differ from the expected losses”. It can also include other classes of risk, such as fraud, security, privacy protection, legal risks, physical (e.g. infrastructure shutdown) or environmental risks.

11. Prudential regulation Commercial banks regulation in G-10 countries
In developing the revised Framework, the Committee tried to arrive at significantly more risk-sensitive capital requirements that are conceptually sound;
Significant innovations of the revised Framework are:
the greater use of assessments of risk provided by banks’ internal systems as inputs to capital calculations;
a detailed set of minimum requirements designed to ensure the integrity of these internal risk assessments.

12. Prudential regulation Commercial banks regulation in G-10 countries
The revised Framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations
Standardized approach: under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk
Internal rating based approach (IRB):
Foundation IRB: banks are allowed to develop their own empirical models to estimate the PD (probability of default) for individual clients or groups of clients.
Advanced IRB: banks are allowed to develop their own empirical models to quantify the required capital for credit risk

13. Prudential regulation Commercial banks regulation in G-10 countries Minimum Capital Requirement (MCR)

14. Prudential regulation Commercial banks regulation in G-10 countries
Basel 2 consists of three pillars:
Minimum capital requirements for credit risk, market risk and operational risk—expanding the 1988 Accord (Pillar I)
Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II)
Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)

15. Prudential regulation Commercial banks regulation in G-10 countries

16. Prudential regulation Investment firms
In Europe investment firms must obey the same capital requirements as banks since 1999 (amendment of Basel I regarding requirements for markets risk of 1996).
In the U.S.A. the Consolidated “Supervised Entities program for investment bank holding companies” of 2004 established prudential rules (the Basel standards for computing bank capital for market risk) for investment firms. It’s a voluntary regulation because the SEC, nor any other regulator, was given the statutory authority to regulate investment bank holding companies

17. The recent financial crisis
The facts
The surge in global demand for U.S. securities by banks, hedge, and pension funds supported by unrealistically positive rating designations by credit agencies
The breakdown in the securitization of home mortgages (subprime mortgages)
The failure to properly price such risky assets precipitated the crisis
When in August 2007 markets eventually trashed the credit agencies’ rosy ratings, a blanket of uncertainty descended on the investment community (Alan Greenspan)

18. The recent financial crisis
During summer 2007 Bear Stearns pledges a collateralised loan to one of its hedge funds but does not support another; one German bank receives bailout from German savings bank association; Bank of England announces it has provided a liquidity support facility to Northern Rock. Following a retail deposit run, the Chancellor announces a government guarantee for Northern Rock’s existing deposits.
During the first months of 2008 UK Government announces temporary nationalization of Northern Rock; JPMorgan Chase & Co. agrees to purchase Bear Stearns with the intervention of Federal Reserve that provides US$30 billion non-recourse funding; in the summer US Treasury announces a rescue plan for Fannie Mae and Freddie Mac, but one months later Fannie Mae and Freddie Mac were taken into conservatorship.
In autumn 2008, the US Government's decision not to save Lehman Brothers led to a wide-spread breakdown of trust and a crisis of confidence that practically shut down inter-bank money markets, thus creating a large-scale liquidity crisis

19. The recent financial crisis
At the moment is difficult to understand cause and consequences of the recent financial crisis, but we can highlight some regulatory failures:
Gaps and asymmetries in financial regulation, particularly of the U.S.A regulatory framework
Absence of incentive compatible rules regarding how to compute regulatory capital for asset-backed securities
Differences in supervision legal systems

20. The recent financial crisis
Gaps and asymmetries in financial regulation of the U.S.A regulatory framework:
Prudential regulation of investment firms was not proper
There were no disclosure requirements for credit default swaps- CDS

21. The recent financial crisis
Rules regarding regulatory capital for asset-backed securities:
Many securitization vehicles were of a particularly complex strucuture, due to the possible repetition of exposures in the underlying CDO- Collateralized debt Obligation (e.g. squared CDOs are CDOs backed primarily by the tranches issued by other CDOs);
In the securitization structure there was a loss of information due to the complexity of the chain (Gorton 2008)
Many banking authorities allowed the use of rating agencies to calculate capital requirement for asset-backed securities in banks portfolio.

22. The recent financial crisis
Differences in supervision legal systems
Notwithstanding the harmonization process, EC directives leave national legislators too much regulatory options (in the Capital Requirements Directive there are more than 150 options)
Lack of coordination between national authorities in the event of difficulties of an international financial intermediary

23. The recent financial crisis and Basel 3
The Basel III requirements were in response to the deficiencies in financial regulation that is revealed by the 2000’s financial crisis. Basel III was intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–2011, and was scheduled to be introduced from 2013 until 2015.
However, changes made from April 2013 extended implementation until March 31, 2018.

24. The recent financial crisis and Basel 3

25. The recent financial crisis and Basel 3
The global capital framework and new capital buffers require financial institutions:
to hold more capital and higher quality of capital than under Basel II rules.
The new leverage ratio introduces a non risk-based measure to supplement the risk-based minimum capital requirements.
The new liquidity ratios ensure that adequate funding is maintained in case there are other severe banking crises.

26. The recent financial crisis and Basel 3
Capital requirements
The Basel III rule introduced the following measures to strengthen the capital requirement and introduced more capital buffers:
Capital Conservation Buffer is designed to absorb losses during periods of financial and economic stress. Financial institutions will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress, bringing the total common equity requirement to 7% (4.5% common equity requirement and the 2.5% capital conservation buffer). The capital conservation buffer must be met exclusively with common equity. Financial institutions that do not maintain the capital conservation buffer faces restrictions on payouts of dividends, share buybacks, and bonuses.
Countercyclical Capital Buffer is a countercyclical buffer within a range of 0% and 2.5% of common equity or other fully loss absorbing capital is implemented according to national circumstances. This buffer serves as an extension to the capital conservation buffer.

27. The recent financial crisis and Basel 3
Capital requirements
Higher Common Equity Tier 1 (CET1) constitutes an increase from 2% to 4.5%. The ratio is set at:
3.5% from 1 January 2013
4% from 1 January 2014
4.5% from 1 January 2015
Minimum Total Capital Ratio remains at 8%. The addition of the capital conservation buffer increases the total amount of capital a financial institution must hold to 10.5% of risk-weighted assets, of which 8.5% must be tier 1 capital. Tier 2 capital instruments are harmonized and tier 3 capital is abolished.

28. The recent financial crisis, Basel 3
Leverage ratio
Basel III introduced a minimum "leverage ratio“, non risk-based measure.
the banks were expected to maintain a leverage ratio in excess of 3%.

29. The recent financial crisis and Basel 3
Liquidity requirements
Basel III introduced two required liquidity ratios: Liquidity Coverage Ratio (LCR) ensures that sufficient levels of high-quality liquid assets are available for one-month survival in a severe stress scenario.
Net Stable Funding Ratio (NSFR) promotes resilience over long-term time horizons by creating more incentives for financial institutions to fund their activities with more stable sources of funding on an ongoing structural basis.

30. The recent financial crisis and Basel 3
Changes to Counterparty Credit Risk (CCR)
capital requirements to cover Credit Value Adjustment (CVA) risk and higher capital requirements for securitization products.

31. The recent financial crisis and CRDIV package
EU legislative history
In 2013, the EU introduced the so-called CRD IV package comprising Directive 2013/36/EU and Regulation (EU) N° 575/2013.
This is the third set of amendments to the original banking directive (CRD), following two earlier sets of revisions adopted by the Commission in 2008 (CRD II) and 2009 (CRD III).

32. The recent financial crisis and CRDIV package
Directive on banking prudential requirements provides rules for:
the access to deposit-taking activities
corporate governance of banks powers
responsibilities of national authorities (e.g. authorization, supervision, capital buffers and sanctions)
requirements on internal risk management that are tied to national company laws
Regulation on prudential requirements for credit institutions and investment firms establishes the prudential requirements that institutions need to respect. It sets out the rules for:
calculating capital requirements
reporting
general obligations for liquidity requirements