Supervision and Regulation

1
Supervision and Regulation

• Chapter 10
• Hughes and MacDonald

2
Please Read

• Chapter 20 (page 447) Saunders, Cornett and
  McGraw Text for a full discussion of capital
  adequacy (probably one of the most important
  topics from a supervisory point of view.)

3
What is supervision?

• Supervision includes

4
What is supervision?

• Supervision includes
• Authorization of institutions in the business
  (licensing or granting bank charters)
• Licensing and approval in the field of regulated
  business
• Issuing rules stipulated in law and drafting
  guidelines for the conduct of regulated business
• Performing the actual task of supervision on an
  ongoing basis

5
What is transparency?

• Transparency is the need to reveal to
  stakeholders of financial institutions, the
  riskiness of the FIs asset portfolio, liquidity,
  off-balance activities and the adequacy of
  capital.
• In a transparent world, depositors, customers,
  regulators, and managers can negotiate
  arrangements in full view of the risks presented
  by the FI, its financial position and its
  management style.

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The Bank for International Settlements

• When and why was BIS established?

7
The Bank for International Settlements

• When and why was BIS established?
• Established in 1930
• Its purpose was to promote the cooperation of
  central banks and to provide additional
  facilities for international financial operations
• It has three roles
• Forum for international monetary and financial
  cooperation
• BIS is a bank whose depositors are limited to
  central banks and international financial
  institutions
• Agent or trustee in support of international
  financial settlements.
• BIS seeks to reflect changes in global finance by
  providing technical expertise and
  information-sharing forums to a growing
  membership.

8
Basel Committee and Capital Adequacy

• What is the Basel Committee and why the focus on
  capital adequacy?

9
Basel Committee and Capital Adequacy

• Was established by OECD countries in 1974 to
  improve collaboration among bank supervisors.
• The Basel Committees work covers three major
  areas
• Forum for discussion on the handling of specific
  issues
• Coordinates the sharing of supervisory
  responsibilities among national authorities
• Seeks to enhance standards of supervision among
  its members
• This is required because banking regulation and
  supervision is a national (domestic)
  responsibilityand when supranational banks
  operatethey can operate outside of the countrys
  jurisdictionyet instability can through
  contagion affect the country and its other
  financial institutions this is what the failure
  of Bankhaus Herstatt showed.
• See Saunders, Cornett and McGraw Chapter 20 on
  Capital Adequacy p. 334

10
What is Capital Adequacy and Why is it so
Important?
11
What is Capital Adequacy and Why is it so
Important?

• Capital adequacy refers to the minimum continuing
  capital a bank must have according to domestic
  regulation, or by agreement at the international
  level through the Basel Accord.
• It is important because FIs are highly
  leveredand it is the equity cushion that serves
  to absorb losses when they occura sufficient
  cushion must be maintained to allow the FI to
  weather losses, right offs, and asset value
  erosion.

12
According to the Basel Accordwhat is Capital

• Capital includes
• Paid-in capital
• Retained earnings
• Tax-loss carry forwards,
• Preferred stock
• Subordinated debts
• Hidden assets
• Loan-loss reserves that have been set aside for
  future possible losses

13
Assets to Capital Multiple
Total assets include off-balance sheet items
specified by OSFI. Total capital is the FIs
risk-based capital and includes common equity
(book value) plus qualifying cumulative preferred
shares plus minority interests in equity accounts
of consolidated subsidaries. If the firm is
totally financed by equity or capital then the
ratio is 1.0. The higher the assets to capital
multiple, the greater is the leverage. OSFI
requires the multiple to be less than 20.
14
Assets to Capital MultipleExamples of Canadian
banks as at October 31, 2004

• Bank of Montreal 17.0
• Bank of Nova Scotia 13.8
• CIBC 17.9
• National Bank 16.8
• Royal Bank 18.1
• TD Bank 17.1

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Problems with Assets to Capital Multiple as a
measure of capital adequacy

• Market Value
• Even if OSFI closed an FI before its multiple
  reached a high level, the market value of the
  FIs assets could have resulted in a negative
  market value net worth.
• Asset Risk
• By taking the numerator of the assets to capital
  multiple as total assets, the leverage ratio
  fails to take into account the different credit,
  interest rate and other risks of the assets.
• Off-balance-sheet activities
• Despite the massive growth in off-balance sheet
  activities, only off-balance sheet credit
  substitutes are included in the calculation.
  Thus, even though derivatives may contribute
  greatly to an FIs risk, for the purposes of the
  assets to capital multiple, no capital is
  required to be held to meet the potential
  solvency risks involved in such contingent assets
  and liabilities.

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Basel II Proposals

• Canadian, U.S. and other bank regulators agreed
  with other member countries of the BIS to
  implement two new risk-based capital ratios for
  all commercial banks under their jurisdication.
• Basel II consists of three mutually reinforcing
  pillars which together contribute to the safety
  and soundness of the financial system. (See
  figure 20-4, page 458 of Saunders text.)

17
What is Tier 1 capital and Tier 2 capital

• Tier 1 capital
• Common equity
• Qualifying non-cumulative perpetual preferred
  stock
• Minority interests
• Less goodwill
• Tier 2 capital
• Is secondary capital including non-allocated
  loan-loss reserves, subordinated debt and all
  preferred stock that doesnt count for Tier 1

18
What is capital adequacy according to the Basel
Committee?

• It is equal to 8 percent of total assets with
  half of the cushion in the form of Tier 1 capital.

19
What do markets price as far as capital adequacy
is concerned?

• Markets exact a higher standard that what the
  Basel Accord set
• Banks have managed their risk exposure by shying
  away from credit risk to interest-free risk which
  requires little or no capital
• Risk shifting techniques include securitization
  and hedging risk exposures through derivatives
  contracts.

20
Are capital adequacy rules enough?

• No
• In 1999, the BIS suggested a three pillars
  approach which centered on quantitative capital
  requirements supervisory review and market
  discipline through enhanced transparency.

21
What is meant by Market Discipline?

• It refers to the ability of markets, if given the
  information (transparency) to move money in and
  out of exposure to FIs based on the risk exposure
  of the FI.

22
What is VAR?

• Value-at-Risk (VAR) is a mathematical risk model.
• Please review the Thomas and Saunders text for
  full coverage of this model (page 244)

23
The Role of the IMF in International Banking
Supervision

• IMF is one of the most important institutions
  providing support for international cooperation
  in better banking.
• IMF maintains training programs and sends teams
  of experts to help governments formulate and
  implement regulatory and supervisory systems
• IMF provides support of multilateral and
  bilateral supervision.

24
The IMF and the aftermath of the Asian financial
crisis

• Complied a list of the sources of banking
  problems
• Weak internal governance
• Financial deregulation, competition, and
  innovation outstrip the capacity of banks to
  manage risk prudently
• Financial deregulation takes place before
  adequate prudential regulation and supervision
  are in place
• Weak and insolvent FIs are allowed to continue to
  operate
• Capital account liberalization occurs before the
  soundness of the domestic financial system and
  macroeconomic policy is assured
• Declining business profits, together with
  excessive corporate indebtedness lead to a
  deterioration in asset quality
• Overexpansionary monetary and fiscal policies
  spur lending booms, excessive debt accumulation,
  and overinvestment in real assets, which drive up
  equity and real estate prices to unsustainable
  levels.

25
The IMF and the aftermath of the Asian financial
crisis

• Complied a list of best practices
• Strengthen internal governance by bank owners,
  boards of directors and managers
• Increasing transparency and the role (discipline)
  of market forces
• Limit distortions imposed by the public sector
  policies
• Control risk through regulatory and supervisory
  oversight
• Strengthen the broader structural framework
• Foster national and international supervisory
  coordination

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Problem 10 - 1

• What is the Bank for International Settlements

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Problem 10 - 2

• What is the Basel Accord? How did it evolve, and
  what were the forces behind it?

28
Problem 10 - 3

• One of the key measures proposed by the Basel
  Accord is capital adequacy. What is capital
  adequacy, why is it regarded as important, and
  how does it relate to international banking
  supervision?

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Problem 10 - 4

• What is the significance of Bankhaus Herstatt to
  international banking supervision?

30
Problem 10 - 5

• What are the three core areas of responsibility
  for the Basel Committee on Banking Supervision?

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Problem 10 - 6

• What role does the IMF play in international
  banking supervision? Should the IMFs role as a
  lender of last resort in international crisis be
  expanded?

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What is the significance of the Failure of
Bankhaus Herstatt?

• What happened?
• A small German bank hit by foreign currency
  losses 1974 had its bank license withdrawn and
  ordered into liquidation during the business day
  but after the close of interbank payments systems
  in Germany.
• Because a number of the bank counterparties had
  irrevocably paid Deutsche marks too the bank
  against anticipated receipts of U.S. dollars
  later the same day in New York in respect of
  maturing spot and forward transactions.
• The suspension of outgoing U.S. dollar payments
  left counterparty banks fully exposed to the
  value of the Deutsche mark deliveries. In
  addition counterparties lost money in replacing
  forward contracts not yet due for settlement.

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What is the significance of the Failure of
Bankhaus Herstatt?

• It showed how vulnerable banks (counterparty
  banks) in other countries can be affected by the
  failure of another bank.
• It reinforced the notion that there is a need to
  improve international supervisory relations.

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Question 1

• What is the Bank for International Settlements?

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Question 2

• What is the Basel Accord? How did it evolve, and
  what were the forces behind it?
• Dina

36
Question 3

• One of the key measures proposed by the Basel
  Accord is capital adequacy. What is capital
  adequacy, why is it regarded as important, and
  how does it related to international banking
  supervision?
• Kevin

37
Question 4

• What is the significance of Bankhaus Herstatt to
  international banking supervision?
• Jay

38
Question 5

• What are the three core areas of responsibility
  for the Basel Committee on Banking Supervision?
• Brady

39
Question 6

• What role does the International Monetary Fund
  play in international banking supervision?
  Should the IMFs role as lender of last resort in
  international crisis be expanded?
• Sal