AC942 Modern Banking

1
AC942 Modern Banking

• Dr. Paul Hamalainen
• pkhamal_at_essex.ac.uk
• Office Hours
• Monday 2-4
• Tuesday 9-10

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Lecture 3 Regulation in banking - International
financial architecture

• Aims of the lecture
• Understand the international system of financial
  regulation
• Explain the need for international regulatory
  authorities
• Describe the key international regulatory
  authorities
• Critically appraise the key international
  regulatory achievements

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International financial organisations

• IMF (International Monetary Fund)
• World Bank

4
Why international regulation?

• Global institutions could undermine the stability
  of the international financial system (global
  contagion/systemic risk)
• Communication Home Country or Host Country or
  both?
• Level-playing field / harmonisation
• Global regulations lower compliance costs and
  prevent drifting to lowest common denominator
• remove incentive for banks to shift business
  between locations on the basis of differential
  costs imposed by supervision

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Objectives of international financial
architecture

• Design a global financial structure, and a means
  of regulating and coordinating institutions
  within that structure, so as to minimize the
  probability of a major financial crisis
  occurring.
• To have in place methods for dealing with a
  crisis.

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The Basel Committee

• Bank for International Settlements in Basel
  (Switzerland) hosts the Committee of Central
  Banks and Bank Supervisors (Basel Committee)
  since 1974.
• Key agreements
• Basel Concordat (1975, 1983 and 1992)
• Principals
• 1997 Core Principals for Effective Banking
  Supervision (revised 2006)
• Capital adequacy regulations/standards
• 1988 Basel Capital Accord (Basel I)
• 1996 Amendment for Market Risk
• 2004 Basel II

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Why capital adequacy? (1)
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Why capital adequacy? (2)

• Two major reasons for holding capital
• 1. Cushion against shocks
• higher capital ? lower financial leverage ? lower
  insolvency risk
• 2. Reduction of moral hazard
• banks maximise profit of shareholders ? the more
  capital required to hold, the more cautionary
  behaviour of banks ? less moral hazard for
  depositors
• 3. Prevent excessive risk-taking
• Higher capital requirement ? lower return on
  equity ? Unregulated banks likely to hold less
  capital than desirable
• 4. Raise confidence in banks and the financial
  system
• protect depositors, reduce systemic fragility

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1988 Capital Accord

• Set of minimum capital adequacy standards
• International coverage (widely utilised)
• Capital precisely defined
• Assets subdivided into risk groups
• Capital adequacy ratio set at minimum 8 of
  risk-weighted assets (calculated using
  Risk-assets ratio)

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Risk-assets ratio (RAR)
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Basel I Risk-weights
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RAR example
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1988 Accord - critique

• Why 8?
• some countries implemented higher ratios
• Choice of risk-weight coefficients
• Not true-reflection of risk
• Regulatory capital arbitrage
• Portfolio diversification inadequately recognised
• One size fits all approach
• Not legislation
• EU directives (solvency ratio, own funds)
• Local variations
• Focus on banking risks to detriment of others

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1996 amendment to Basel I to incorporate market
risk

• Market risk included
• Equity price risk, foreign exchange risk,
  interest rate risk etc.
• internal models or basic approach
• Portfolio diversification accommodated
• Banking book or trading book?
• Extended definition of capital
• Tier III capital

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Revised RAR
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Basel II

• More comprehensive and risk-sensitive treatment
  of banking risks
• Closer alignment of regulatory capital and
  economic risks of the bank
• Three pillars to capital regulation
• 1. Capital adequacy ratio
• internal risk weighting models or external rating
  agencies (for credit risk)
• Include operational risk for first time
• 2. Supervisory review
• evaluation of capital management in banks
  (internal capital assessment process)
• judgments on the ability of banks to measure and
  to manage risks
• regulatory power to require capital in excess of
  minimum requirements
• 3. Market discipline
• information disclosure

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Basel II
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Ongoing international issues (1)

• Home / Host country (cross-border) supervisory
  arrangements
• Harmonisation of national supervisory
  arrangements
• Bilateral agreements
• Cross-border crisis management
• Supervision remains at the national level
• What if Northern Rock had overseas operations?
• ECOFIN (Oct. 2007) - enhance arrangements for
  financial stability in the EU (co-operation (?)
  and review of the tools for crisis prevention,
  management and resolution)
• Basel Committee (Dec. 1997) - Working party to
  study resolution of cross-border banks
• Different measures to deal with crisis / deposit
  insurance arrangements

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Ongoing international issues (2)

• Cross-border crisis management (cont.)
• The cross-border dimension was echoed in Ways to
  Fix the Worlds Financial System by Gordon Brown
  published in FT 25 Jan 2008 As financial
  markets become increasingly interlinked,
  countries must ensure they have robust and
  effective cross-border crisis management
  arrangements
• Financial Stability Forum?
• Supervisory clubs

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Ongoing international issues (3)

• Improved compliance
• Improved disclosure
• Financial Stability Forum (FSF)
• Participation and cooperation by developing
  countries / emerging markets
• Harmonisation of accounting standards
• IASB
• IFRS