Chapter 1

Chapter 1

International banking regulation and the Basel Accords Preview Types of regulation Capital requirement Debt requirement Basel Accords: I, II and III Criticisms of the Basel regulations 7-2 Types of regulation Regulations can be separated into 3 types: those that address 1. systemic risksthose that can create contagion, moral hazard and other negative externalities for those throughout the financial

system and economy. 2. institutional risksthose that can create losses for customers, creditors and/or stock holders of a financial institution due to imprudent financial practices. 3. unfair practicesthose that can create losses for customers, creditors and/or stock holders of 7-3 a financial institution due to deceptive, Simplified balance sheet of a bank Assets Cash assets (reserves) cash in the vault cash deposited at the central bank Loans secured/collateralized loans:

home, car, commercial, other real estate unsecured/uncollateralized loans: credit card, commercial Bonds and other securities government private sector short-term: <= 1 year long-term: > 1 year Liabilities + Capital Deposits: from depositors checking/checkable/transaction saving money market time

Borrowed funds, debt, credit: from creditors short-term: <= 1 year long-term: > 1 year Capital tier 1: retained earnings capital paid in from stock/ equity/share holders tier 2: funds from other sources 7-4 Capital requirements As described below, capital represents funds paid (in) by stock holders, retained earnings (for reinvestment in the corporation) and a few other sources. This is called the economic definition of capital.

Capital also represents the value of assets minus the value of liabilities. This is called the accounting definition of capital. Because capital represents the net value of a firm, it is also sometimes called the net worth of the firm. 7-5 Capital requirements According to the accounting and/or economic definition, capital serves two functions: 1. it represents an extra source of funds to pay for liabilities if income from assets unexpectedly decrease and if expenses from liabilities unexpectedly increase. 2. because it comes from partial owners and the corporations' own profit, it creates incentives for the owners to manage and to monitor risk

more carefully than otherwise. In other words, stock holders and the bank will lose their funds if the bank is not careful in 7-6 Capital requirements Regulators adjust the value of assets according to their risk, and require that the total amount of capital relative to the riskadjusted value of assets be at least 8%: where wi refers to the weights for different kinds of assets. Risk weights are defined by Basel Accords (see below). Risky assets generally, but not always, have

7-7 Capital requirements Liabilities + Capital Assets Cash assets (reserves) Deposits: from depositors w1 cash in the vault cash deposited at the central bank Loans secured/collateralized loans: home, car, commercial, other

real estate w2 w3 w4 unsecured/uncollateralized w4 loans: credit card, commercial Bonds and other securities government private sector short-term: <= 1 year long-term: > 1 year w5 w6 w5 w6 checking/checkable/transaction saving money market time

Borrowed funds, debt, credit: from creditors 8% short-term: <= 1 year long-term: > 1 year Capital tier 1: retained earnings capital paid in from stock/ equity/share holders tier 2: funds from other sources 7-8 Debt/leverage requirements Regulators in some countries also limit borrowing, credit and debt relative to capital.

Borrowing/credit/debt is sometimes called leverage because it gives the borrower a greater ability to invest in assets. These regulators now require a leverage ratio of at least 3%: Because this measure does not use weights, the leverage ratio is easy to calculate and easy to understand. The leverage ratio is intended to limit credit risk and settlement risk for the lender; capital risk, moral hazard,7-9 Debt/leverage requirements Liabilities + Capital Assets Cash assets (reserves) Deposits: from depositors

cash in the vault cash deposited at the central bank Loans secured/collateralized loans: home, car, commercial, other real estate unsecured/uncollateralized loans: credit card, commercial Bonds and other securities government private sector short-term: <= 1 year long-term: > 1 year 3%

checking/checkable/transaction saving money market time Borrowed funds, debt, credit: from creditors short-term: <= 1 year long-term: > 1 year Capital tier 1: retained earnings capital paid in from stock/ equity/share holders tier 2: funds from other sources 7-10 Debt/leverage requirements A large amount of short term debt may

indicate that the bank can not acquire other types of financing and may soon be unable to pay for other liabilities. Creditors are generally willing to lend long term debt/credit/ leverage if they believe that the borrower is a viable institution in the long term. In contrast, retained earnings and capital paid in (tier 1 capital) are more stable sources of financing. Retained earnings, also called internal finance, is the least risky way to finance expenditure 7-11 Bank of International Settlements The Bank for International Settlements (BIS) is an international organization made of representatives of national central banks

which fosters international monetary and financial cooperation. During financial crises, central banks sometimes work together to lend each other official international reserves with the goal of stabilizing exchange rates. 7-12 Basel Accords To make regulations consistent across countries, regulators from large economies have formed the Basel Committee on Banking Supervision, an international committee that meets at the Bank of International Settlements in Basel, Switzerland to negotiate the Basel Accords. Enforcement of the recommended regulations, however, must occur within each country.

There were 3 sets of Accords: Basel I (in 1988), Basel II (in 2004) and Basel III (in 2010). See www.bis.org 7-13 Basel Accords Basel I Accords These tried to implement consistent capitalasset ratios, in which the assets were adjusted for credit risk. These regulations defined the types of funds that can be used as capital in a weighted capital/asset ratio (see next 5 pages). weights to value assets and off-balance sheet activities in the capital/asset ratio, which were subsequently revised in the Basel II accords (see below). the amount of capital necessary to be considered financially sound (8% for total capital and 4% for tier 1 capital) against default and delinquency.

7-14 Types of capital for banks Tier 1 capital retained earnings: savings from profit that are retained by the bank capital paid in (funds from stock/equity/ownership shares) 1. funds from common stock: stock/equity/share holders have partial ownership claims (ex., voting rights) and partial claim to profit, but profit claims, called dividends, are not guaranteed and are paid only after all liabilities (ex., deposits and debt) have been paid for. 2. funds from preferred stock: stock/equity/share holders receive dividends before common stock 7-15

Types of capital for banks Tier 1 capital represents the most available form of capital to pay for a decrease in the value of assets or an increase in the value of liabilities, because no dividend payments or other obligations need to be made if such an event occurs. the most effective form of capital to limit problems (credit risk, moral hazard and adverse selection) caused by taking too many risks and extending too much credit, because the bank and its owners will lose their money if risks cause losses. 7-16 Types of capital for banks Tier 2 capital represents less available funds to pay for a decrease in the value of assets or an increase in the value of

liabilities, because some obligations may need to be paid as well if such an event occurs. less reliable forms of capital to limit problems (credit risk, moral hazard and adverse selection) caused by taking too many risks and extending too much credit because these funds are not directly earned by the bank nor owned by the banks stock/equity/share holders. 7-17 Types of capital for banks Tier 2 capital similar to retained earnings undisclosed reserves: earnings and reserves that are recorded off the publicly disclosed balance sheet for privacy reasons, but whose value has been viewed and approved by regulators. revaluation reserves: a change in the (market) value of physical assets or ownership shares (stock) in another company is matched with a

change in the value of capital. But because market values can be volatile, the value of this capital can also be volatile, so the revaluation of equity (stock) in another company is discounted by 55%. 7-18 Types of capital for banks Tier 2 capital similar to retained earnings general (loan) loss reserves or provisions for general losses are reserves for unrecognized general losses in the value of assets that have not yet occurred. Reserves can be set aside as capital even though the market value of assets remains high and no losses have yet occurred; capital can remain high until losses in the value of assets actually occur. Note: these are not cash reserves, which are

recorded as an asset, but funds set aside for future losses rather than for current expenses. 7-19 Types of capital for banks tier 1 tier 2 Retained earnings: savings/reserves that are the most safe and readily available for any purpose Undisclosed reserves: why undisclosed ? Revaluation reserves: volatile and risky

General loss reserves: available today but are necessary to pay for expected future losses 7-20 Types of capital for banks Tier 2 capital similar to capital paid in hybrid securities are securities that have characteristics of both debt and ownership shares (stock). Hybrid securities may promise only a principal payment, or may offer only an unspecified date in the future when interest and principal payments can be made. subordinated debt is debt paid after regular forms of debt, which is treated as a liability, both on a regular basis and during bankruptcy. However, payments are made before dividend

payments to stock/equity/share holders. There is some obligation to pay 7-21 Types of capital for banks order of payment characteristics of securities 1. deposits 2. borrowed funds: credit/debt/leverage contracts 3. subordinated debt 4. preferred stock/equity/shares 5. common stock/equity/shares borrowed funds: credit/debt/leverage securities: require principal +

interest on specified date hybrid securities: require only principal payments or do not specify a date stock/equity/shares (common and preferred): do not require principal or dividends on any date 7-22 Types of capital for banks Tier 1 Retained earnings Tier 2 Tier 2 capital similar to retained earnings a. undisclosed reserves b. revaluation reserves: adjustments in the book value of assets/capital c. general loss reserves: adjustments in the

book value of assets/capital Capital paid in Tier 2 capital similar to capital paid in a. funds from common stock, equity or a. funds from hybrid securities shares b. funds from preferred stock, equity or b. funds from subordinated debt shares 7-23 Basel Accords The Basel I Accords were amended in 1996 to weight the value of securities according to their perceived market risk, instead of only credit risk. Market risk is represented as a fraction of gross

or net values of asset/liability holdings. Basel II Accords, which were initially published in June 2004, broadened regulations to measure and to manage operational risk. Operational risk is represented as a fraction of gross income. 7-24 Basel Accords Basel II Accords also allow banks with regulatory approval to measure risk using internal models that try to estimate: the probability of default the size of the loss given default expected losses: losses that will occur with a similar frequency and size to those that occurred

in the past unexpected losses: losses that can not be predicted with past data but could be estimated through computer simulations Banks estimate these values either by using 7-25 Basel Accords In addition, the Basel II Accords revised the risk weights for various assets and offbalance items: 0%: general and legal reserves and other cash; bonds of, deposits and other claims on government institutions and central banks rated AAA to AA 20%: claims on government institutions and central banks rated A+ to A 50%: claims on government institutions and central banks rated BBB+ to BBB 100%: claims on government institutions and central banks rated BB+ to B 150%: claims on government institutions and central banks rated below B7-26

Basel Accords In addition, the Basel II Accords revised the risk weights for various assets and offbalance items: for claims on depository institutions, investment banks and corporations: risk weights from 20% to 150% depending on ratings by external agencies for loans to individuals and small businesses: 75% mortgage loans for homes: 35% loans and other claims secured by commercial real estate: 100% past due loans: 150% to 100% depending on how much has already been secured with general loss reserves or collateral 7-27 Basel Accords Safer assets have lower weights for the

capital/asset ratio, which implies less capital is needed to meet the current 4.5% (tier 1) or 8% (tier 1 + tier 2) requirements: 20% bonds 35% 50% bonds 0% of BBB+ cash reserves, of AAA mortgage rated bonds of AAA rated loans for private homes governments rated and central governments financial banks and central institutions banks 75% loans

to individuals and small businesses 100% loans and other claims secured by commercial real estate 150% some past due loans and bonds of Bor below rated governments and private

institutions 7-28 Basel Accords Basel III regulations were promulgated in 2010 to address the financial crises in Europe and the US: banks should increase the ratio of tier I capital to risk adjusted assets from 2% to 4.5% by January 2015. an additional counter-cyclical capital requirement up to 2.5% of the value of risk adjusted assets: more capital is required domestic expenditure is growing to prevent excessive credit growth and to protect banks later when domestic expenditure, production and income contract. 7-29

Basel Accords Basel III regulations also require: a leverage ratio of 3% that measures tier 1 capital/debt. computer simulations (stress tests) that consider the effects of economic contractions and financial crises. longer time series of past data to estimate probabilities of default. additional capital, liquidity and other supervisory requirements for systemically important institutions, to reduce contagion and other externalities. 7-30 Basel Accords Criticisms of the Accords include 1. The definitions of capital are inconsistently

applied across countries. In particular, tier 2 capital can be loosely or strictly defined: undisclosed reserves, hybrid securities, subordinated debt can vary depending on the regulator or contract. 2. The 8% capital/asset ratio is arbitrary, is inflexible to market and technical changes, and can be manipulated because risk is not accurately measured: 7-31 Basel Accords Criticisms of the Accords include 3. Risk weights do not accurately measure the risk of individual assets because the weights are too broad. the risk of individual assets because they rely on ratings by external agencies, who are often

uninformed or even inept. the possible reduction in risk from diversification. the reduction or accumulation of risk from offbalance sheet activities, like buying and selling derivative contracts. 7-32 Basel Accords Criticisms of the Accords include 4. Operational risk and market risk as a fraction of gross income and gross/net positions are not accurately measured. 5. Other risks, like risks to reputation, are ignored because they are too difficult to assess. 6. Implementing the recommendations is expensive and time consuming, especially for poorer countries who need to redesign regulatory institutions and increase their 7-33

Summary 1. Capital requirements require a given amount of capital relative to the riskadjusted value of assets. 2. Debt requirements require a given amount of capital relative to debt or leverage. 7-34 Summary 3. Basel I Accords defined capital and recommended a risk-weighted capital/asset ratio of at least 8%. 4. Basel II Accords redefined the risk-weights and allowed banks to estimate their own credit risk, as well as to consider market risk and operational risk. 5. Basel III Accords increased tier 1 capital/asset ratio to 4.5% and requires

banks to hold extra capital during economic expansions. 7-35

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