Financial Regulation and Capital Adequacy: Arthur Centonze FIN644 - Slides 6
Financial Regulation and Capital Adequacy: Arthur Centonze FIN644 - Slides 6
Financial Regulation and Capital Adequacy: Arthur Centonze FIN644 - Slides 6
Overlapping:
- institutional regulators, e.g. bank regulators
- functional regulators, e.g. securities trading regulators
Outdated
Bank Investment
Bank
Securities
Firm
Insurance
Foreign
Company Subsidiaries
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Regulatory architecture did not reflect the way the financial system
operates
- regulators tended to live in silos
- there was no systemic risk regulator to ensure safety across
financial institutions and markets
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Early 1980s:
- inflation interest rates
- yields on ST deposit liabilities but not on LT asset base NIM
- S&Ls needed to increase returns on LT assets
- started making outrageously risky loans
Bank managers and regulator (FSLIC) were not prepared for the
scope and complexity of the new business model
Source: www.fdic.gov/bank/historical/bank/index.html.
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11
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Regulation:
- micro-prudential regulation to protect investors and customers
against idiosyncratic risk
- macro-prudential regulation to protect the economy against
systemic risk
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FED
FDIC
SEC
FHFA
CFTC
CFPB
OCC
NCUA
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Volcker Rule
Prohibits US Banks from:
1. engaging in short-term proprietary trading of securities for their
own account
2. owning, sponsoring or having certain relationships with hedge
funds or private equity funds
Allows US banks to:
1. make markets in financial instruments for clients
2. hedge the risks of market-making
3. trade in US government and certain foreign government
securities for their own account
Allows foreign banks in the US to:
- trade as long as the principal risks are held outside the US
Why the need for a Volcker Rule?
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A reform of:
- the complex and fragmented regulatory structure
- Fannie Mae and Freddie Mac
- key markets prone to runs, e.g. money markets, derivatives,
- the shadow banking system
- the credit rating agencies
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Capital Adequacy
Sufficient equity to sustain a loss in
asset values and earnings
and
Sufficient loan loss reserves
to sustain a loss from loan defaults
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Capital Adequacy
Today:
- fosters monetary and financial cooperation among central banks
- about 60/175 central banks are members
- no formal authority reach consensus on best practices
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Traditional measurement:
Basil I:
C = Total Capital
8% 10%
Risk Weighted Assets
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4%
4%
Well Capitalized*
Adequately Capitalized
Undercapitalized**
Significantly Undercapitalized**
Critically Undercapitalized***
10%+
8%+
<8%
<6%
<2%
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Amt
RW
T-Bills
$20b
0%
Res Mort
$40b
50%
100%
$160b
RW
Min
Asset CapReq
0
Cap
Req
8%
$0
$20b
8%
$1.6b
$100b
8%
$8.0b
$120b
8%
$9.6b
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Basel I: Issues
Did not sufficiently differentiate the risk among assets
- developed country bonds vs. emerging market country bonds
- AAA bonds vs. junk bonds
Banks gamed the system: shifted high risk assets into low risk
categories which required less capital, e.g. loan securitization
Bank mergers in the 1990s potential for greater risk
100% weight on business and consumer loans high capital
cost to banks, a disincentive to give loans
Basel II
Refines the Estimation of Risk Adjusted Assets to More
Accurately Reflect Actual Risks
cash: 10%
corporate bonds: 0%, 20%, 50%, 100%, 150%
sovereign bonds:0%, 20%, 50%, 100%, 150%
bank debt: 20%, 50%, 100%, 150%
home mortgages: 35%
commercial RE mortgages: 50%, 100%
off-balance sheet items: 20%, 50%, 100%
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Basel II
Requires Stronger Oversight of Bank Risk Management
Processes
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Decrease the asset base: e.g. sell assets, stop renewing loans,
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Microprudential
- increase capital requirements to reduce idiosyncratic risk
Macroprudential
- impose capital buffers and surcharges to reduce systemic risk
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Basel III
Minimum % of RWA
4
2
6
4.5
Countercyclical Buffers
Common Equity
Capital
2.5
0 - 2.5
Common Capital
Basil II
8
Basil III
15.5
US
17.5
10
17.5
19.5
9.5
11.5
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Problem
Calculate the capital required under Basel II for this EU bank to be adequately capitalized
for each asset class and total.
RW
Min
Cap
Asset
Amount ()
RW (%)
Asset ()
Cap Req (%) Req ()
Cash
10b
A Bonds
30b
CCC Bonds 20b
Com RE
50b
110b
10
20
150
50
Total ()
Calculate the amount of Tier I capital this bank must hold under Basel II.
Calculate the amount of Tier I capital this bank must hold under Basel III.
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Study Questions