Week 4

Bank Regulation

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Week 4 Chapter 10

Bank Regulation

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives
10.1 Identify the reasons for and forms of a government
safety net in financial markets.
10.2 List and summarize the types of financial regulation
and how each reduces asymmetric information problems.
10.3 Explain the main features of Basel regulations, ,
particularly Basel III.
What is regulation?
• Establishment of specific rules of behaviour for banks
(or financial institutions)

• Aspects of financial regulation

–Establishing regulatory framework
▪Bank charters, capital adequacy, reserve
requirements
▪Deposit insurance, Lender of Last Resort
–Monitoring
▪Observing whether rules are obeyed
–Supervision
▪More general observation of financial firms
Systemic (macro-prudential) regulation

• “Top down supervision”

• Systemic regulation concerns mainly with the
safety and soundness of the financial system and
the aggregate effect of individual banks’ actions.
–all public policy regulation designed to
minimise the risk of bank runs that goes under
the name of the financial safety net.
• The safety net encompasses two main features:
–deposit insurance arrangements
–the lender of last resort function
The Demise of Northern Rock with Robert Peston (youtube.com)
Prudential (or micro-prudential) regulation

• “Bottom-up supervision”
• Prudential regulation concerns with consumer
protection.
• Micro-prudential supervision checks that
individual financial firms are complying with
financial regulation.
• It relates to the monitoring and supervision of
financial institutions, with particular attention
paid to asset quality and capital adequacy.
Why Financial Firms are regulated?
• Externalities: Banks play a pivotal role in modern
economies.
–Any disruption in financial system has a
serious adverse consequences for the rest of
the economy.
• Concerns on bank collapse
–Contagion: The collapse of one bank leading
to the collapse of others. → Effect on real
economy.
▪Deposit withdrawals, interbank market.
–Consumer protection.
Economic rationale for Regulation

• Basic problem in banking is its reliance on

public confidence and collapse of a bank result
heavy loss to its creditors
–Fractional reserve banking system (holding
relatively small reserves against deposits)
increases the potential profitability in
banking
–But also leaves banks at risk from loss of
public confidence which may cause a run on
their deposits
 Economic rationale for Regulation
• Again: A situation of imperfect information
–Depositors are less informed than suppliers of
financial services:
▪Inability to assess soundness of financial
institutions
▪Inability to ascertain product quality at purchase
▪Under-supply of information because of free rider
problems
• Imperfect information of depositors leads to
–Adverse selection
–Moral hazard
Economic rationale for Regulation
• Unregulated financial industry gives rise to supply of
lemons
–Example: ‘cowboys’ in banking:
▪Set up a bank with minimum capital
▪Offer high deposit rates to attract funds
▪Make loans to related companies in offshore
locations
▪Depart to a sunny location
▪Banking industry suffers loss of reputation
–Erodes consumer confidence
–Financial markets collapse
• Implication: regulate entry and supervise
 Objectives of Financial Regulation
• Core objectives:
–To maintain systemic stability (avoid systemic risk)
▪Contagion can compromise solvent banks
▪Self-fulfilling nature of bank runs due to maturity
transformation
▪Lender of last resort / deposit insurance
–To maintain safety and soundness of financial
institutions
▪Address moral hazard / adverse selection
–To protect the consumer
▪From failure of financial institutions
▪From unsatisfactory conduct of business
1. Safety Nets
• Deposit Insurance
–Depositors lack information on private loans.
▪Unable to learn if bank managers is taking too much
risk
▪Lack of information on quality of bank assets.
▪Which bank is insolvent which bank is not?
▪First come first serve for withdrawal of funds.
▪→ Contagion effect

• A government safety net for depositors can prevent bank

panics and promote contribution to financial system

• Deposit insurance is a common method of safety.

• Lender of Last resort: A second safety net.

Deposit insurance around the world
Some drawbacks of Safety Nets
• Safety net arrangements themselves induce moral hazard &
adverse selection:
– Depositor would not impose the discipline of the
marketplace on banks by withdrawing deposits.
– Safety net prevents bank runs due to asymmetric
information: depositors can’t tell good from bad banks
– Creates moral hazard incentives for banks to take on too
much risk
– Creates adverse selection problem of risk-takers
wanting to control banks
– “Too-Big-to-Fail” increases moral hazard incentives for
big banks – depositors do not monitor
• If you provide a safety net, you must also supervise
25
2. Restrictions on Asset Holdings

• Attempts to restrict financial institutions from

too much risk taking:
– Bank regulations
▪Promote diversification
▪Prohibit holdings of common stock
– Capital requirements
▪Minimum leverage ratio (for banks)
▪Basel Accord: risk-based capital
requirements
3. Financial Supervision

• Chartering, or screening of proposals to open

new financial institutions, to prevent adverse
selection
• Examinations and stress testing to monitor
capital requirements and restrictions on asset
holding to prevent moral hazard
– Capital adequacy
– Asset quality
– Management quality
– Liquidity
– Sensitivity to market risk
4. Capital Requirements

• Government-imposed capital requirements

are another way of minimizing moral hazard
at financial institutions
• There are various forms (i.e. Basel III):

1. Based on the leverage ratio

2. Risk-based capital requirements
Other regulatory measures
5. Disclosure Requirements
–To ensure that there is better information about
the quality of bank’s assets.

6. Consumer Protection
–Provide information on cost of borrowing.
– For example: Standardized consumer rates
(APR)

7. Restrictions on competition
–Restrictions on branching
–Restrictions to non-banking institutions
 Basel Accords: Basel I, II & III
Basel I (1988)
• Capital Adequacy Ratio:
–Banks must hold as much capital as 8% of risk
weighted assets
–Including off-balance sheet activities
• Level of Capital Adequacy Ratio depends on:
–Absolute volume of assets
–Quality in terms of risk of assets
–The more risky the assets the greater must be the
cushion of capital funds to meet required level of 8%
• Risk weighted assets (RWA)
What is risk weighting?
Category of asset Risk weight

OECD Government bonds and reserves 0%

Claims on banks in OECD countries 20%
Local authority bonds and secured loans 50%
(e.g. mortgages)
• Consider
Consumera bank withloans
loans and following assets:
to businesses 100%
• cash for £100m (0% risk weighting)
• loans to other banks £500m (20% risk weighting)
• mortgage loans: £800m (50% risk weighting)
• commercial loans £1,500m (100% risk weighting)
• Total Risk-Weighted Assets (TRWA) is
= (£100×0)+(£500×0.2)+(£800×0.5)+(£1,500×1) = £2,000
• Minimum Capital Requirement is 8% of £2,000
Capital adequacy ratio: Tier 1 + Tier 2

• Ratio considers two different definitions of capital

–Tier1: known as core capital and it consists of
shareholders' equity
–Tier2: reserves for losses on loans, hybrid instruments
and subordinated term debt
• Required Capital Adequacy Ratios:
–Tier 1 capital ratio = Tier 1 capital / Risk-adjusted
assets = 4%
–Tier 1 + Tier 2 ratio = (Tier 1 + Tier 2 capital) / Risk-
adjusted assets = 8%
Basel Accords: Basel II
Basel II (2004)
• Complexity of financial products and financial
innovation makes traditional bank supervision unlikely
to be effective
• Incentive-based approach more likely to work:
–Banks may be allowed to choose their own risk
management systems and to set their own capital
requirements
–Requires increased disclosure, which will result in
market discipline
–Role of supervisors to evaluate banks’ risk
management systems
–Supervisors should intervene at an early stage
Basel Accords: Basel III
Basel III (after the GFC) – Rationale for change

• The banking sectors of many countries had built up

excessive on and off-balance sheet leverage
• A gradual erosion of the level and quality of the capital
base
• Many banks were holding insufficient liquidity buffers
• The banking system was not able to absorb the resulting
systemic trading and credit losses.
• The crisis was further amplified by a pro-cyclical
deleveraging process
• Also amplified by the interconnectedness of systemic
institutions through an array of complex transactions.
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Basel III – Aim
• The crisis was observed in developed countries;
however, it also spread to a wider circle of countries
around the globe.
• It is critical that all countries raise the resilience of their
banking sectors to both internal and external shocks
• Basel III reforms aims to strengthen bank-level, or micro-
prudential, regulation, which will help raise the resilience
of individual banking institutions to periods of stress.
• The reforms also have a macro-prudential focus,
addressing system-wide risks that can build up across
the banking sector as well as the pro-cyclical
amplification of these risks over time.
 Basel III – Capital adequacy measures
1) Raising the quality, quantity, consistency and
transparency of the capital base.
• The crisis revealed:
–The inconsistency in the definition of capital
across jurisdictions
–The lack of disclosure that would have enabled
the market to fully assess and compare the
quality of capital between institutions.
–Certain Tier 1 capital instruments – classed,
after all, as core capital – were unable to
absorb losses.
 Basel III – Capital adequacy measures
• Basel III abandons the ‘core Tier 1’ concept in favour of
the stricter ‘common equity Tier 1’.
• In Basel II deductions have been imputed to total
regulatory capital.
• They will now apply to the common equity component of
Tier 1 capital.
A. Quality and level of capital: Greater focus on common
equity.
–Common Equity Tier 1 must be at least 4.5% of risk-
weighted assets at all times.
–Total Capital (Tier 1 Capital plus Tier 2 Capital) must
be at least 8.0% of risk weighted assets at all times.
Basel III – Capital adequacy measures
B. Capital loss absorption at the point of non-viability:
–Contractual terms of capital instruments will
include a clause that allows – at the discretion of
the relevant authority – write-off or conversion to
common shares if the bank is judged to be non-
viable.
–This principle increases the contribution of the
private sector to resolving future banking crises
and thereby reduces moral hazard.
 Basel III – Capital adequacy measures
2) Enhancing risk coverage
–One of the key lessons of the crisis has been the
need to strengthen the risk coverage of the capital
framework.
–Failure to capture major on- and off-balance sheet
risks, as well as derivative related exposures, was a
key destabilising factor during the crisis.
Securitisations
• Strengthens the capital treatment for certain complex
securitisations.
• Requires banks to conduct more rigorous credit
analyses of externally rated securitisation exposures.
 Basel III – Capital adequacy measures
3) Capital conservation buffer
• Outside of periods of stress, banks should hold buffers of
capital above the regulatory minimum.
• Comprising common equity of 2.5% of risk-weighted
assets, bringing the total common equity standard to 7%.
• When buffers have been drawn down, one way banks
should look to rebuild them is through reducing
discretionary distributions of earnings.
• This could include reducing dividend payments, share-
backs and staff bonus payments.
• Banks may also choose to raise new capital from the
private sector as an alternative to conserving internally
generated capital.
 Basel III – Capital adequacy measures
4) Countercyclical buffer
• One of the most destabilising elements of the crisis
has been the procyclical amplification of financial
shocks throughout the banking system, financial
markets and the broader economy.
• Imposed within a range of 0-2.5% comprising
common equity, when authorities judge credit
growth is resulting in an unacceptable build up of
systematic risk.
 Basel III – Capital adequacy measures
5) Systematically Important Financial Institutions
• While procyclicality amplified shocks over the time
dimension, excessive interconnectedness among
systemically important banks also transmitted shocks
across the financial system and economy.
• Addressing systemic risk and interconnectedness
– Systemically important banks should have loss
absorbing capacity beyond the minimum standards
– Imposed within a range of 0-2.5% comprising
common equity

2023 List of Global Systemically Important Banks (G-SIBs) - Financial Stability Board (fsb.org)
 Basel III – Capital adequacy measures
6) Leverage ratio
• One of the underlying features of the crisis was the build-
up of excessive on- and off-balance sheet leverage in the
banking system.
• In many cases, banks built up excessive leverage while
still showing strong risk based capital ratios.
• The main theoretical justification for the leverage ratio lies
in the fact that risk-based ratios cannot completely
prevent the undervaluation of certain risks in the
denominator.
Tier 1 Capital/(Balance sheet + Off-balance sheet) > 3%
Basel III – Global liquidity standards
• During the early “liquidity phase” of the financial crisis,
many banks – despite adequate capital levels – still
experienced difficulties because they did not manage
their liquidity in a prudent manner.
1. Liquidity coverage ratio (LCR)
2. Net Stable Funding Ratio (NSFR)
 Basel III – Global liquidity standards
1. Liquidity coverage ratio (LCR)
• LCR promotes the short-term resilience of the liquidity risk profile
of banks.
• LCR does this by ensuring that banks have an adequate stock of
unencumbered high-quality liquid assets (HQLA)
• HQLAs can be converted easily and immediately to meet
liquidity needs of banks for a 30 calendar day liquidity stress
scenario.
• LCR improves the banking sector’s ability to absorb shocks
arising from financial and economic stress
• Reduces the risk of spill over from the financial sector to the real
economy.
 Basel III – Global liquidity standards
2. Net Stable Funding Ratio (NSFR)
• NSFR promotes resilience over a longer period of time.
• NSFR requires a minimum amount of stable sources of
funding at a bank relative to the liquidity profiles of the assets
over one year horizon.
– Includes contingent liquidity needs arising from off-
balance sheet commitments
• NSFR aims to limit over-reliance on short-term wholesale
funding during times of buoyant market liquidity.
• And encourage better assessment of liquidity risk across all
on- and off-balance sheet items.
Learning Objectives
10.1 Identify the reasons for and forms of a government
safety net in financial markets.
10.2 List and summarize the types of financial regulation
and how each reduces asymmetric information problems.
10.3 Explain the main features of Basel Accord regulations,
particularly Basel III.