chapter 7 international banking and the basel accords

Chapter 7

International Banking and the

Basel Accords

Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa

Slides prepared by Afaf Moosa

Objectives

• To find out why banks are assigned special importance and why banking is more regulated than other business

• To consider the types of risk a bank is exposed to• To consider the pros and cons of banking regulation

7-2

(cont.)



Objectives (cont.)

• To outline the regulatory functions and the forms of banking regulation

• To evaluate the Basel I and Basel II accords

7-3



Why banks are important

• Banking regulation centres on the objective of minimising the possibility of bank failure because banks command more importance than other financial and non-financial firms

• The failure of banks creates more turmoil in the economy than perhaps any other kind of firm

7-4



Reasons for the special importance of banks

• The difference between the degrees of liquidity of their assets and liabilities, which makes them highly vulnerable to depositor withdrawal and bank runs in extreme cases

• Banks are at the centre of the payment system (they are the creators of money, the medium of exchange)

7-5

(cont.)



Reasons for the special importance of banks (cont.)

• They face an asymmetric loss function, which is a consequence of handling other people’s money

• The sheer size of the interbank market, resulting from the fact that banks deal with each other on a massive scale

7-6

(cont.)



Reasons for the special importance of banks (cont.)

• The failure of banks leads to a reduction in credit flows to the rest of the economy, and hence adverse economic consequences

• The levels of turnover and product innovation are high, making it unlikely that employees would experience full business and product cycles

7-7



The kinds of risk facing banks

• Financial risk Credit risk Market risk

• Interest rate risk

• Foreign exchange risk

• Equity price risk

• Commodity price risk

• Energy price risk

• Real estate price risk

7-8

(cont.)



The kinds of risk facing banks (cont.)

• Non-financial risk Operational risk Other kinds of non-financial risk

7-9



Examples of operational risk

• Liquidity risk• Herstatt risk• Compliance risk• Processing risk• System risk• Human resources risk

7-10

(cont.)



Examples of operational risk (cont.)

• Crime risk• Disaster risk• Fiduciary risk• Model risk• Legal risk

7-11



Examples of other non-financial risk

• Business risk• Reputational risk• Macroeconomic risk• Business cycle risk• Country risk• Political risk• Sovereign risk• Purchasing power risk

7-12



Operational risk

• The risk of loss resulting from the failure of people, processes, systems or from external events.

• It is more diverse than either credit risk or market risk

7-13



Types of operational loss eventsEvent Definition Example

Internal fraud Losses due to acts of fraud

involving at least one internal party.

Bribes, credit fraud and theft

External fraud Same as internal fraud

except that it is carried out by an external party.

Computer hacking and forgery

Employment practices and workplace safety

Losses arising from violation of employment and health and safety laws.

Discrimination

Clients, products and business practices

Losses arising from failure to meet obligations to clients or from the design of a product.

Product defects and misuse of confidential information

Damage to physical assets

Losses arising from damage inflicted on physical assets by a natural disaster or another event.

Terrorism, vandalism and natural disasters

Business disruption and system failures

Losses arising from disruptions to or failures in systems, telecommunication and utilities.

Hardware, software and telecommunications

Execution, delivery and process management

Losses arising from failed transaction processing with counterparties such as vendors

Negligent loss or damage of client assets and unapproved access to accounts

7-14



Operational risk in the FX market

• One reason for the increasing level of operational risk encountered in executing foreign exchange transactions is increasing diversity of the foreign exchange market, which is no longer dominated by commercial banks

7-15

(cont.)



Operational risk in the FX market (cont.)

• The level of operational risk in the foreign exchange market has risen also because the increasing complexity and size of the market have made it necessary to introduce regular changes in trading procedures, trade capture systems, operational procedures and risk management tools

7-16



Justification for banking regulation

• Banking regulation can be justified on the basis of market failure such as externalities, market power, and asymmetry of information between buyers and sellers

• The second justification for banking regulation is the inability of depositors to monitor banks

7-17



Arguments against banking regulation

• Some economists dispute the arguments typically presented in favour of bank regulation

• There is significant scepticism about the role of regulation as a means of achieving financial stability

• Regulators do not take into account the fact that risk creates value and that profits come from taking risk

7-18



Regulation in the post-crisis era

• While the proponents of banking regulation argue that their views have been vindicated by the global financial crisis, those who hold opposite views still argue otherwise

• Some proponents of free banking assert that the impact of the crisis would have been worse if it were not for deregulation

7-19



Regulatory functions

• Macroprudential supervision is intended to limit financial system distress that might damage the economy

• Microprudential supervision focuses on the solvency of individual institutions rather than the whole system

• Conduct-of-business regulation is also justified in terms of consumer protection

7-20



Segregation of regulatory functions

• The segregation of regulatory functions (for example, between APRA and the RBA in Australia) is a controversial issue on which there is no consensus

• Some would argue that one lesson learned from the global financial crisis pertains to the segregation of supervisory roles, particularly between central banks and other supervisors

7-21



Forms of banking regulation

• Deposit insurance: Arguments against are moral hazard and adverse selection

• Operations regulation, including loans (highly leveraged activities), investment in securities and off-balance sheet transactions

7-22

(cont.)



Forms of banking regulation (cont.)

• Regulation of the accounting process, which became necessary following the accounting scandals at Enron and WorldCom

• In 2002, the Sarbanes-Oxley Act was implemented in the United States to make corporate managers, board members and auditors more accountable for the accuracy of the financial statements of their firms

7-23

(cont.)



Forms of banking regulation (cont.)

• Capital-based regulation requires banks to be subject to capital requirements, holding a minimum capital ratio, which is the ratio of capital to total assets

• This is the basis of the Basel accords

7-24



Global banking regulation

• The Basel accords • The US International Banking Act of 1978• The Single European Act of 1987

7-25



Capital and related concepts

• Capital is simply the arithmetic difference between assets and liabilities, which is also known as net worth or shareholders’ equity

• Thus, a bank is solvent if the difference between assets and liabilities is positive and vice versa

7-26

(cont.)



Capital and related concepts (cont.)

• Economic capital is the capital that a firm must hold to protect itself against insolvency with a chosen level of certainty over a given period of time

• Regulatory capital is determined by regulators, for example, as a given percentage of the risk-weighted value of assets

7-27

(cont.)




• Capital adequacy refers to the requirement that banks hold adequate capital to protect themselves against insolvency

7-28

(cont.)




• The capital ratio and the risk-adjusted capital ratio are calculated as follows:

A

Kk

A

Kk

n

ii

n

iii

w

AwA

1

1

7-29

(cont.)




• The risk-adjusted rate of return on capital is calculated as:

KRAROC

7-30

(cont.)




• Regulatory capital arbitrage is a process whereby banks exploit differences between a portfolio’s true economic risk and regulatory risk by, for example, shifting the portfolio’s composition towards high-yield, low-quality (or high-risk) assets

7-31



The Basel Committee

• The BCBS was established in 1974 following the collapse of Bankhaus Herstatt

• The BCBS does not have any supranational authority with respect to banking supervision, and this is why its recommendations and standards do not have legal force

7-32



Functions of the Basel Committee

• Defining the role of regulators in cross-jurisdictional situations

• Ensuring that international banks do not escape comprehensive supervision by the domestic regulatory authority

• Promoting uniform capital requirements so that banks from different countries may compete with each other on a ‘level playing field’

7-33



The Basel I Accord

• In 1988, the BCBS established the Basel I Accord for measuring capital adequacy for banks

• The objective of Basel I were:

(i) to establish a more ‘level playing field’ for international competition among banks

(ii) to reduce the probability that such competition would lead to bidding down of capital ratios to excessively low levels

7-34



Requirements of Basel I

• Banks are required to hold as capital an amount of no less than 8% of their risk-weighted assets

• The capital ratio, k, can be calculated as:

08.0CR

Kk

7-35



Criticism of Basel I

• It has very limited sensitivity to risk, giving rise to a gap between regulatory capital as assigned by the regulators, and economic capital as required by market forces

7-36

(cont.)



Criticism of Basel I (cont.)

• Failure to differentiate between high-quality and low-quality assets within a particular asset classes (such as commercial and industrial credit) contributed to a steady increase in the credit risk of bank loan portfolios

7-37

(cont.)




• Adding up the credit risks of individual assets ignores gains from diversification across less-than-perfectly correlated assets

7-38

(cont.)




• The initial exclusion of market risk from capital requirements and high regulatory costs induced banks to shift their risk exposure (via securitisation) from priced credit risk to unpriced market risk

7-39

(cont.)




• It completely ignores operational risk. This sounds odd when it has become a consensus view that operational risk can be detrimental to the wellbeing of a bank or any business firm for that matter

7-40

(cont.)




• The Accord gives very limited attention to credit risk mitigation despite the availability of risk management tools such as credit derivatives

7-41

(cont.)




• Basel I did not have the provisions to adequately measure credit risk in the mortgage market, creating disincentives for banks to purchase mortgage insurance and encouraging the issuance of uninsured mortgages

7-42



The Basel II Accord

• In response to the criticism of the Basel I Accord and to address changes in the banking environment that the 1988 Accord could not deal with effectively, the BCBS decided to create a new capital accord, Basel II

7-43



Requirements

• While retaining the key elements of the Basel I Accord, including the general requirement that banks ought to hold a regulatory capital ratio of at least 8% of their risk-weighted assets, Basel II provides a range of options for determining capital requirements, allowing banks to use approaches that are most appropriate for their operations

7-44



The capital ratio under Basel II

• Because Basel II accounts for operational risk, the capital ratio formula becomes:

08.0

ORMRCR

Kk

7-45



The pillars of Basel II

• The Basel II Accord has three pillars:

(i) minimum regulatory capital requirements

(ii) the supervisory review process

(iii) market discipline through disclosure requirements

7-46



Calculating capital against credit risk under Basel II

• The standardised approach is structurally similar to what is found in the 1988 Accord. Banks are required to classify their exposures into broad categories, such as the loans they have extended to corporate and sovereign borrowers and other banks

7-47

(cont.)



Calculating capital against credit risk under Basel II (cont.)

• Under the internal-ratings based approach, banks may use their own internal estimates of credit risk to determine the regulatory capital for a given exposure

• Internal models are designed to estimate or predict the constituent components of credit risk:

(i) probability of default (PD)

(ii)loss given default (LGD)

(iii)exposure at default (EAD)

7-48



Calculating capital against market risk under Basel II

• Two approaches are used to measure market risk:

(i) the standardised approach

(ii)the internal models approach• To be eligible for the use of internal models, a bank

must satisfy certain conditions

7-49



Calculating capital against operational risk under Basel II

• Under the basic indicators approach, banks must hold capital against operational risk that is equal to the average of the previous three years of a fixed percentage of positive annual gross income:

n

yK

n

ii

1

7-50

(cont.)



Calculating capital against operational risk under Basel II (cont.)

• Under the standardised approach, regulatory capital for the whole bank is calculated as a three-year average of the simple sum of capital charges of individual business lines in each year:

3

03

1

8

1

t jjtj ],ymax[

K

7-51

(cont.)



The Betas of business lines

7-52




• According to the advanced measurement approach (AMA), regulatory capital is calculated by using the bank’s internal operational risk models

7-53

(cont.)




• The Basel II Accord allows three alternative approaches under the AMA:

(i) the loss distribution approach (LDA)

(ii) the scenario-based approach (SBA)

(iii)the scorecard approach (SCA), which is also called the risk drivers and controls approach (RDCA)

7-54

(cont.)




• A bank’s regulatory capital can be calculated from the capital charges of individual business units by adding them up under the assumption of zero correlation. Otherwise, the loss data can be combined to calculate regulatory capital for the whole bank from a single loss distribution, in which case we assume perfect correlation

7-55



Criticism of Basel II

• Basel II represents inappropriate or inadequate financial supervision. While capital adequacy requirements are designed to protect banks from insolvency, the problems faced by banks during the onslaught of the global financial crisis were illiquidity and leverage

7-56

(cont.)



Criticism of Basel II (cont.)

• Banks should not be regulated in the same way as they are managed. The objective of aligning regulatory capital with economic capital (which implies running the bank the same way as regulating it) is way off the mark

7-57

(cont.)




• The resulting risk-sensitive capital requirements enhance procyclicality of the banking system

• Over-reliance on the ratings of the rating agencies to determine the riskiness of assets sounds ludicrous in the post-crisis era

7-58

(cont.)




• Business and reputational risks, which are not recognised by Basel II, may be more significant than the direct operational losses that the banking industry has been asked to monitor

• By increasing its complexity, pillar 1 does not necessarily make the regulation more accurate

7-59

(cont.)




• As far as operational risk is concerned, pillar 1 is criticised on the grounds that operational risk modelling is not possible in the absence of comprehensive databases

• The basic indicators approach is criticised for the calculation of the capital charge as a percentage of gross income

7-60

chapter 7 international banking and the basel accords

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