Lecture International finance: An analytical approach (3/e): Chapter 7 - Imad A. Moosa

Chapter 7 - International banking and the basel accords. The objectives of this chapter are: 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…

Chapter 7

International Banking and the

Basel Accords

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

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

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)

(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

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

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

The kinds of risk facing banks

Examples of operational risk

Examples of operational risk (cont.)

Examples of other non-financial risk

Types of operational loss events

Event   Definition  Example 

Internal fraud   Losses due to acts of fraud 

involving at least one  internal party. 

Bribes, credit fraud and theft     

Discrimination   

of a product. 

Product defects and misuse of  confidential information 

Terrorism, vandalism and  natural disasters 

Business 

disruption and  Losses arising from disruptions to or failures in  Hardware, software and telecommunications 

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

(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

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

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

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

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

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

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 balance sheet transactions

off-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

(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

Global banking regulation

• The Basel accords

• The US International Banking Act of 1978

• The Single European Act of 1987

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

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

(cont.)

Capital and related concepts (cont.)

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

Capital and related concepts (cont.)

• The capital ratio and the risk-adjusted capital ratio

are calculated as follows:

A

K k

A

K k

n i i

1 1

(cont.)

Capital and related concepts (cont.)

• The risk-adjusted rate of return on capital is

calculated as:

K RAROC

Capital and related concepts (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

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

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’

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

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

0

CR K k

Criticism of Basel I (cont.)

• Failure to differentiate between high-quality and quality assets within a particular asset classes (such

low-as commercial and industrial credit) contributed to a steady increase in the credit risk of bank loan

portfolios

(cont.)

Criticism of Basel I (cont.)

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

Criticism of Basel I (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

(cont.)

Criticism of Basel I (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

Criticism of Basel I (cont.)

• The Accord gives very limited attention to credit

risk mitigation despite the availability of risk

management tools such as credit derivatives

(cont.)

Criticism of Basel I (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

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

• 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

The capital ratio under Basel II

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

08

0

OR MR

CR

K k

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

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

(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

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

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:

y K

n i i

1

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:

The Betas of business lines

Calculating capital against

operational risk under Basel II

(cont.)

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

(cont.)

Calculating capital against

operational risk under Basel II

(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)

Calculating capital against

operational risk under Basel II

(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

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

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

(cont.)

Criticism of Basel II (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

Criticism of Basel II (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

(cont.)

Criticism of Basel II (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