Banking Regulation: An introduction. By A V Vedpuriswar

Transcription

1 Banking Regulation: An introduction By A V Vedpuriswar June 27, 2018

2 Thus small depositors across the world are protected by deposit 1 insurance. Introduction(1) For all their prestige and high profile, banks are fragile institutions. They contribute to systemic risk in the economy. If one bank collapses, other banks can also get affected by the general mood of uncertainty and panic. It is generally accepted that banking crises must be prevented. The costs of a bank failure to society are enormous and exceed the private costs to individual financial institutions. Banks borrow short term and lend long term, creating a asset liability mismatch. If all depositors demand their money back at the same time, even healthy banks will get into trouble and not be able to meet their liquidity needs.

3 Introduction (2) In most countries depositors will get back their money, up to specified amounts, even if a bank goes bankrupt. But deposit insurance implies moral hazard. Depositors have less incentive to monitor a bank. Banks can take reckless lending decisions in a bid to boost returns for shareholders. Banks are also highly leveraged institutions. They keep large amounts of debt and small amounts of equity on their balance sheet. That is how they provide good returns to shareholders. But leverage can create serious problems during downturns. Many banks also trade risky assets. All these reasons explain why banking is highly regulated. 2

4 Micro and Macro Prudential regulation(1) A combination of micro and macro prudential regulation is needed for the proper functioning of banks. Micro prudential regulation is concerned with factors that affect the stability of individual institutions. The regulation of an individual financial institution would depend on its size, degree of leverage and interconnectedness with the rest of the system. Macro-prudential regulation is concerned with factors that affect the stability of the financial system as a whole. A critical focus of macro-prudential regulation is cyclicality. Regulation must discourage risk taking in a boom. Regulation must incentivize banks to take risk in a downturn. 3

5 Micro and Macro Prudential regulation(2) Making individual banks safe is not enough. In trying to make themselves safer, banks can behave in ways that collectively undermine the system. For example, it makes sense for a bank to sell an asset when the price of risk increases. But if many banks act in this way, the asset price will collapse, forcing institutions to reduce their positions further. This in turn may lead to a general decline in asset prices, and enhanced correlation and volatility in asset markets. 4

6 The Basel framework: A Historical perspective Till the Basel framework came into practice, banking regulation across the world was pretty much conducted on a country by country basis. Definitions and capital adequacy ratios varied from country to country. Basel I refers to the first round of deliberations by central bankers from around the world. In 1988, the Basel Committee on Banking Supervision (BCBS), published a set of minimum capital requirements for banks. This is also known as the 1988 Basel Accord. Basel I primarily covered credit risk. 5

7 The collapse of Herstatt Bank The BCBS was formed in response to the messy liquidation of Germany s Herstatt Bank in On 26 June 1974, a number of banks had remitted Deutsche Marks to Herstatt in exchange for dollar payments deliverable in New York. Due to differences in the time zones, there was a lag in the remittance of dollars. And before the dollar payments could be effected in New York, the Herstatt Bank was liquidated by German regulators. This incident prompted the G-10 nations to form BCBS in late

8 Basel I (1) Basel I was primarily focused on credit risk and appropriate risk weighting of assets. Assets of banks were grouped in different categories according to credit risk, carrying risk weights of : 0% (eg cash, bullion, home country debt like Treasuries), 20% (eg mortgage backed securities (MBS) with the highest AAA rating), 50% (eg municipal revenue bonds, residential mortgages), 100% (eg most corporate debt) Banks were required to hold capital equal to 8% of their riskweighted assets (RWA). This was called the Cooke ratio. At least 50% of the capital had to be Tier 1. The Assets/ Capital ratio had to be less than 20. Assets included off-balance sheet items that were direct credit substitutes such as letters of credit and guarantees. 7

9 Basel I (2) Tier 1 Capital, the most reliable form of capital, included common equity, non-cumulative perpetual preferred shares. Tier 2 Capital, the second most reliable form of capital, included cumulative preferred stock, certain types of 99-year debentures, subordinated debt with an original life of more than 5 years. Tier 2 capital is divided into two tiers. The upper tier includes undisclosed reserves, revaluation reserves, undated subordinated debt and general provisions. The lower tier includes hybrid instruments and subordinated debt. The 1996 amendment required banks to measure and hold capital for market risk for all instruments in the trading book including those off balance sheet. Tier 3 capital which included short term subordinated debt and undisclosed reserves and general loss reserves was introduced under Basle II and withdrawn later. 8

10 Basel II : An overview Basel II was initially published in June Implementation began in Basel II tried to ensure that a bank had adequate capital for the risks relating to its lending, investment and trading activities. Basel II was more comprehensive than Basel 1 and took into account credit, market and operational risks. Basel II identified 3 pillars: Capital Adequacy Banks must have enough capital to cope with risks. Supervisory Review Supervisors must be equipped to deal with risk more proactively. Market Discipline. Banks should make better disclosures about risk and capital management. 9

11 Development of Basel Requirements

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13 Credit Risk- The standardized approach The standardized approach, extends the approach to capital weights used in Basel I to include market-based rating agencies. Claims on sovereigns Credit AAA to BBB+ to A+ to A- BB+ to B- Below B- unrated Assessment AA- BBB- Risk Weight 0% 20% 50% 100% 150% 100% Claims on banks and securities companies Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- unrated Risk Weight 20% 50% 100% 100% 150% 100% Claims on corporates Credit Assessment AAA to AA- A+ to A- BBB+ to BB- Below BB- unrated Risk Weight 20% 50% 100% 150% 100% 12

14 Credit Risk the Internal Ratings Based Approaches (1) Basel II proposes two alternate approaches toward risk-weighting capital, known as Internal Ratings Based Approach, or IRB. These approaches encourage banks to create their own internal systems to rate risk with the help of regulators. The first internal ratings based approach is known as the Foundation IRB. Banks, with the approval of regulators, can develop probability of default models that provide in-house risk weightings for loan books. Regulators provide the assumptions in these models, namely the probability of default, the exposure at default, and the maturity risk associated with each type of asset. 13

15 Credit Risk The Internal Ratings Based Approaches (2) The second internal ratings based approach, Advanced IRB, is essentially the same as Foundation IRB, except for one important difference. The banks themselves rather than regulators determine the assumptions of proprietary credit default models. Therefore, only the largest banks with the most complex modes can use this standard. 14

16 Market Risk Basel II makes a clear distinction between fixed income and other products such as equity, commodity, and foreign exchange vehicles. Basle 2 also separates the two principal risks that contribute to overall market risk: interest rate and volatility risk. For fixed income assets, value at risk (VAR) is proposed. Banks can develop their own calculations to determine the reserves needed to protect against interest rate and volatility risk for fixed income assets on a position-by-position basis. For banks that cannot or chose not to adopt VAR models, Basel II recommends two separate risk protection methodologies. For interest rate risk, the risk that interest rates may fluctuate and decrease the value of a fixed-income asset, reserves are tied to the maturity of the asset. 15

17 Market Risk : Simplified Approach Basel II s risk weightings for all other market-based assets, such as stocks, commodities, currencies, and hybrid instruments, is based on a second, separate group of methodologies. The first group of methodologies is called the Simplified Approach. This approach divides assets by type, maturity, volatility, and origin and assigns risk weights from 2.25% for the least risky assets to 100% for the most risky assets. 16

18 Market Risk : Scenario Analysis. The second approach is called Scenario Analysis. Here, risk weights are not grouped according to the cosmetic features of an asset. Risk weights are allocated according to the possible scenarios assets may face in each country s markets. This approach, while much more complex than the Simplified Approach, is much less conservative and therefore more profitable for a bank. 17

19 Market Risk : Internal Model Approach The Internal Model Approach, or IMA encourages banks to develop their own internal models to calculate market risk on a case-by-case basis. On average, the IMA is seen to be the most complex, least conservative, and most profitable of the approaches toward market risk modeling. 18

20 Operational Risk: The Basic Indicator Approach The Basic Indicator Approach, recommends that banks hold capital equal to fifteen percent of the average gross income earned by a bank in the past three years. Regulators are allowed to adjust the 15% number according to their risk assessment of each bank. 19

21 Operational Risk: The Standardized Approach The Standardized Approach, divides a bank by its business lines to determine the amount of cash it must have on hand to protect itself against operational risk. Each line is weighted by its relative size within the company to create the percentage of assets the bank must hold. Business Line Corporate finance 18% Trading and sales 18% Retail banking 12% Commercial banking 15% Payment and settlement 18% Agency services 15% Asset Management 12% Retail Brokerage 12% Beta Factor 20

22 Operational Risk: The Advanced Measurement Approach The Advanced Measurement Approach, is much less arbitrary than its rival methodologies. On the other hand, it is much more demanding for regulators and banks alike. This method allows banks to develop their own reserve calculations for operational risks. Regulators, of course, must approve the final results of these models. 21

23 Basel 2.5 As the sub prime crisis unfolded, changes were felt necessary in the calculation of capital for market risk in the Basel II framework. In April 2008, BCBS announced a series of changes to the Basel II framework as an immediate response to the financial crisis. These enhancements, referred to as Basel 2.5 or as Basel II Enhanced mostly affected the definition of the capital and the riskweighting rules for credit risk, market risk and concentration risk. Changes to Operational Risk remain minimal. The changes proposed were : Stressed VaR Incremental Risk Charge Comprehensive Risk measure 22

24 Stressed Value at Risk This is superior to the traditional VAR measure. Stressed VAR is calculated for a one year period of stressed market conditions. Banks calculate the usual VAR based on historical data. They also calculate the stressed VAR. An average of the two VARs is worked out to arrive at the capital needs. 23

25 Incremental Risk Charge Banks have tended to move assets around from the banking book to the trading book to reduce capital requirements. Market Risk for trading book is typically measured as 99% 10 day VAR. IRC ensures that products such as bonds and credit derivatives in the trading book have the same capital requirement that they would if they were in the banking book. IRC requires banks to calculate a one year 99.9% VAR for losses from credit sensitive products in the trading book. 24

26 Comprehensive Risk Measure Instruments such as asset backed securities and collateralized debt obligations are sensitive to the correlation between the default risks of different assets. CRM tries to ensure that sufficient capital is kept for instruments in the trading book that are sensitive to credit default correlations CRM is a single capital charge replacing the incremental risk charge and the specific risk charge for instruments dependent on credit correlation. 25

27 Basel III (1) Basel III was agreed upon by the BCBS members in It is expected to be implemented by 31 March Basel III is a response to the gaps in financial regulation revealed by the global financial crisis of Basel III focuses primarily on the risk of a run on the bank. Basel III stipulates higher quality and levels of capital, lower leverage and greater liquidity. Basel III does not, for the most part, supersede Basel I and Basel II and will work alongside them. 26

28 Basel III ( 2) The original Basel III rule required banks to fund their risk weighted assets with 4.5% of common equity (up from 2% in Basel II). This Common Equity Tier 1 (CET1) ratio of 4.5% must be maintained at all times by the bank. Minimum Tier 1 capital of 6%, consists of 4.5% of CET1, plus an extra 1.5% of Additional Tier 1 (AT1). ( In Basel II, Tier 1 was 4%.) Basel III prescribes a mandatory capital conservation buffer, equivalent to 2.5% of risk-weighted assets. Basel III also calls for a discretionary counter cyclical buffer allowing national regulators to require up to an additional 2.5% of CET1 capital during periods of high credit growth. In short, banks may have to hold a total of 7-9.5% CET1 capital, from 2019 onwards. 27

29 Basel 4 Compared to Basel III, Basel 4 is expected to have more stringent capital requirements and greater financial disclosure. Basel 4 will require banks to meet higher maximum leverage ratios. Basel 4 is likely to emphasise simpler or standardised models, rather than banks' internal models, for calculation of capital requirements. Basel 4 may insist on a more detailed disclosure of reserves and other financial statistics. 28

30 Focus on liquidity in Basel III Basel III introduces two liquidity ratios. Liquidity Coverage Ratio. Net Stable Funding Ratio. 29

31 Liquidity Coverage Ratio (1) Under the Liquidity Coverage Ratio (LCR), banks will be required to maintain a specified level of cash and liquid assets that would be available to survive a 30-day severe downturn. A bank s unencumbered high-quality liquid assets must equal or exceed 100% of its total net cash outflows over a 30-day period. Qualifying assets for HQLA are Level 1 assets, Level 2A assets, and Level 2B assets. (See next slide for more details.) The combination of Level 2A and 2B assets cannot exceed 40% of HQLA, after accounting for haircuts. Level 2B assets are capped at 15% of HQLA. 30

32 Liquidity Coverage Ratio (2) 31

33 Net Stable Funding Ratio (1) NSFR equals available stable funding (ASF) divided by required stable funding (RSF). ASF is a measure of a bank s liabilities that regulators believe to be reliable over a one-year time horizon. ASF equals the weighted sum of an institution s capital and liabilities after the application of an ASF factor. Regulatory capital and long term debt have an ASF factor of 100%. Retail and small business deposits have an ASF factor of 90-95%. Short term borrowings have an ASF factor of 0-50%. Deposits from other banks have an ASF factor of 0%. 32

34 Net Stable Funding Ratio (2) RSF is the portion of the bank s assets and off-balance sheet commitments that are illiquid over a one-year time horizon thereby requiring a more stable funding source. Cash, central bank reserves have a 0% RSF factor. Unencumbered Level 1 assets. receive a low 5% RSF factor. These include US Treasuries, foreign withdrawal reserves, and certain liquid and readily marketable US government/sovereign entity securities. Illiquid assets command a % RSF factor. 33

35 Net Stable Funding Ratio (3) NSFR is designed to promote more medium- and long-term funding of banking organizations. NSFR tries to ensure that long-term assets are funded with a minimum amount of stable liabilities in relation to their liquidity risk profiles. NSFR tries to limit over-reliance on short-term wholesale funding during times of buoyant market liquidity. By holding more stable and longer term funding sources against their least liquid assets, banks can reduce maturity transformation risk. NSFR aims at reducing the need for emergency liquidity support from central banks in a crisis. 34

36 Focus on leverage: Supplementary leverage ratio The supplementary leverage ratio (SLR) was first introduced in SLR means banks must hold capital against gross balance sheet exposure, in addition to off-balance sheet exposures (e.g., derivatives exposure) without risk weighting. SLR is calculated by taking a bank s Tier 1 capital and dividing it by its total leverage exposure, which includes all on-balance sheet assets and many off-balance sheet exposures. Exposure includes on-balance sheet assets, derivatives, repostyle transaction exposures and other off-balance sheet exposures. 35

37 Focus on bank failures: Total Loss Absorbing Capacity (TLAC) TLAC is intended to ensure that banks have an adequate mix of liabilities and equity to cover potential losses in the event of failure and do not have to be bailed out with taxpayer funds. TLAC aims at preventing systemic disruption to the financial system. TLAC requires additional bail-in-able capacity, in the form of unsecured debt, that can be written down or converted into equity during the resolution of a systemically important bank without disrupting the critical functions. Initial TLAC proposals count unsecured debt, Preferred stock/additional Tier 1(AT1), and CET1 in the numerator. Qualifying unsecured debt includes unsecured senior and subordinated debt issued by the parent holding company with at least one year remaining until maturity. 36

38 Contingent Convertible Bonds Contingent Convertible bonds are bonds which automatically get converted into equity if certain conditions are satisfied. Lloyds Banking Group, Rabobank and Credit Suisse were among the first banks to issue CoCo bonds. In Feb 2011, Credit Suisse issued such bonds to middle eastern investors. The bonds convert automatically into equity if the following conditions are fulfilled: Tier 1 Capital of Credit Suisse falls below 7% of risk weighted assets. The Swiss bank regulator determines that the bank requires government support to prevent it from becoming insolvent. Later Credit Suisse made a public issue of similar bonds. 37

39 Focus on bank failures: Global Systemically Important banks The failure of a large, globally active financial institution can send shocks through the financial system. Some banks have been designated Global Systemically Important Banks and are covered by stronger regulation. Regulation attempts to reduce the probability of failure of G- SIBs by increasing their going-concern loss absorbency. Regulation also reduces the impact of failure of G-SIBs, by improving global recovery and resolution frameworks. G-SIBs are required to hold extra Tier 1 equity capital between 1% and 3.5% of risk-weighted assets. There are also proposals from the regulators concerning the total loss absorbing capacity (TLAC) of G-SIBs. 38

40 Comprehensive Capital Analysis and Review (1) Stress testing procedures have been strengthened. The annual CCAR process of the US Fed requires banks with over $50bn in assets to demonstrate sufficient capital to withstand a (hypothetical) highly stressful operating environment, while executing on its submitted capital plan. A capital plan may include not just plans for dividends and stock repurchases, but also potential acquisitions, divestitures, and more general balance sheet actions (e.g., calling debt). The test is divided into two portions: quantitative assessment of a bank s post-stress capital adequacy; qualitative assessment of the capital plan itself, and importantly, the practices and processes used by the banks to assess its capital needs. 39

41 Comprehensive Capital Analysis and Review (2) Each year, US banks submit a capital plan with expected uses and sources of capital over a 9-quarter horizon, under the following three scenarios provided by the Fed a supervisory baseline scenario; a supervisory adverse scenario; a supervisory severely adverse scenario this being the scenario the banks must withstand in order to get approval for capital plans. The Fed also requires submission under two bank-defined scenarios (a baseline and a stress), designed to help regulators understand each individual bank s unique vulnerabilities. 40

42 Comprehensive Capital Analysis and Review (3) 41

43 Other recent developments The US Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank), passed in 2010 : requires periodic stress testing for many institutions, mandates most derivatives trading to be conducted on exchanges, bans proprietary trading by banking institutions, creates a new Consumer Financial Protection Bureau, Financial Stability Oversight Council, and Office of Financial Research. The European Market Infrastructure Regulation requires many derivatives contracts to be cleared through central counterparties. The United Kingdom has reorganized its financial regulatory agencies and created a new agency for consumer protection. In many countries, the frequency and intensity of regulatory examinations and related enforcement activities have also increased. There is a proposal to centralize supervision for European banks under the European Central Bank. 42

44 Concluding Notes: Basle 4 approved With the approval of Basel IV in early December 2017, regulators seem to have put the finishing touch on post-crisis reforms. At the global level, policymakers have effectively drawn a line under dealing with the problems of the past. If the same problems were to arise again, banks and the financial system as a whole would be better prepared to deal with them. Banks are more resilient, and the financial system is more robust. Higher going-concern capital makes banks less likely to fail while greater gone-concern capital makes them easier to resolve. Ref: EY 43

45 Concluding Notes: Risk weighted assets Basel IV revises the standardized approach that banks should use to calculate the risk weights for their exposures. The new rules limit the ability of banks to use their own models. The bank s risk weighted assets (RWA) can be no lower than 72.5% of the RWA calculated under the revised standardized approach, even if the bank s own models produce a lower result. But this floor will not begin to take effect until 2022 and will only become fully effective in 2027 provided jurisdictions actually implement the Basel Committee s decisions. Ref: EY 44

46 Concluding Notes: Stress tests Stress tests conducted by supervisors will be the binding constraint on banks. Stress tests will determine whether banks will have enough capital even if macroeconomic and market conditions deteriorate. In case of stress test failures, the supervisor may require the bank to stop dividends and distributions. For extreme shortfalls, the supervisor may require the bank to raise more capital immediately. Thus, the stress test effectively sets the capital requirement. Key issues for the 2018 stress tests are likely to include: the probable increase in interest rates, the shift in accounting (e.g., IFRS 9) to provisioning for credit risk on the basis of expected loss the impact of tax reform in the US and other jurisdictions. 45

47 Concluding Notes: Liquidity The post-crisis reforms have increased liquidity requirements. Key issue for 2018 is the implementation of the net stable funding ratio. Supervisors will expect banks to make significant progress in intraday liquidity reporting as well as in incorporating asset encumbrance and re-hypothecation into their liquidity models and funding plans. Ref: EY 46

48 Concluding Notes: Digital disruption Additional pressure on banks is likely to come as regulators reset rules in response to new technology. Governments are now actively promoting the entry of technologybased firms (FinTech) as a means to disrupt traditional banking and introduce more competition into banking services. Various supervisory authorities have created regulatory sandboxes in which a firm may play or experiment to find a profitable business model that is compliant with regulation. Open banking takes this approach one step further. Ref: EY 47

49 Concluding Notes: Digital disruption Under the EU s Second Payment Services Directive (PSD2), banks have to make available to third-party providers any data pertaining to the customer that the customer authorizes the bank to disclose. A separate measure, the General Data Protection Regulation (GDPR), requires firms in the EU, as well as firms in third countries dealing with EU persons, to assemble the data pertaining to each person. Together, these measures facilitate the ability of FinTech firms to acquire customers and grow their businesses quickly. Ref: EY 48

50 Concluding Notes: Outlook for banks In early 2018, the immediate outlook for banks is favorable: GDP growth is picking up and interest rates may rise while corporate tax rates in US, UK and other areas will decline. With the pruning of the legacy list of crisis-related compliance cases, banks may reduce the amount to be put aside for fines and settlements. But these favorable conditions are unlikely to last. At some point, the economic cycle will turn down again. And sooner, rather than later, technology will disrupt banking and finance, just as it has disrupted other industries. Ref: EY 49

51 Concluding Notes: Outlook for banks The penalties for failure are likely to be swifter and harsher. Thanks to resolution reform, investors, not taxpayers, will bear the cost of bank failures. The rule is likely to be bail-in, not bailout. Consequently, investors, like supervisors, will ask whether the bank has a business model that is strong enough to survive a possible downturn and also technology disruption. Ref: EY 50