Revision Notes 2

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Basel II Three Pillars Approach: In response to the criticism of Basel I and its amendment, a number

of changes were made

More option for banks to determine its capital charge for risk

improved credit risk weighting

Recognition of operational risk

Subject to National supervisory approval, banks will be allowed to use their own internal rating models as a measurement of risk

Introduction of "Supervisory" and "Market Disciple" pillars

The fundamental ratio to be computed in Basel II for the minimum capital requirements is:

Capital (tier 1 and 2) / Amended credit risk + market risk + operational risk

Criticism of Basel II:

The internal approach to forecasting risk, based on VaR, neglects crucial aspects of risk in the financial markets. It is assumed that the bank’s own actions, based on its forecast of future volatility, does

not affect this volatility. Financial risk is created by the market behavior of all agents,

including the banks which are forecasting their risk. This leads to the contagion phenomena known

from financial crises, where expectation of falling prices triggers more sales with an increased down-

turn of prices as result

Too many rules, excessive prescription

Pro-Cylclical - A condition where value of goods and services tend to move in correlation with the economy

Failure to recognise benefits of diversification. Overestimating risk of lending to developing countries.

High cost of implementation

The main points of Basel III:

Increased capital reserves: In addition to the existing system of capital regulation, two new Items are added, namely

capital buffer, which comes into force in cases where the activities of the bank increase very rapidly

countercyclical buffer, which should prevent the tendency that capital reserves according to the existing rules will be small during booms and large in slumps

Leverage rule: This is a rule which is aimed to prevent too small capital reserves even in cases where assets have low risk and therefore would not give rise to building up reserves by using the existing rules

Liquidity rules: High quality assets should be large enough to cover one month net cash out- flow.

The Financial Services and Markets Act was passed in 2000. It established the FSA as the sole regulator of all UK financial institutions.

FSA Goals:

Maintain confidence in the UK financial system

Educate the public with risk associated with different forms of investing

Protect consumers but encourage them to take responsibility for their financial decisions

Reduce financial crime

FSA Risk Based Approach To Regulation:

The core of the operating framework for the FSA is sometimes described by the acronym, ARROW, which stands for Advanced, Risk-Responsive Operating Framework. ARROW defines the essence of the FSA's risk-based approach to regulating financial markets, services, and firms.

As supervisor for all financial

institutions, the FSA is trying to move away from specific rules for each of

the different types of financial institutions

The RTO Approach (risk to our

objectives) involves computing a score for each firm supervised by the FSA.

The score shows the probability of

the firm having an impact on the ability of the FSA to meet its statutory

objectives

The score is obtained from a simple

equation:

Impact Score = Impact of the

problem X Probability of the problem arising

A firm’s score determine how

closely the FSA monitors it

The FSA (Financial Services Authority) is an independent, non-governmental body that regulates the financial services industry in the UK, including most financial services markets, exchanges and firms. It sets standards to which such organizations must comply and can take action against them should they fail to meet required standards.

Bank

structure and regulation in the USA:

Large number of banks, banking

market not concentrated

Federal Reserve System: 12 Federal

Reserve Banks

By the 1990s, 92% of banks were

owned by BHCs (any firm holding at least 25% of the voting stock of a bank

subsidiary); BHCs could circumvent the interstate branching laws, via

“multi-bank” holding companies

The

US Financial Holding Companies:

Supervision of the FHCs is functional, i.e. insurance firms continue to

be supervised by the Department of Trade and Industry, investment banks by the

Securities and Exchange Commission, and the banking subsidiaries by the Federal

Reserve Bank

Firewall between commercial

securities subsidiaries: they are prohibited from cross marketing with each

other, and a bank can sell but may not underwrite insurance

US

Branch Banking Regulations:

To discourage concentration in

banking sector there were limitation in setting up banks’ branches, mainly

interstate branching

Each state had different degrees of

restriction

Bank Holding Companies might

establish bank subsidiaries in each state, but each was an individual legal

entity, which had to be separately capitalised

In 1994 the Riegle Neal Interstate Banking and Branching Efficiency Act largely

eliminated these restrictions

To prevent excessive concentration,

a BHC/FHC may not hold more than 30% of total deposits in any given state, and

10% nationally

Deposit

Insurance in US:

All member banks of the Federal

Reserve System are required to join the Federal Deposit Insurance Corporation

(FDIC)

The FDIC member banks pay an

insurance premium, which is used to purchase securities to provide the

insurance fund with a steam of revenue

The FDIC insures deposits of up to

$ 100,000; deposits are fully insuranced and it can creates moral hazard

problems

Premia are linked to capital at risk

Bank

Structure in Japan:

Keiretsu system

A Keiretsu is a group of companies

with cross-shareholdings and shared directorships which normally include a

bank, trust company, insurance firm and a major industrial concern (i.e. cars,

steel)

The bank supplies services to the

other keiretsu members, including loans

The Ministry of Finance (MoF) was the key regulator through

three bureaux: Banking, Securities and International Finance

Bank

Regulation in Japan:

MoF’s responsibilities included all

aspects of financial institution supervision: examination of financial firms,

control of interest rates and products, supervision of the deposit protection

scheme, setting the rules on activities to be undertaken by financial firms

Bank of Japan was responsible for

the implementation of monetary policy, but under the influence of MoF

High protected market

Japanese companies largely

dependant on banks’ loans

Theories (Functions) for Financial Intermediation:

Delegated Monitoring

Information Production

Liquidity Transformation

Consumption smoothing

Commitment Mechanisms

Basel II & III

Bank Structure and Regulation

General