4WEEK FOUR
GLOBAL REGULATION OF BANKS
Introduction Meaning of Bank RegulationThe Principles and Requirements of Bank RegulationsTypes of Bank Regulation International Regulations
Prudential Regulation Basel I Basel II Basel III
Drawbacks of Regulation Conclusion
OUTLINE
Outline the rational for banking regulationAppreciate the diff erent types of regulationExplain the causes of the persistent changes in bank
regulations Identify the general principles and requirement of
bank regulationAssess the shortcomings and costs of bank
regulations
OBJECTIVES
This lecture focuses on the rationale for the regulation of both national and international banks.
The banking industry is relatively the most regulated. Prudential RegulationBasel I, II, and III
The lecture focuses on the nature and types of bank regulation and the pros and cons of such regulations
INTRODUCTION
Bank Regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines.
These government regulations or controls are stricter than those on business in generals. The justification for stricter controls is that; bank failures
may disrupt the rest for the financial system in a way that can affect other businesses.
Bank provide intermediation services serves as the backbone of every economy.
The failure of this function will have rippling effects on the economy hence the tight regulation.
MEANING OF BANK REGULATION
The regulator is normally a bank and therefore a participant in the market. This is very uncommon in the regulation of other businesses.
The business of banking gives birth to a contractual relationship between the bank and customers. Agency issues or problems with this relationship makes it imperative for government to regulate the market.
THE RATIONALE FOR REGULATION
The Rationale:To protect the bankers and customersTo ensure prudence in the banking industryTo reduce systemic risk To avoid misuse of banks (Money laundering activities, terrorist financing etc)
To protect the banking confidentialityTo allocate credit to most needed sector of the economy
To check the abuse of Oligopolistic and Monopoly powers
THE RATIONALE FOR REGULATION
General principles of bank regulation are the canons upon which bank regulation is carried out. These have been developed over time by the Basel Committee on Banking Supervision.
These are: Minimum Capital Requirements Supervisory Review Market Discipline
GENERAL PRINCIPLES OF BANK REGULATION
Minimum CapitalThis requirement is normally imposed to promote the objective of the regulator.
The requirement differs for different classes of financial institutions.
The requirement cut across all issues relating to capital of banks Minimum Capital Minimum Capital Ratio Approval of banks business plan Shareholders’ requirements etc
GENERAL PRINCIPLES OF BANK REGULATION
Supervisory Review Requirement Licensing requirements prior to commencement of business Giving directives Imposition of penalties for breaching laws
Market Discipline Disclosure of financial and relevant non-financial
information This enables the regulator to assess the financial health of
the commercial banks. It also helps other stakeholders to reasonably make
investment decisions on the basis of the risk profile of the banks
GENERAL PRINCIPLES OF BANK REGULATION
Capital RequirementsReserve RequirementsCorporate Governance RequirementFinancial Reporting and Disclosure RequirementsCredit Rating RequirementsLarge Exposure RequirementsRelated Party Exposure Restrictions
REQUIREMENTS OF BANK REGULATION
Structural (or Systemic) RegulationPrudential RegulationConduct of Business Regulation
Structural (Systemic) Regulation: Concerned with safety and soundness of the financial
system. Considers all public policy regulation designed to
avoid bank runs Normally in the form of government safety nets:
Deposit insurance Lender of Last Resort
TYPES OF BANKING REGULATION
Prudential RegulationConcerned with consumer protection Involves the regulations of deposit-taking institutions Supervision Risk-taking limits etc
Conduct of Business RegulationFocuses on how banks and other financial institutions conduct their business
Relates to Information disclosureFair business practicesCompetence
TYPES OF BANKING REGULATION
The growth of banks and emergence of banks that operate in multiple jurisdictions have called for bank regulation on a global scale.
Key issues in this arena include:The complexity of international banking regulation
The level of oversight requiredThe regulatory bodyHow should the implementation be done and where?
Prudential RegulationBasel Accord
INTERNATIONAL BANKING REGULATION
Prudential Regulation in the International Arena:Prudential regulation is an appropriate legal framework for financial operations which is a significant contributor to preventing financial sector problems.
There is the need for global coordination of prudential banking regulation as a result of:Policy makers, bank management, and regulators recognition of the fact that the stability of the global financial system can compromised
Where a branch is located in other jurisdiction, who has supervisory authority?
Global regulation, when implemented will standardize bank operations and level the competitive playing field
INTERNATIONAL BANKING REGULATION
Basel AccordBasel IBasel IIBasel III
Basel IA round table of central bankers from around the world in 1988
The Basel Committee was formed in response to the messy liquidation of a Cologne-based bank (Herstatt) in 1974.
The deliberations were lead by the Bank of International Settlements (BIS) in Basel, Switzerland.
INTERNATIONAL BANKING REGULATION
Basel I, Main Framework Focused on credit risk Assets of banks were grouped into five categories with
risk weights 0%, 10%, 20%, 30%, 40%, to 100% Banks with international presence are required to hold
capital equal to 8% of risk weighted assets Implemented progressively among G-10 nations. Several other countries including Ghana adopted the
core principles of the Basel AccordPurpose of Basel I
Strengthen the stability of international banking system
To set up a fair and consistent international banking system in order to decrease competitive inequality among international banks
INTERNATIONAL BANKING REGULATION
Basel I, Major AchievementA working definition of bank capital ratioThis definition of bank capital has been universally accepted
Basel I – Capital RequirementCapital Ratio by definition was categorized into two tiers; Tier 1 Tier 2
INTERNATIONAL BANKING REGULATION
Basel I – Capital Requirement: Step One (Definition of Capital)Tier 1 Capital (Core Capital)
Include stock issue and declared reserves.Tier 2 (supplementary Capital)
Includes gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (excess allowances for losses on loans and leases)
INTERNATIONAL BANKING REGULATION
Basel I – Capital Requirement: Step Two (Risk Weighting of Capital)Defined bank capital in terms of credit risk exposure of the bank
The level of credit risk exposure is determined by the risk weighted assets of the banks.
The accord identifies three types and level of credit risk exposure On-balance sheet risk Trading Off-balance sheet risk Non-trading off-balance sheet risk
INTERNATIONAL BANKING REGULATION
RISK WEIGHTS ASSET CLASS
0% Cash and gold held in the bank
20% Claims on OECD banksClaims issued by U.S government agenciesClaims on municipalities
50% Residential Mortgages
100% All other claims such as corporate bonds, less-developed countries debt.Claims on non-OECD banks, equities real estate, plant and equipment
INTERNATIONAL BANKING REGULATION
Example on risk weights
INTERNATIONAL BANKING REGULATION
Asset category Risk weight
Capital ratio
Amount RWA Capital
Treasury bond 0% 8% $1000 $0 $0
Municipal bond 20% 8% $1000 $200 $16
Residential mortgage
50% 8% $1000 $500 $40
Unsecured loan 100% 8% $1000 $1000 $80
Revision of Basel I in 1996 To include Market RiskMarket risk emanates from four economic variables Interest rates Foreign exchange Equities commodities
This risk is calculated in two different ways: Standardized Basel Model Value at Risk (VaR)
INTERNATIONAL BANKING REGULATION
Pitfalls in Basel ILimited Differentiation of Credit RiskStatic Measure of Default riskNo recognition of term structure on credit riskSimplified calculations of potential future counterparty risk
Lack of recognition of portfolio diversification effects
The culmination of these factors lead to the introduction of the Basel II
INTERNATIONAL BANKING REGULATION
Basel II Second of the Basel Accords published in 2004
Aimed at: Ensuring that capital allocation is more risk sensitive Separating operational risk from credit risk, and
quantifying both risks Aligning economic and regulatory capital more closely
to reduce the scope for regulatory arbitrage
INTERNATIONAL BANKING REGULATION
Basel II in OperationFundamentally based on three pillars, same as those contained in Basel II, but deeper in term of coverage
Minimum capital Requirements (1), Supervisory (2) Review, and Market Discipline (3)
Basel I dealt with only one aspect of these pillars.
Basel II introduces more dimensions to each of the canons or pillars.
INTERNATIONAL BANKING REGULATION
Pillar 1 Maintenance of Regulatory Capital This is calculated for three major risks: Credit Risk,
Operational Risk, and Market Risk
INTERNATIONAL BANKING REGULATION
Risk Measurement
Credit Risk Standardized Approach, Foundation IRB and Advanced IRB
Operational Risk Basic Indicator Approach, Standardized Approach
Market Risk Value At Risk
Pillar 2Deals with regulatory response to Pillar 1. Provides a framework for dealing with residual risks: systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk, and legal risk.
Introduced more forward looking approach to capital supervision by encouraging banks to identify potential risks they may face in the future and try to mange them.
INTERNATIONAL BANKING REGULATION
Basel IIIThese are ongoing new updates to the Basel Accord
The draft Basel III include: Tighter definition of tier 1 capital The introduction of leverage ratio A framework for counter-cyclical capital buffers Measures to limit counter-party credit risk, and Short and medium term quantitative liquidity ratio
INTERNATIONAL BANKING REGULATION
Regulation comes at a cost despite its benefits. These include:Cost of administering and monitoringCost of supervisionPoor record keepingControl of interest ratesCapital requirements Impediment to growth and economic development
DRAWBACKS OF REGULATIONS
This lecture reviewed the issue of bank regulation
Began with a rationale for bank regulationFocused on regulation in the local contextFocused on regulation in the international
arena
CONCLUSIONS
4END OF LECTURE
FOURQUESTIONS?