© k.cuthbertson and d.nitzsche lecture regulation of financial institutions 1/9/2001 financial...
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![Page 1: © K.Cuthbertson and D.Nitzsche LECTURE REGULATION OF FINANCIAL INSTITUTIONS 1/9/2001 FINANCIAL ENGINEERING: DERIVATIVES AND RISK MANAGEMENT (J. Wiley,](https://reader038.vdocument.in/reader038/viewer/2022110116/5517f0f6550346c1568b4b69/html5/thumbnails/1.jpg)
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LECTURE REGULATION OF FINANCIAL INSTITUTIONS
1/9/2001
FINANCIAL ENGINEERING:DERIVATIVES AND RISK MANAGEMENT(J. Wiley, 2001)
K. Cuthbertson and D. Nitzsche
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REASONS FOR REGULATION
TYPES OF RISK
REGULATORY FRAMEWORK
WHAT IS “CAPITAL” ?
TYPES OF RISK
BASLE (1988) ACCORD - CREDIT RISK
TOPICS
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1. MARKET FAILUREa)externalities
eg. bank run, credit crunch = systemic risk
b)market powereg. fixed commissions
monopoly/cartels (eg Japanese Banks)
REASONS FOR REGULATION
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2. OTHER REASONS
protection of payments system(BoE)
protection from fraud (FSA)
promotion of competition (FSA)
protection of small depositors (FSA)
education (FSA)
REASONS FOR REGULATION
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3. INFORMATION PROBLEMS
asymmetric information leads to deposit insurance
Fixed rate deposit insurance leads to problems of
adverse selection (eg. motor insurance, too many risky drivers)
moral hazard (eg. drives recklessly because he’s insured)
Regulator has principal-agent problem(can’t fully monitor behaviour, eg. drinking and driving, after providing insurance).
REASONS FOR REGULATION
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WHAT IS “CAPITAL” ?
Capital(Equity) =Shareholder’s funds + past retained profits
Capital
acts as like a “deductible” or “excess” on an
insurance policy
It is a financial “cushion” for the “bank”
Bank’s equity represents the amount the bank’s
assets may fall, such that the depositors could in
principle still sell off the remaining ‘good’ assets and
obtain the full face value of their deposits
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STYLISED BALANCE SHEET(S)HIGHLY (LOW) CAPITALISED BANK
ASSETS LIABILITIES
1.Cash Reserves
10 (10) Deposits 10 (90)
2.Securities 30 (30) Capital 90 (10)
3.Loans 60 (60)
100 (100) 100 (100)
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What Drives Financial Markets ?Rational Behaviour or :
PIGS
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TYPES OF RISK
Legal Risk : the risk that a contract is not enforced as expected
Liquidity Risk : lack of a counterparty to trade with in the time scale desired
Credit Risk : lack of funds available by the counterparty who then defaults
Operational Risk : origination, settlement and clearing of trades is mishandled (eg. faulty IT, fraud).
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Assimilation Risk : participants do not fully understand how assets are priced
Incentive Risk : remuneration packages which encourage excessive risk taking.
Market Risk : risk due to a fall in asset prices which involves ~
Model and estimation risk = Choosing the wrong model or the wrong estimation technique to estimate the ‘risk model’ (eg. assume niid returns)
TYPES OF RISK
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Nikkei Future (Leeson Loses)
12000
14000
16000
18000
20000
22000
24000
Buy
Close out\Sell
“ Five eights make $1.4bn ?“
Leeson’s Futures Trades on Nikkei225
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FINANCIAL “SCANDALS”
South Sea Bubble, Tulipmania Pensions Mis-selling (£1bn+) \ Maxwell(£400m)Barlow Clowes (Gov.Bonds)BCCI-1991 ( Drug Money / Laundering)Proctor and Gamble (Int Rate Derivatives)Orange County (Int Rate Derivatives, $7bn)Metallgeschellschaft (oil derivatives >$1bn)Barings ( Leeson -Derivatives, $1.4bn)Sumitomo ( Copper $1bn )Morgan Grenfell ( Asset Management, £240m) Nat West/UBS ( Derivatives £100m)LTCM ($4.4bn- Sept 98)
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OPEN PRISON ?
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Basle (1988) “Accord”
on Credit Risk
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TOPICS
BASLE (1988) ACCORD
Risk Weights
Equity-Assets Ratio/ Risk Adjusted Asset Ratio
Bank Capital: Tier I and II
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Basle (1988) Risk Weights
Risk Weights (0 ot 100%) given to all types of counterparty (e.g. OECD governments, corporates etc) and asset (e.g. bank loans, securities held)
Equity capital required for ‘credit risk’ is set at a min. = 8% of value of (risk weighted) total assets
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“RELATIVE RISK WEIGHTS
Zero %
20%
50%
100%
cash and gold bullion
claims on OECD central banks
claims on development banks
claims on other OECD banks
mortgages on residential property
claims on private sector (eg. bank loans)
claims on governments outside OECD
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RISK-ADJUSTED ASSETS RATIO, RAR
Risk Weights of wi= 10, 20 or 50 and 100% Ai = market value of bank’s assets
Risk Weighted Total Assets [1] RWTA = (wi/100) Ai
Risk Adjusted Assets Ratio, RAR [2] RAR = (Equity Capital /RWTA) x 100
Basle Accord requires RAR to be greater than 8%
The more Equity capital E, you hold (as proportion of total assets), the bigger “cushion” against potential losses
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SOLVENCY AND THE BASLE RATIO
Solvency requires:Tot Assets(TA)- Bad Debts(BD) >Deposits (D) TA - BD > D
But balance sheet gives TA=D +E
Hence solvency requires: E > BD or (E/TA) > (BD/TA)
(BD/TA)= proportion of Bad Debts (g)(E/TA) = Equity assets ratio
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SOLVENCY AND THE BASLE RATIO
Solvency requires:
The equity-assets ratio, EAR (= E/TA), exceeds the proportion of bad debts, g.
Risk Adjusted Assets Ratio RARReplace ‘equity-assets ratio’ with RAR
Solvency requires:
RAR > g (latter set at 8% by Basle)
g = proportion of bad debts
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BASLE/EC : BANK CAPITAL
Tier I Capitala) share capital/common stockb) cumulative retained earningsc) non-cumulative perpetual preference
sharesTier 2 Capitala) cumulative perpetual preference sharesb) undisclosed reserves b) revaluation reserves +hybrid debt/equity +
subordinated term debtNote: deductions for investments in other
banks and ‘goodwill’
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Basle 2000 Suggestions
Table B20.1 : Proposed Basle Credit Risk Weights (%)
CLAIM ON: AAA toAA-
A+ to A- BBB+ toBBB-
BB+ to B- BelowB-
Unrated
Sovereigns
Banks – Option 1*
Option 2†
Corporates
0
20
20
20
20
50
50
100
50
100
50
100
100
100
100
100
150
150
150
150
100
100
50
100
* Based on risk weighting of sovereign in which the bank is incorporated† Based on the assessment of the individual bank Claims on banks of a short original maturity e.g. less than six months, would receive a
weighting that is one category more favourable
Source: Basle Committee on Banking Supervision (Economist 5/12/99)
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OFF-BALANCE-SHEET ACTIVITIES
1. INCOME FROM FEESa) commissions on FX transactions
b) servicing mortgage-backed security c) guaranteeing debt securities d) backup lines of credit
2. NET POSITION IN FORWARD FOREIGN EXCHANGE
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ENDS LECTURE