© k.cuthbertson, d.nitzsche financial engineering: derivatives and risk management (j. wiley, 2001)...

© K.Cuthbertson, D.Nitzsche

FINANCIAL ENGINEERING:DERIVATIVES AND RISK MANAGEMENT(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

Lecture

Regulation in the UK and USA

Version 1/9/2001


Topics

Reasons for Concern

UK: Regulatory Framework

US: Regulatory Framework for Banks and S&Ls

US: Modernising the Financial System

1992 Onwards


Reasons for Concern

Increased global competition, narrowing of margins

More firms raise money from the capital markets, which leaves banks with less credit worthy companies

Collateral (e.g. in the form of land and buildings) less secure, banking crises associated with falling property prices (e.g. in Japan in the 1990s and Thailand in 1997/8)

Margins on lending have been squeezed by increased competition and the ending of cartels

The growth in ‘off balance sheet’ items, such as forwards and swaps has led to increased credit risk exposure.


UK REGULATORY FRAMEWORK


UK, REGULATORY FRAMEWORK

STRUCTURAL REGULATION

who is allowed to engage in activities“fit and proper persons”, capital base.

CONDUCT REGULATION

ensures ‘product quality’ eg. Good risk control, accounting, no misleading

information

FSA : Financial Services Authority~UK


REPUTATION EFFECT ? Self Regulation ?


Board of Banking supervision to assist the Governor of the Bank of England in his supervisory responsibilities.

To be licensed as a bank, requires a minimum level of paid up capital and those running the bank must be ‘fit and proper persons’.

Bank auditors should have close liaison with the supervisors and banks are legally obliged to report large exposures (eg. to a specific borrower).

UK Banking Act (1987):


Capital adequacy and liquidity ratios were to be monitored but there were no minimum mandatory targets to be set across the board.

As in the 1979 Banking Act, depositor protection was retained. (This is now currently at £20,000 per depositor, or 75% of a persons total deposits, whichever is the smaller).

‘CAMEL approach’: Capital Adequacy, Asset Quality, Management Quality, Earnings and Liquidity.

Adopted Basle Accord of 1988, for credit risk and principle of subordination

UK Banking Act (1987):


Loosened restrictions on the lending and depositsAllowed diversify (eg. selling insurance, buying and selling shares, entry into Estate Agency).

A (fixed maximum) proportion of lending could now be unsecured (rather than solely backed by property) and they could enter the wholesale deposit market for a proportion of their deposit funds.

UK Building Societies therefore became more like banks and they are now allowed to convert to full public liability companies (eg. Abbey National plc, Halifax plc).

UK Building Societies Act (1986)


Security and Investment Board (SIB). The SIB was to oversee and certify the rule books of a group of self-regulatory organisations (SROs).

If an individual (firm) is allowed to become a member of an SRO, then this becomes a ‘license to practice’. The rule books of the SROs were therefore the effective ‘entry hurdle’.

Regulatory Capture

Financial Services Act 1986


Took over the resposibilities of the Security and Investment Board (SIB) and the group of self-regulatory organisations (SROs).

Responsibility for regulation of banks and building societies also (later) transferred to FSA

FSA is now the ‘super regulator’

Overseas, compliance with Basle rules on market and credit risk for banks, as well as regulation of investment and life assurance funds.

Bank of England retains responsibility for ‘systemic risk’ in the banking system

Financial Services Authority, FSA (1999/2001)


US REGULATORY FRAMEWORK

FORBANKS AND S&L’s


USA : Bank and S&L Failures in 1980’s

S&L’s failed with huge losses to the taxpayer

Payouts from the Federal Savings and Loan Insurance Corporation (FSLIC), so it became insolvent.

The defaults in banking were less severe

numerous banks failed and again (some of) their deposits, covered by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (FDIC). The FDIC sustained losses in the 4 years to 1991 and also threatened to become insolvent.


Regulatory procedures

Corrective Action: only allow the bank to remain open if it can raise enough capital to satisfy minimum capital requirements within a reasonable period of time.

Forbearance: allow the bank to continue operating with low capital and some additional restrictions on its behaviour so it can rebuild its capital base.

Government Investment: the government provides some or all of the capital the bank needs to comply with minimum capital requirements.

USA : Bank and S&L Failures in 1980’s


USA MODERNISING THE FINANCIAL SYSTEM

1992 onwards


USA : MODERNISING THE FINANCIAL SYSTEM

Increase Capital Ratio of Weak Banks by:

Divesting assets (eg. Closing branches)

Issue new equity

Increase margins: rL - rD. This may imply increased profits

Merge with “healthy” bank or non-financial company


Limit Deposit Insurance

$100,000 per individual

Eliminate coverage for brokered deposits

Don’t pay out to uninsured depositors (e.g. Continental Illinois)

Investigate Risk Based Deposit Insurance Premiums

Get private sector to insure some deposits


The Regulators

annual on-site investigation

accurate capital measures/reserving

some market value reporting

improve reporting from auditors


FIVE ZONES OF CAPITAL ADEQUACY

Zone 1 :engage in wide range of activities

new acquisitions granted (mergers)

Zone 2 :regulator expects to move to Zone 1

will not allow new activities unless managers are adequate


Zone 3 : dividend restrictions, remove management

constraints on loans (type)

Zone 4 / 5 :bank into conservatorship

presumption that congress cannot stop/impede regulator

FIVE ZONES OF CAPITAL ADEQUACY


ENDS LECTURE

© k.cuthbertson, d.nitzsche financial engineering: derivatives and risk management (j. wiley, 2001)...

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