Introduction to Banking and Finance

Guy HargreavesACE-102

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Recap of yesterdayKey risks managed by banksTools used to manage bank balance sheet

risks Pros and cons of regulations for balance

sheet risk management

Bank regulation and the future

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Today’s goalsAppreciate the reasons for strong bank

regulationUnderstand the history of bank regulationDescribe the typical types of financial crisesDiscuss the causes and effects of the 2007-9

GFCAppreciate the impacts of financial crises on

the real economyReview current and future proposed bank

regulation

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Why do we need bank regulation?Financial systems suffer periods of instability

Business cycle, fundamental changes, technology can all cause instability

The banking sector is vulnerable to this instability due to its in-built high leverage

An unstable banking system can cause “bank runs” when depositors lose confidence

Central bank regulation of banks and the banking system is vital to minimise the chances of banking system instability and to protect bank customers

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Types of bank regulationBank regulations come in the form of either

Systemic Regulation of Prudential RegulationSystemic regulation is usually:

Government deposit insurance Lender of last resort

Prudential regulation is usually: Capital rules Liquidity rules Code of conduct

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History of bank regulationEach local financial system has its own history

of bank regulationGlobally a number of major regulatory

milestones have had widespread impact: 1933 Glass-Steagall – separation of Investment and

Corporate Banking in the US (largely repealed in 1999) 1988 first Basel Capital Accord “BIS I”. Concept of Tier

1 (Equity) and Tier 2 (sub debt, hybrids, other) and Risk Weighted Assets (RWAs). Tier 1 + Tier 2 capital = 8% * RWA

1996 second Basel Capital Accord “BIS II”. Three “Pillars” – 1: capital, 2: supervisory review, 3: disclosure

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BIS IICurrently the “global” banking system is supposed

to be operating under BIS IIPillar 1:

Risk Weightings aligned to actual expected credit risk Credit risk calculation could be “Standardised” or

“Internal Ratings Based” Market and Operational risk also included

Pillar 2: Boosting regulatory powers to review and supervise banks

Pillar 3: More disclosure of risk, capital adequacy and risk

management

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Financial CrisesThere are many types of financial crises,

including: Banking crises Currency crises Speculative asset price bubbles Economic crises

2007-9 GFC was mostly a banking crisis but it came from a speculative asset bubble

Economic crises are usually deep recessions or depressions where GDP falls sharply

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Banking CrisesLoss of confidence in a bank or number of

banks leading to bank run where depositors withdraw funds rapidly

Often associated with periods of poor lending decisions leading to high loan portfolio loss provisions

High leverage in the banking system means confidence is fragile

Small loan losses can quickly turn into a banking crisis

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Currency CrisesA large increase in country risk can cause foreign

investors to lose confidence in the countryCountry risk might come from a local economic

crisis or perhaps political changeForeign investors will sell a currency quickly if

they lose confidence 25%+ fall on relevant FX rate Often the Central Bank will try to support the currency

by increasing local interest rates

1997 Asian Currency Crisis is classic example of currency crisis – began in Thailand and flowed across the region

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Currency Crises - IDRIndonesian Rupiah – USD FX rate:

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Speculative Asset Price BubblesA speculative asset price bubble is a large

increase in the price of an asset, often over longer periods, which leaves the asset valuation out of line with underlying fundamental valuations

Dutch tulip bubble of 1637 1929 Wall St crash 1980s Japan property bubble Late 1990’s “dot-com” bubble US housing price bubble 2003-6

Bubbles usually end with a large price crash!

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2007-9 Global Financial CrisisGFC had its roots in US property prices

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2007-9 Global Financial CrisisUS property prices from 1987:

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Over-investment in propertyBoth US Agency lenders (Fannie Mae and

Freddie Mac) lent aggressively to US home buyers in 2002-6

Securitised lenders also lent aggressively over this time – Investment Banks arranged funding of their using securitisation

Loans for “sub-prime” borrowers were made at 100% LVR!

By 2006 the US property market was a bubble financed by lenders and investors all over the world, often using large amounts of leverage

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The property bubble burstsIn 2006 the US property market bubble burst and

mortgage borrowers started defaulting in large numbersBanks had massive exposure to the mortgage loan

business through loans and securitised productsBy 2007 banks around the world were reporting huge

losses and confidence in the global banking system had collapsed

Extraordinary measures were taken by 2009 to rescue the system

USD 700m TARP recapitalised the US banking system USD short term interest rates were lowered to near 0% Banks and insurers were forced into mergers or government

ownership Etc etc!

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Fed FundsFed Funds lowered to historic levels:

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Impact on the “real economy”US GDP growth collapses during the crisis:

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Impact on the “real economy”US unemployment rises sharply from 2008:

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Impact on the “real economy”US automobile industry goes bankrupt and

needs government bailoutAIG – large international insurer -

nationalisedBank of America forced to buy Merrill LynchProperty market collapse worsensUS government injects USD2 billion+ into

the economy through fiscal measuresEtc etc!

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Conclusion: improve bank regulationThe 2007-9 wasn’t just a US crisis – Europe

has had enormous problems as wellResult was fast track Basel / BIS IIIUS passed “Dodd Frank” law

Reduce bank trading Increase derivative transparency through clearing Allow for orderly bank closures Rid system of “too big to fail” Reform mortgage market Toughen consumer finance protection laws

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BIS IIIRequired Capital – increase required capital –

Tier 1 up from 4% to 6%Introduce Leverage Ratio – ratio of Tier 1

capital divided by “total exposure” to be a minimum of 3%

Introduce Liquidity Cover Ratio – High quality liquid assets divided by net cash outflow over the next 30 days >100%

Introduce Net Stable Funding Ratio – Long Term Stable Funding divided by Long Term Assets (> 1-year) > 100%

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BIS IIIIntroduce counter-cyclical capital buffers –

increase capital in good times so banks have more protection for bad times

Strengthen risk frameworks across a lot of areas of the banks eg:

Credit Valuation Adjustment (CVA) for swap counterparty risk management

OTC derivative clearing through centralised exchanges

BIS III is costly for banks and will be less efficient (ie a burden for the global economy) - but should strengthen the banking system

Timetable for introduction 2011-19

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Banking of the future?Banking in the future may look nothing like

the past! Same basic functions of financial intermediation

and direct finance will probably exist “Fintech” or Financial Technology is changing the

banking landscape dramatically 2000: 300M internet users mostly on dial-up 2015: 3,000M internet users mostly on 4G

smartphones

Cryptocurrencies – what if Bitcoin is the future?

P2P decentralised “trustless” “currency” No Central Bank can control supply of

cryptocurrencies The “Blockchain” may change banking forever!

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Fintech at a glance

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Fintech is the place to be!Retail branch banking will die out with our

parents!Everyone has a smartphone and can use it to

bankBanking has been slow to change and adopt

technology in the past 20 yearsDisruption is the BIG economic theme of the

2010s and probably the next two decades Think Uber, Paypal, iTunes Store, Amazon, Alibaba,

Tencent