Regulating the Financial System

 

Liquidity Capital Macroprudential

Basel Committee on Banking Supervision

Central Bank governors and Finance ministers from Argentina, Australia, Belgium, Brazil, Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United

Kingdom and the United States.

In 1993, Exchange Fund merged with Commissioner of Banks to form HKMA which currently regulates HK banks.

Authorization Examination Capital Requirements (since 1986) Liquidity Requirements (since 1964) Restrictions on Lending to Related Parties and

maximum exposure to any given borrower. Commitment to Basil Capital Accords

HKMA sets Minimum Criteria for Authorization of banking institutions. Banks must have a minimum level of capital. Ability of the Applicant to Run a Banking

Business▪ HKMA discourages non-financial conglomerates from

owning banks. ▪ Applicant needs substantial experience operating a

non-bank financial business in HK. HKMA approves directors and chief

executives, and controllers.

Liquidity Ratio (HK)

Liquidity Coverage Ratio (Basel)

1.25

1

Liquifiable Assets Assets with Maturity month

Liabilities with Maturity month

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1)E E E

Liquifiable AssetsProjected Net Outflows = Outflows - min(Inflows , Outflows

Most profitable bank assets, loans, are illiquid.

Banks have a liquidity mismatch between assets and liabilities.

Liquidity Risk: The possibility that depositors may collectively decide to withdraw more funds than the bank has on hand.

No matter how well a bank is managed or how good the credit quality of their loans, if all liquid deposits are withdrawn at once, banks could not raise enough liquid funds to pay all obligations.

Banks have very illiquid assets (loans) and obligations to repay their depositors in full at any time.

If all of the depositors at a bank withdraw their funds at the same time, the bank will have to sell their loans at a discount, and they will not have enough funds to pay all of their depositors.

If all of their depositors keep their money in the bank, most banks will be able to repay all of their depositors with interest.

Thus, the payoff to any individual depositor depends on what other depositors decide to do.

In many economic situations, agents returns depend on the actions of other agents. In such a situation, agents must think strategically. Economists use game theory to describe such situations.

John (“A Beautiful Mind”) Nash developed a concept called the Nash equilibrium. A Nash equilibrium occurs when every player in a game is playing their best strategy given the strategy that the other players play.

Economists believe that outcomes of strategic situations are likely to be well-described by Nash equilibrium. Since every individual in a Nash eq. is playing there best strategy given the actions of others, no one has any incentive to change their strategy individually.

Depositors each deposit $1000 at 10% interest.

They can choose to withdraw their funds before collecting interest or keep their funds with the bank.

The right hand table shows pay-offs for each decision under two possible situations.

1. All other depositors keep their funds in the bank and the bank survives.

2. All other depositors withdraw funds and the bank must liquidate.

Payoffs1. If an individual keeps their funds with the bank

and everyone else does likewise, everyone gets their funds with interest.

2. If an individual doesn’t withdraw, but everyone else does, the bank will have nothing left to pay the individual who gets nothing.

3. If the individual depositor withdraws but no one else does, the depositor loses only interest.

4. If an individual depositor withdraws and everyone else does, they have some chance of getting some funds (say $500) back.

Individual Depositors Decision

AllOther Depositors Decision

Withdraw Don’tWithdraw

Withdraw Payoff:$500

Payoff: $0

Don’tWithdraw

Payoff:

$1000

Payoff: 1100

The phenomenon in which all depositors compete to withdraw their funds at the same time is called a bank run or a bank panic. Depositors lack complete information about the value of banks assets. If depositors believe that there is a significant fraction of loans which will not be repaid, depositors may have an incentive to immediately withdraw funds. Bank deposits are first come, first serve. If you withdraw your funds before the bank declares losses you may not suffer at all. Further, even if you believe that banks assets are sound you may have an incentive to immediately withdraw, if you believe that other depositors will also withdraw their funds.

In 1964, there was a collapse in the property market. In January 1965, the Banking Commissioner closed Ming

Tak bank which suffered losses in property investment. Two weeks later there was a run on deposits at Canton

Trust which also had property holdings. Canton Trust suspended business on February 8.

On February 9, there were runs on deposits at many native banks including Wing Lung, Dao Heng, and the strongest of the native banks Hang Seng.

On April 9, Chinese newspapers published rumours that the head of Hang Seng was being interviewed by the police.

By the end of the day, depositors had withdrawn half of the savings and checking deposits at Hang Seng.

On April 10, Hongkong Bank took over Hang Seng.

Hong Kong Deposit Protection Board•compensation limit is set at HK$500,000 per depositor per bank;•secured deposits are protected;•Hong Kong dollar, Renminbi and foreign currency deposits are protected;•a DPS Fund with size of 0.25% of relevant deposits will be built up through the collection of contributions from Scheme members; and•differential contributions will be assessed based on the supervisory ratings of individual Scheme members.

Liquidity Crisis: Sudden deposit withdrawal requires liquidation of otherwise sound assets.▪ Bank of East

Asia, 2008 Link

Retail deposits, long-term bonds, equity get high stability weights/Hot money low weights.

Long-term loans, assets used as collateral for repo get high illiquidity weights.

1

Required Stable FundingNSFRStable Funding Needs

Stability Weighted Average of Liabilities=Illiquidity Weighted Average of Assets

• Modern Diamond & Dybvig model

Bank

2 Equilibria 1.All money market institutions roll-over lending2.Sudden Stop: Money market dries up

Money Markets

Banking system sufficiently important that gov’ts will usually protect depositors and prevent mass bankruptcies. Liquidity Crisis: Lend at penalty rates against

good collateral. Walter Bagehot, 1840’s. Solvency Crisis: Recapitalize banks through

gov’t purchase of equity, diluting or destroying shareholder value.

Moral Hazard: Banks creditors and (sometimes owners) are protected from consequences of risky behavior. Link

Regulatory Capital CARRisk Adjusted Assets

The HKMA/Basel requires HK banks to maintain a Capital Adequacy Ratio of at least 8%

Higher capital requirements may be set according to assessment of bank examiners.

Capital Adequacy Ratio – related to inverse of equity multiplier

The risk adjusted assets of a bank are a weighted some of loans and other assets, with the weights being an increasing function of risk.

A bank has n = 1, …, N assets. Asset n has a dollar value of Ln.

Total assets = L1 + L2 + ….LN Regulators assign a weight to each asset,

wn, that is increasing in the level of credit risk.

Risk adjusted Assets = w1L1 + w2L2 +….wN L3

Risk Adjusted Assets are weighted sum of assets with higher weights for higher risk. Original risk weight categories have become more complicated1.OECD Government. 0%2.Banking. 20% (weight = .2)3.Secured Residential Lending. 50% (weight = .5)4.Commercial and consumer loans, corporate bonds.

100%-150% (weight = 1-1.5)

Since Basel II, large banks will construct their own (regulator approved) internal models to identify risk of assets.

Take portfolio of assets and use historical information on distribution of returns/losses of each asset to calculate statistical distribution of portfolio.

Choose some critical probability (i.e. .1%) and calculate maximum losses at 99.9% of the time. This maximum loss is the value at risk.

Capital cushion must be more than enough to cover this value at risk.

Problem: Typically uses normal distribution which is unrealistic and may not account for crises which is when banks most need capital.

Tier 1: Shareholder funds Tier 2: Subordinated debt + Loan Loss

Reserves

Capital: Regulatory Capital Includes both Tier 1 and Tier 2 Capital.

For regulatory purposes, banks are required to have some quantity including shareholders funds plus subordinated debt (uncollateralized junior debt).

More emphasis on Tier 1 Capital, 4.5% adjusted Tier 1 ratio + 2.5% buffer.

Leverage Ratio: Tier 1 Capital/Total Exposures > 3%.

Systematically Important Financial Institutions (SIFIs) have additional 1-2.5%.

Countercyclical Buffer (0-2.5%).

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-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

pre-1985 post-1985

Panel 1: Credit/GDP Growth

% Deviation

From 8 quarter trend

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1.Loan Eligibility Criteria. 2.Capital and Liquidity Requirements. 3.Asset concentration and growth limits.

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Challenges to Monetary Policy Effectiveness 25

Maximum loan-to-value ratio and loan prohibition (LTV)Maximum debt-service-to-income ratio and other lending criteria (DSTI) Risk weights on housing loans (RW)Loan loss provisioning applied to housing loans (Prov)Limits on banks’ exposure to the housing sector (Expo)

Shim et al. Database

26Link

HKMA operates "continuous supervision", of authorized institutions. On-site and off-site examinations

▪ Examiners classify loan assets Reporting Requirements. Returns

▪ Examiners grade balance sheets of the banks according to the CAMELS framework.

HKMA requires authorized institutions to categorize their outstanding loans

1. Pass – Loans for which borrowers are current in meeting commitments and the full repayment of interest and principle is not in doubt.

2. Special Mention – Loans with which borrowers are experiencing difficulty.

3. Classified1. Substandard: Loans in which borrowers are

displaying a definable weakness.2. Doubtful: Loans for which collection in full is

improbable and the authorized institution expects to sustain a loss of principal or interest.

3. Loss: Loans that are considered Uncollectible.

CAMEL rating system an international framework for grading banks (on a scale of 1 to 5) based on 6 factors.1.Capital Adequacy2.Asset Quality3.Management4.Earnings5.Liquidity Risk6.Sensitivity to Market Risk

Protect depositors from problems of asymmetric information.

Ensure the stability of the financial system

Protect depositors and borrowers from banking monopoly power.