Bank Regulation
21 important questions on Bank Regulation
How are banks different? 5 reasons
- Capital structure: they are highly leveraged and have demand deposits as liabilities
- Public confidence matters
- They have diffuse debt holders
- They are large creditors
- Bank assets are opaque (bank risk taking can be unnoticed & fast changing)
- They are systemically important & benefit fro the safe net (i.e. deposit insurance, LoLR, TBTF)
Why are banks regulated?
- Traditional: banks fulfil important and special roles in the economy such as (delegated monitoring, liquidity provision, payment system)
- Representation of depositors (depositors are small and diffused)
- Systemic risk / social cost of bank failure
Name two pro's and con's of Portfolio restrictions:
Pro's:
- Prevents conflict of interests: consumer / borrower protection
- Constrains moral hazard on the part of banks (risk-taking)
Con's:
- Economies of scale and scope
- banks can't diversify their income
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Contagion is arguably the most important source of systemic risk. Name 3 different types:
- Domino effects trough the payments system or interbank markets
- Common assets exposure
- "Informational contagion" Uncertainty about how events will play out because of a lack of precedent (unknown unknowns)
What are the challenges in banking regulation?
Regulation is the rational response to market failures because failing to respond would lead to excessive risk taking and / or monopoly powers. But there are also costs of regulation:
- lobbying costs
- Implementation costs
- market distortions
- To little risk taking
- And the existence of bank regulation changes the nature of the information problems because the regulator itself is an interested party (regulatory capture).
- Any intervention will create its own inefficient/externalyity (lucas critique / Goodshart's law)
What are the instruments of bank regulation?
- Deposit interest rate regulation (obsolete)
- Entry, branching, network and merger restrictions
- Portfolio restrictions (Glass-Steagall, Volcker)
- Reserve requirements
- Deposit insurance
- Capital requirements
- Regulatory monitoring (including closure policy)
Name two pro's and con's of Entry, branching and merger restrictions
- Prevent concentration and anticompetitive behavior
- Foster relationship banking
Con's:
- economies of scale and scope
- lack of competition
- Concentrated assets: banks can't diversify their income
What is the rational behind reserve requirements:
- Banks should retain a certain fraction of their deposits in a non interest bearing, liquid form
- The basic ration al is to address moral hazard associated with the LoLR & borrowers exposure to Foreign Exchang (FX) risk.
Minor role today in the US but in use by the ESCB (Basel III)
Explain about the capital adequacy ratio. What are the two main advantages.
What are it's advantages:
- Ex ante: bankers have less incentive to engage in "excessive" risk taking, so that actual risk talking is more in line with what is in the interest of all stakeholders (skin in the game effect)
- Ex post: banks have an additional liquidity reserve, which mitigates insolvency and bank failure risk (buffer effect)
What does supervision of banks do?
Name 4 resolution for the failure of banks during the crisis?
- Private sector method. 1 (sale of failed bank to health one (M&A), 2. sale of parts of assets and liabilities (purchase & assumptions)
- Government intervention using public funds
- Bail-in (ad-hoc or via instruments as CoCos)
- Liquidation
What are the costs of bank regulation, 4 points?
- Administrative costs (cost of implementing regulation)
- Influence and lobbying costs (lobbying cost may be a social waist, see inside job)
- Regulatory opportunism and uncertainty (how to make sure regulators do not abuse their power.
- Impair net present value creation: No risk, no return
Shortly explain the basel time line. Small sum of important points per new accord and or amendment.
- under coordination of the bank of International settlements
- CAR 8% for commercial banks
- Focus on loan book
1996 amendment:
- including market risk (risk stemming from changes in market prices, e.g. interest rates, equities, FX, commodities)
- Focus on trading book (banks trading in financial instruments
2004 Basel II accord:
- 3 pilars: Minimum requirements, supervisory review, transparancy
- standardised and internal rating based
Recent: Basel III
- liquidity risk
- trading book: counterparts risk (failure of Lehman prime reason)
- Including of Leverage ratio
What were the shortcomings of Basel I (1988)
- The risk classes are crude, inviting for exploitation (e.g. mortgages require half of the capital of business loans)
- Risk classes do not properly reflect actual credit risk exposure; risk classes can be manipulated
- Does not reward diversification with portfolios
- No recognition of covariance of returns that affect diversification and portfolio risk
- It assumes that banking risk is the same across time and over countries
- Capital ratios are expressed in book-value and fail to adjust changes in return volatility.
What are the 4 key principles of the supervisory review? under Basel II
- The bank should have a process for assessing overal capital adequacy including board and senior management oversight.
- supervisors should review and evaluate banks internal capital adequacy assessments and have the ability to monitor and ensure compliance with regulatory ratios
- Supervisors should expect banks to operate above regulatory capital requirements minima and be able to require excess capital
- Early supervisory intervention should be deployed to prevent capital form falling too low
What were the key drivers to reform under Basel III
- Too high leverage
- No liquidity framework
- Poor risk management
- interconnectedness
- Too big to Fail
- Too low quality and quantity of capital
What are the indicators of a systemically important bank? What additional elements do they face under Basel III
- indicators: Cross country activities, size, interconnectedness, complexity
- additional elements: recovery and resolution plans, higher capital requirements, more intensive supervision
What is the purpose of the leverage ratio, what is the instrument
- Limit excessive borrowing: (i.e. to counter the ballooning of the balance sheet).
- Underlying idea is to use a simple ratio, in addition to more complex risk weighted ratios.
The instrument is the total capital / total assets.
What is the purpose of a liquidity buffer, what two instruments, explain how to calculate them
- Liquidity Coverage Ratio (LCR); 30 day horizon (short-term distress, do you have enough to pay cash flows for 1 month), buffer may account of cash, government bonds, high rated, covered bonds.
- Net stable Funding ratio (NSFR): 1 year. (Long term funding stability) What is a funding stop occurs.
What does the example of the dog and the frisbee explain?
What are banks more heavily regulated that other firms?
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