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Chapter 5: Regulation of banks (Traditional regulation mechanism) (Bank…

- - - - Provides liquidity in exchange for assets to banks in times of financial distress
        
        Does not increase value of assets bought
- - - - USA
        
        Banks must obtain a national or state charter (by Comptroller of Currency or a state authority)
        
        Must submit application containing operational plan of the bank
        
        Bank will be evaluated on soundness of application:
        
        Quality of management
        
        Estimated earnings
        
        Initial capital
      - UK
        
        Application of banking license from Financial Services Authority (FSA)
        
        Must offer broad range of services
        
        Must be well-capitalized - paid capital and reserves of at least 5 million pounds
        
        Evaluated based on liquidity, internal control and quality of management
  - - - Capital acts as the first safety net (Equity takes on losses first)
        
        Depositors rank senior in claims, their deposits are 100% protected so long as capital does not dry up
    - - Accuracy of reports
      - Overall operation of the bank
      - Adequacy of bank's risk management systems and internal control procedures
      - Quality of loan portfolio
        
        Restrictions on asset holding
        
        Restricts holding of risky assets
        
        Limitation on the amount of loans, particularly on the categories of individual borrowers
        
        Reduce risk of loans through diversification
      - Competence of mangement
- - - - High gearing ratio translates to higher risk of bank losing its capital
  - - - Capital divided by risk-weighted assets (RWA)
        Also referred to as Capital Adequacy Ratio (CAR)
        
        Under Basel 1, minimum ratio is 8%
        
        RWA recognizes that different types of assets carry different degrees of risk
        
        RWA is calculated by asset multiplied by appropriate risk rate
        
        Asset type
        
        Interbank (OECD) - 20%
        
        Mortgages - 50%
        
        Government security (OECD) - 0%
        
        Non-bank commercial loans - 100%
        
        Cash - 0%
        
        Off-balance sheet instruments are converted into credit equivalents and assigned an appropriate risk weight
        
        Capital consists of 2 components: Tier 1 and Tier 2
        
        Tier 1: Issued share capital and published /disclosed accumulated shares
        
        Tier 2: Medium to long term subordinated debt (debt which ranks below all other debts in event of liquidation), general provisions and current year unpublished results
    - - Issue subordinated debt
      - Securitize loans
      - Issue shares
      - Outright sale of loans
    - - Its simple design
        
        Assumes risks are independent, therefore permits a simple addition of RWA
        
        Portfolio theory states that risks might be independent in certain cases
        
        Diversification makes risk of whole portfolio lower than the sum of risks of individual loans
        
        RAR does not reward banks that diversify their loan portfolio with lower capital charges
      - Risk factor may not measure the relative degree of risk associated with each asset (e.g is a loan to Microsoft twice as risky as a mortgage loan to an individual? probably not)
      - All loans to non-bank private sector are 100% risk weight
        
        All commercial loans are treated as equally risky, regardless of their credit rating
        
        Does not reward banks with prudent lending policies
- - - - Federal Deposit Insurance Corporation (FDIC) since 1934
        
        Payoff method
        
        FDIC pays off deposits up to the USD250,000
        
        Balance is paid after bank's liquidation
        
        Typically account holders can get back 90% but process can take several years
        
        Purchase and assumption method
        
        FDIC finds a merger partner who takes over all the deposits of the failed bank so that no depositors loses money
        
        Used when failing institution is 'too big to fail'
        
        Leads to moral hazard as depositors do not care whether the bank fails since they are 100% insured and banks do not care since they will be bailed out if they are big enough (takes on more risk)
        
        Increases chance of bank failure
        
        Solutions
        
        Use of 'least cost' approach for resolving bank failures
        
        Risk based insurance premium
        
        The more risk banks take on, the higher the premium they have to pay
        
        Use of co-insurance
        
        Benefits
        
        Provides speedy compensation of depositors without recourse to the government
      - Insurance may be compulsory or voluntary
      - Insurance limits may differ widely (from USD250,000 to 100,000euro in pounds in UK)
- - - - As shown in the Northern Rock case study, these sources of liquidity began to close down as banks found out they could no longer securitize assets or borrow easily from other banks through wholesale markets
        
        The early stages of the financial crisis showed up as liquidity problems at banks where central banks have to inject liquidity to sustain the financial system
        
        Basel committee has proposed that banks hold more HQLA that are capable of being sold in in times of financial stress
- - - - General disclosure statement
        
        A comprehensive statement for users with financial sophistication, aimed at financial professionals who monitor the bank in their capacity for the general investor
      - Key information summary
        
        2 page summary targeted at non-sophisticated investor
      - Directors face unlimited liability if found to have made false or misleading statements
      - Based on 3 pillars
        
        Self discipline
        
        Responsibility for risk management (best placed on the shoulders of banks' upper management
        
        Requires registered banks to publicly disclose financial position and risk profile quarterly
        
        Disclosure of false or misleading information carries criminal charges
        
        Presence of independent directors (minimum of 2)
        
        Financials audited twice a year
        
        Regulatory intrusion kept to a minimum, to reduce compliance costs
        
        No government guarantee of banks and no deposit insurance
        
        Market discipline
        
        Reinforces incentives for prudent management of banks
        
        Lower pricing for funding
        
        Greater market share
        
        Higher share price
        
        Weak banks are punished by the markets (the ultimate discipline relies on creditors to run on the bank, forcing its closure)
        
        Regulatory discipline
        
        Banks must meet specific requirements as a condition for registration as a bank
        
        International standing
        
        management capability
        
        Regulatory or disclosure requirements it faces in other juridisctions
        
        Business strategies and practices
        
        Benefits
        
        Lower costs of compliance due to no premiums paid for deposit insurance
        
        Fewer rules stifling competition and innovation
        
        Crtiticisms
        
        Banks are less willing to admit to problems if that information is to be made public
        
        Depositors may not understand the information produced
        
        Unlimited liability for directors may discourage the best people from taking these positions - therefore, weakening management of banks