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CHAPTER 5: INTERNATIONAL BANKING RISKS (Supervision and Regulation on…

- - - - [ii]The GATS and the ANNEX also specify the restrictions that may be imposed on trade in services for prudential purposes by the current 161 WTO member countries
        
        Their important purposes is a country may implement regulatory measures in contravention of its GATS obligations and commitments including the protection of depositors, policy holders or persons to whom a fiduciary duty is owned by a financial services supplier, or to ensure the integrity or stability of the financial system.
        
        The difference between a prudential and a protective measure, restrict trade i financial services, because the ANNEX and the GATS do not provide any specific guidance regarding the scope and extent of the prudential exception.
        
        GATS even prohibits member countries from listing prudential restrictions in their schedule of commitments.
        
        Member countries retain the discretion to invoke prudential regulations to restrict cross-border trade in financial services at any time.
  - - - Examples : Money earned from drug trafficking, arms smuggling, nuclear secrets and weapon.
        
        There are three stages of money laundering:
        
        Layering
        The movement of funds from one institution to another in order to disguise the original source and ownership of the funds.
        
        Integration
        The time when the funds, having been laundered are reinvested into a legitimate business.
        
        Placement
        Placement of currency into a banking and financial institutions. Examples, commercial bank, brokerage house, investment bank and others.
        
        The prevention measures of AMLA:
        
        Develop a customer acceptance policy and procedures to address the establishment of business relationships with the customers.
        
        Conduct customer due diligence (reasonable care) and obtain satisfactory evidence in its record, the identity and legal evidence thereon.
        
        Keep all records and documents of transactions obtained during customer due diligence procedures, for at least six years and to ensure the retained documents are able to create an audit trail.
        
        Conduct ongoing customer due diligence to examine and clarify the economic background and purpose of any transaction.
        
        Promptly submit a suspicious transaction report to the Financial Intelligence Unit in CB when any employees involved proceeds from an unlawful activity.
        
        Appoint one or more officer at senior management level.
        
        Provide training and guidance to staff in the operation of procedures and controls relating to anti-money laundering.
  - - - Single Bank Supervisory Authority- fear a competition in laxity (weakness) between multiple bank supervisors
        
        Multiple Bank Supervisors - Those who favor a system with two or more bank supervisors stress the benefits of a competition in ideas among multiple bank supervisors
  - - - Prohibition against the payment and receipt of a fixed or predetermined rate of interest (riba)
        
        This replaced by profit and loss sharing arrangements
        
        Rate of return (ROR) on financial assets held in banks is not known and not fixed
        
        Five essential elements to make a contract as valid under the Islamic jurisdiction
        :soccer: Must have buyer
        :soccer: Seller
        :soccer: Asset
        :soccer: Price
        :soccer: Ijab & Qabul / Offer & Acceptance
    - - Two Windows
        
        :pushpin:Bank liabilities are divided into two windows
        
        For demand deposit
        
        For investment deposit
        
        :pushpin:Demand deposits are assumed to be placed as Amanat thus they are considered to belong to depositors at all times
        
        :pushpin:They cannot be used by bank as basis to create money through fractional reserves
        
        :pushpin:Banks operate according to arrangement must apply 100% reserve requirement ratio on demand deposit
        
        :pushpin:Investment deposits are used to finance risk-bearing investment project with depositiors
        
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      - Two-tier Mudarabah
        
        :explode:Asset and liabilities side of balance sheet bank are fully integrated
        
        :explode:On liability side, depositors enter into a Mudharabah, a profit sharing contract with the bank to share the overall profits occuring to the banks business
        
        :explode:Depositors act as capital providers by provide fund and banks act as entrepreneur by accepting them
        
        :explode:Mudarabah with agent-entrepreneur who search for investable funds and who agree to share profits with the bank according to a certain percentage
        
        :explode:Banks are allowed to accept demand deposit that that yield no returns and may be subject to a service charge
  - - - :check: Central Bank as bank supervisor - CB will have the first-hand knowledge of the condition and performance of banks- can help to identify and respond to the emergence of a systematic problem in a timely manner
        
        :heavy_minus_sign: Conflict of interest between supervisory responsibilities and responsibility for monetary policy - could become critical during recession - CB may be drawn to pursue a too-loose monetary policy to avoid adverse effects on bank earnings and credit quality and encourage bank to extend credit more liberally than warranted based on credit quality conditions to complement an expansionary monetary policy
  - - - Supervisor with broad scope to cover all financial services - supervise such entities effectively
        
        Ensure that supervisory oversight of risk management by such conglomerates is not fragmented, uncoordinated or incomplete
        
        :heavy_minus_sign: Supervisory authority with broad scope - would result in undue concentration of power that would otherwise be dispersed among several agencies and could increase the likelihood of regulatory capture and retard financial innovation.
  - - - Provide forum for regular cooperation on banking supervisory matters.
        
        Its objective is to improve understanding of fundamental supervisory aspects and increase the quality of banking supervision worldwide.
        
        The purpose is to encourage convergence toward common approaches and standards.
        
        BCBS does not issue regulation rather it functioned as an informal forum in which policy solution and standard are developed.
        
        Basel III is a comprehensive set of reform measures developed by the BCBS in order to strengthen the regulation, supervision and risk management of the banking and financial sector.
        
        Basel III is a part of the BCBS’s continuous effort to enhance the banking regulatory framework.
  - - - It is the supervisors who have direct contact with the bank and therefore represent the main line of defence against unsafe and unsound banking practices
        
        :heavy_check_mark:There are several main dimensions to bank supervisory approaches
        
        Primary supervisor approach - to assess the riskiness of banks is through the examination process where is hard to quantify, and cross-country data are thin at best
        
        However, new information on three significant aspects of supervisory practice is available that can give one an indication of the relative effectiveness of supervision
        
        These dimensions include ENFORCEMENT POWERS, the degree of enclosure supervisory authorities must comply with and the independence of supervisory authorities
        
        Independence - refer to whether or not the supervisors are legally liable for their action
        
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  - - - Measures included interest rate ceilings, restrictions on the range of products supervised financial instructions could offer, capital controls and high effective tax rates.
        
        OFCs have posed special regulatory and supervisory challenges.
        
        OFCs exist in large part because they offer financial market participants tax, regulatory and supervisory advantages not available in their home markets.
        
        Offshore finance is the provision of financial services by banks and other entities to non-residents.
        
        The definition of what constitutes an OFCs is less straightforward and indeed a number of different categorizations of OFCs are widely recognized.
        
        IMF (2000) suggests a more practical definition of OFC?
        
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- - - - 4 individual instrument
        
        ✔CREDIT DEFAULT OPTION (CDO)
        
        Also known as credit spread
        
        Involve a purchase of one option and sale of another option in the same class and expiration but different strike prices
        
        It is an option to buy protection or sell protection as a credit default swap on a specific reference credit with a specific maturity
        
        ✔CREDIT FORWARD AGREEMENT (CFA)
        
        Hedges against an increase in default risk on a loan or decline in credit quality of a borrower after the loan rate is determined and the loan has been issued
        
        Its specifies a credit spread for example. risk premium above the risk free rate to compensate for default risk on a benchmark bond issued by the borrower.
        
        ✔CREDIT DEFAULT SWAP (CDS)
        
        Financial swap agreement that the seller of CDS will compensate the buyer in the event of a loan of a default or other credit event
        
        Receive compensate in event of default the buyer of CDS usually at the face value of the loan and seller of CDS takes possession of default loan
        
        Seller of CDS insurer the buyer against some reference loan defaulting
        
        ✔CREDIT SECURITIZATIONS
        
        Refer to the complex process of transforming individual loans into assets that may be purchased by investors
        
        Bank coordinate these transaction to reduce their exposure to individual financial risk
        
        Investor prefer securitized products to diversity their respective portfolios and gain entry into multiply financial market
- - - - ▪ Risk : Chance that an investment's actual return will be different than expected
        
        ▪ Risk uncertainty
        
        ▪ Banking and financial institutions are exposed to the same form of risks, failure of one bank normally will give impact to the others
- - - - FUNDING LIQUIDITY RISK Occur when a firm is unable to obtain sufficient funds to meet cash flow obligations
      - MARKET LIQUIDITY RISK
        The inability to conclude a large transaction near the current market price
  - - - In terms of period time, liabilities are usually shorter than its assets
        Meaning, the interest rate paid on deposits and short-term borrowings is sensitive to short-term rates, while the interest rate earned on long-term liabilities is fixed.
        
        Interest rate risk arises in the banking system when financial institutions act as asset tranformers
        eg: they lend out long-term and refinance short-term
        
        Basel l and Basel ll committees did not circulate mandatory capital requirement for interest rate risk in the banking books, must meet for regulatory capiral purposes (APS 117)
        
        Bank should have:
        :sunflower: Framework to manage and keep track on interest rate risk in banking book, according to the nature, scale and complexity of the bank's operations.
        :sunflower: An approval from a regulatory body to use an internal model for determining the bank's capital requirement for interest rate risk in the banking book.
        
        Two types of method for measuring sensitivity of bank income to changes in interest rate:
        :sunny: Income Gap Analysis
        Calculates amount of rate-sensitive liabilities substracted from amount of rate-sensitive asset.
        :sunny: Duration Gap Analysis
  - - - Is a financial risk that exist when financial transactions is denominated in currency other than the currency of the origin country
        
        International banking expose to FOREX risk because trade large amount to currencies
        eg: the value of currency falls with respect to another
        
        If exchange rate of foreign currency falls, both the interest payments and the principal repayment will be worthless than when loan was given, which reduce a bank's profit
        
        Risk of investment value change due to changes in currency exchange rates
        
        Risk that investor have to avoid loss in foreign currency due to an adverse movement in exchange rates either in short or long position
        
        The risk usually affects international businesses (import and export) and affect investors making international investments ( foreign direct investment FDI and real estate)
        
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- - - - Political risk has an adverse effect on any economy, mostly because it affects international banking and financial institutions' behaviour.
        
        Unstable political environment underlies higher banking and financial risk in relation to a constant and continuously developing political system
        
        Many foreign loans are paid in US dollars and repaid with dollars
        
        Native currency will decline rapidly compared to other currencies, and the local governments will often impose capital controls to prevent more capital outflows from happened to the local country.
        
        Foreign borrower are often prohibited from using foreign currency, such as US dollars, in repaying loans in an attempt to conserve the more valuable currency when the native currency is declining in value
        
        Political risk constitutes the major constraint on foreign investment in emerging markets.
        
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- - - - :sunflower: Due to the fact that this phenomenon was in rising mode, Basel l which is primarily focused on credit risk, where banking and financial institutions were required to maintain their capital levels equal to 8 percent of risk-adjusted assets.
      - :sunflower: Thereinafter, Basel ll has revealed numerous loopholes in accurately managing credit risk during the financial crisis. However, recent history showed that many banking and financial institutions underestimated the impact made from the credit risk.
      - :sunflower: As a result, Basel lll had to provide more effective regulations about addressing credit risk. Particularly, it determined several shortcomings and ambiguities present in Basel ll such as enhancing capital for counterparty default risks inheret in structured financing transactions and over the counter (OTC) contracts or securitization.