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Wk 9: Ch11 Regulation, Wk 9: Ch12 Accounting Implications of Credit Risk,…
Wk 9: Ch11 Regulation
Key Regulation Directives
Dodd-Frank
mandate creates a new agency responsible for:
reform the regulation of credit rating agencies
require changes to corporate governance and executive compensation practices
effect significant changes in the regulation of over-the-counter derivatives
Incorporate the Volcker Rule
into more stringent regulatory capital requirements
require registration for advisers to certain private equity funds
implementing and enforcing compliance with consumer financial laws
make significant changes in the securitisation market
emphasises on closing regulatory gap and reducing exposure to systemic risk
8 agencies that impose regulatory rules, each had a myriad of rules affecting: the recognition, measurement, and curtailment of credit risk, and capital allocation
Basel 3
Aim 1: is to absorb shocks arising from financial and economic stress
Aim 2: Improve risk management and governance
Aim 3: Strengthen bank's transparency and disclosures
Designed to help raise the resilience of banks to periods of stress (AKA. Microprudential Regulation
Aims target systemic risk (AKA. Macroprudential Regulation)
Basel 3 sets minimum capital requirements, minimum liquidity and maximum leverage for banks
Risk-weighted-assets formula used to assess Capital
assigning a capital charge and then comparing this to actual capital held
Solvency 2 (EU)
lays out specific requirements for supervised institutions to recognise, measure, curtail, and allocate capital for credit risk exposure
these range from allocating capital based on credit rating and concentration thresholds, to allocating capital for structured credit products based on the quantifiable amount of credit enhancement with which the securities are supported
Use EIOPA formulaic model for determining required capital
US Pension Regulation
US Insurance Regulation
Derivative Regulation
Regulation of Broker Dealer
Doing Business with a Regulated Entity
Benefits of regulation
Alignment of Interests
Regulators act on behalf of the banks' creditors (i.e. depositors, policyholders, bondholders, and customers)
creditors getting a benefit from the regulators' oversight and enforcement activity
Solvency
regulatory rules are there to require an increase in regulatory capital to reflect the heightened risk from the reallocation
Oversight and Governance
Regulators require companies to disclose info
reduces natural info asymmetry
regulatory oversight raises the burden of proof
Systemic Risk and Contagion
systemic risk (contagion) is reduced with regulation
Primary goal of G-20 and Dodd-Frank
Disadvantages of Regulation
Not all creditors are treated equally by the regulator
regulators are usually supporting retail customers not investor or business counter-parties
preferential treatment to retail customers
Seizure and Lack of Orderly Disposition
extreme form of intervention: conservatorship
regulator takes over the entity and manages either its rehabilitation or liquidation
creditor claims will fall in value or even worthless
Moral Hazard
regulated entities possible take on more risk since they know if they encounter losses their is a guarantee fund/ insurance to protect customers
customers rely too heavily on regulator's work and not perform enough of their own due diligence
Regulators' presence can cause an enablement of a safety net to customers that create a demand for regulated entities which increase growth faster.
Faster growth is correlated with excessive risk taking which can be unfavourable
Gamemanship
Uneconomic Decision Making
regulated companies enter into transactions that are favourable from a regulatory capital standpoint
they use less regulatory capital, yet may have lower risk-adjusted returns or use more economic capital
Ratings Arbitrage
decide to take a credit risk exposure to gain a favourable regulatory treatment
Regulatory Arbitrage
bases its decision for operations, financing or strategy based on where it will get the most favourable regulatory treatment
Organisational Arbitrage
Organise the business to have on part of the company to be regulated and the other unregulated
non-regulated company keeps equity financing out of regulator domain.
formed to assume risks, issue securities and manage cash outside of regulatory supervision
Wk 9: Ch12 Accounting Implications of Credit Risk
Loan Impairment
An estimated loss from a loss contingency, including uncollected receivables or loans is needed b/c a fundamental accounting goal is to match revenues and expenses
The estimated loss is thus accrued bu a charge to income if it is probable that an asset had been impaired and that the amount of loss can be reasonably estimated
A loan is impaired when, based on current info and events, it is probable that a creditor will be unable to collect all amount due according to the contractual terms of the loan agreement
Cons: Neither GAAP nor IAS stipulates how a creditor handles this event, leaving some degree of subjectivity:
Determining it is probable that it will be unable to collect all amounts due
Identifying loans to be evaluated for collectability
Recording a direct write-down of an impaired loan
Assessing overall adequacy of allowances for credit losses
Loan Loss Accounting
When a bank originates a loan portfolio, a loan-loss reserve for impairments as a contra asset for losses it expects from the portfolio
Impairment of Debt Securities
Regulatory Requirements for Loan-Loss Reserves
Conslidation of Variable Interest Entities (VIEs)
Accounting for Netting
De-Recognition of Assets
Hedge Accounting
Credit Valuation Adjustments, Debit Valuation Adjustments, and Own Credit Risk Adjustments
IFRS 7
Homework Qs
9.1: Briefly describe the benefits of regulation.
9.2: What are the pitfalls of regulation?
9.3: Why does regulation matter for the regulated financial entity?
9.4: Explain what Table 12.1 on page 204 represents.
9.5: What does impairment of debt securities mean?
9.6: What does accounting for netting mean?
9.7: What is hedge accounting?
9.8: What does IFRS7 deal with?