Banking I Lecture 5: Regulation and Supervision

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Questions and Answers

What is one of the main aims of Basel III?

To ensure banks operate only on historic cost data.

To increase the complexity of banking regulations.

To minimize the probability of financial crises. (correct)

To eliminate all bank regulations.

Which failure of Basel II highlighted the need for Basel III?

Insufficient capital reserves. (correct)

Failure to regulate interest rates.

Lack of branches in international markets.

Inability to provide loans to individuals.

What aspect of banking does Basel III primarily address?

International currency exchange rates.

Bank capital adequacy and market liquidity risk. (correct)

Consumer loan interest rates.

The global stock market performance.

Which of the following is NOT a target of Basel III?

Eliminating supervisory bodies. Signup and view all the answers

What triggered the introduction of Basel III reforms?

The financial crisis of 2007-2008. Signup and view all the answers

What does Basel III intend to improve in the banking sector?

Governance, risk management, and transparency. Signup and view all the answers

Which type of risks does Basel III aim to address?

Macroeconomic risks that could affect the banking sector as a whole. Signup and view all the answers

What accounting principle was adopted in Europe in January 2005 that is relevant to Basel II and III?

Fair-value accounting. Signup and view all the answers

What is the primary focus of the Basel I Accord?

Credit risks Signup and view all the answers

Which of the following best describes the capital ratio targeted by Basel I?

8% capital ratio Signup and view all the answers

What are the two elements that constitute a bank's total capital under Basel I?

Tier 1 and Tier 2 capital Signup and view all the answers

What is the primary purpose of Pillar III under Basel II?

To promote greater financial soundness and stability Signup and view all the answers

Which risk class under Basel I has a weight of 0%?

No risk Signup and view all the answers

Which group is likely to benefit from the new Capital Accord (Basel II)?

Retail banks Signup and view all the answers

What is the consequence if a bank's risk-asset ratio falls below the regulatory minimum?

The bank is not adequately capitalised Signup and view all the answers

What is a potential cost of implementing Basel II for large banks?

0.05% of assets Signup and view all the answers

Which of the following is NOT included in Tier 1 capital?

Undisclosed reserves Signup and view all the answers

Which of the following describes a responsibility of supervisors under Pillar 2?

To continuously review the banks' positions Signup and view all the answers

What type of risk does the Basel I framework NOT address?

Market risk Signup and view all the answers

What impact does Pillar III aim to have regarding the information disclosed by banks?

Contribute to a level playing field among market participants Signup and view all the answers

Which of the following asset types would be considered to have a 50% risk weight under Basel I?

Mortgages Signup and view all the answers

What risk measurement approach can banks choose under the new Capital Accord?

A standardized or internal ratings-based approach Signup and view all the answers

Which is a characteristic of the high-yield loan market under Basel II?

Increased capital requirements for banks Signup and view all the answers

What operational risk is introduced by Basel II?

Risk associated with management failure Signup and view all the answers

What is the purpose of the capital conservation buffer?

To ensure banks maintain excess capital during stable periods. Signup and view all the answers

Which institution is responsible for supervising significant banks in the Euro Area?

European Central Bank (ECB) Signup and view all the answers

What is the main effect of the Single Resolution Board (SRB)?

To harmonize practices for resolving failing banks. Signup and view all the answers

What does the minimum capital standards entail under Basel III?

A new definition of capital and minimum requirements. Signup and view all the answers

What is the role of the capital conservation buffer during periods of stress?

To be drawn down as losses are incurred. Signup and view all the answers

What is meant by 'living wills' in the context of banking resolution?

Strategies for banks to prepare for eventual resolution. Signup and view all the answers

What does the countercyclical capital buffer encourage banks to do?

Increase capital during economic downturns. Signup and view all the answers

Which best describes the 'Single Rule Book' established by the EBA?

A comprehensive framework ensuring uniform regulations across Europe. Signup and view all the answers

What is the purpose of the countercyclical capital buffer?

To ensure adequate capital is available during financial stress Signup and view all the answers

Which of the following describes the Liquidity Coverage Ratio (LCR)?

It mandates banks to hold high-quality liquid assets to survive short-term stress Signup and view all the answers

What is the minimum required value for the Liquidity Coverage Ratio (LCR)?

1.0 Signup and view all the answers

What does the Net Stable Funding Ratio (NSFR) aim to promote?

Medium and long-term funding activities Signup and view all the answers

Which of the following is considered available stable funding (ASF)?

Long-term liabilities with effective maturities of one year or greater Signup and view all the answers

What negative consequence does the NSFR address regarding funding?

Limiting reliance on unstable funding sources Signup and view all the answers

What type of assets should banks hold to comply with the LCR requirements?

High-quality liquid assets Signup and view all the answers

What is one responsibility banks have while maintaining their liquidity requirements?

To estimate the worst-case scenarios impacting their business Signup and view all the answers

What was a primary motivation behind the creation of the Eurobond market in the 1960s?

To avoid taxes imposed in the US when borrowing Signup and view all the answers

Which principle does the second banking co-ordination directive primarily emphasize?

Home country supervision with local authority responsibilities Signup and view all the answers

What does the Capital Adequacy directive specifically address?

Minimum capital requirements for market risks Signup and view all the answers

Which directive prohibits the imposition of exchange controls on capital movements?

Capital Liberalisation directive Signup and view all the answers

What is a significant aspect of the regulatory dialectic concerning financial innovation?

Regulatory changes can lead to unintended consequences Signup and view all the answers

What was established to allow for the automatic recognition of banking licenses across EU countries?

Single European banking license Signup and view all the answers

Which directive is aimed at regulating mutual funds and similar investment vehicles in the EU?

UCITS directive Signup and view all the answers

What responsibility do host country supervisors have according to the EU financial regulations?

Supervise liquidity and risk for banks operating within their jurisdiction Signup and view all the answers

Which legislation focuses on issues related to anti-money laundering and counter-terrorism financing?

AML and CTF rules Signup and view all the answers

What is a recurring theme in the relationship between financial innovation and regulatory reform?

Regulatory avoidance drives the creation of new financial innovations Signup and view all the answers

Study Notes

Banking Lecture 5: Bank Regulation and Supervision

Lecture is part of Banking I, Lecture 5.
Topic is Bank Regulation and Supervision.
Presenter is Dr Robert Suban.
Venue is the University of Malta.

Lecture Outline

Rationale for regulation
Types of regulation
Limitations of regulation
Causes of regulatory reform
EU financial sector legislation
Bank capital regulation

Introduction - Definitions

Regulation: Setting specific rules for firms to follow, often set through legislation or stipulated by regulatory authorities (e.g., MFSA in Malta).
Monitoring: Process where the authority assesses if rules are being followed (on-site and off-site).
Supervision: General oversight of financial firms' behavior.

Rationale for Regulation

Banking and finance rely on public confidence.
Healthy systems are essential for a functioning economy.
Banking activities, such as illiquid assets and short-term liabilities, make the sector more prone to problems than other sectors.
Interconnectedness means one bank's failure can trigger problems in other banks (bank contagion).
Banks are vulnerable to systemic risk (problems in one bank spreading to the entire sector).
Possibility of bank runs.
Illiquidity in short-term cash can convert to insolvency when asset value falls short of liabilities.
Systemic stability (social costs higher than private costs).
Retail client protection (complex and opaque contracts).
Protection against monopolistic exploitation.

Types of Regulation

Systemic regulation: Focuses on safety and soundness of financial system (minimizing bank runs). - This includes deposit insurance and lender-of-last-resort functions - Deposit insurance (Capital Compensation Scheme) guarantees all or part of deposited sums in case of failure. In Malta, deposits up to 100,000 Euros are covered.
Prudential regulation: Customer protection (monitoring and supervision of financial institutions focusing on asset quality and capital adequacy).
- Consumers/small depositors are not financial experts.
- In Malta, the Financial Services Authority (MFSA) undertakes this.
Conduct of business regulation: Ensuring ethical conduct - fair business practices and honest dealings (information disclosure).
- Protecting customers from bad advice, misleading contracts, fraud and misrepresentation
- Ensuring employee competence

Limitations of Regulation

"Safety nets" can create moral hazard (depositors aren't concerned about bank soundness).
Government bailout of too-big-to-fail (TBTF) or too-important-to-fail (TITF) banks can encourage risk-taking.
Regulatory forbearance (renegotiation of rules) can worsen problems.
Regulation can be captured by powerful entities and not protect the customer.
Compliance costs can be substantial.

EU Financial Sector Legislation

EU aims for harmonization to promote a single market for financial services.
Single European banking license (passporting) allows banks to operate in other EU countries.
Home country supervision principle, with local authorities responsible for monetary policy and host country supervisors responsible for liquidity and risk.
This requires harmonization and mutual recognition (allowing financial services firms to operate across the EU).
Minimum capital, supervisory requirements related to shareholders, accounting and internal control requirements.
- Solvency Ratio Directive (relates to credit risk and capital ratios).
- Own Funds directive (defines capital for supervisory purposes).
- Capital Adequacy directive (sets minimum capital requirements for market risks in banks and investment firms).

Bank Capital Regulation

Bank capital is a central regulatory element. - Past profits (retained earnings) and current capital are used to cover losses.
Losses from actions such as loan losses, trading activities, asset devaluation, poor interest margins, and fraud are covered.
Adequate capital is crucial for a bank's ability to withstand losses and maintain public confidence.
Capital adequacy is needed to sustain a banking activities in case of crisis.
Regulation ensures sufficient capital in proportion to risky assets.
Risk-weighted assets (assets with differing levels of riskiness) and capital (capital ratios). The risk assessment is based on quality of these assets. - No risk: 0% weighting. - Low risk: 20% weighting. - Moderate risk: 50% weighting - Standard risk: 100% weighting.

Basel Accords

Series of international agreements establishing minimum capital standards.
Basel I: Initial framework focusing on credit risk.
- Initial framework focusing on a single credit risk factor.
- Capital requirements for banks.
Basel II: Enhanced framework incorporating other risk types and the requirement to account for capital held.
- Incorporating other risks (market risk, operational risk)
- Internal ratings system for higher capital adequacy
- Market discipline pillar.
Basel III: Further improvements after the 2007-08 financial crisis added more factors and improvements
- Additional capital requirements
- Greater focus on systemic risks and interconnectedness.

Other Regulatory Issues

Bank-level and micro prudential vs macro prudential - Measures at the level of an institution.
- Wider measures covering risks across the entire system
Basel III reform elements (e.g., capital reform, increased capital quality and quantity).
Capital conservation buffer - Banks hold additional capital outside stress periods.
Countercyclical capital buffer - Adjusts capital requirements based on macro-economic cycles.
Liquidity standards (LCR and NSFR). -LCR: Hold high-quality liquid assets. -NSFR: Focuses on longer-term funding.
Managing Interest Rate Risk in the Banking Book.

Key Takeaways

Regulation is essential for the stability and soundness of the banking system.
Regulation attempts to mitigate risks and prevent systemic collapses.
The EU has developed harmonized rules for effectively regulating financial institutions.
Basel Accords (Basel I, II, and III) reflect the evolving understanding of risks and the need for global cooperation.

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Description

This quiz covers the key concepts from Banking I, Lecture 5, focusing on Bank Regulation and Supervision. Participants will explore the rationale for regulation, types of regulation, and the limitations of various regulatory approaches in the banking sector. Dive into essential topics like EU financial legislation and bank capital regulation.