Banking I Lecture 5: Regulation and Supervision

Financial innovation often involves finding ways to circumvent existing regulations, leading to a constant game of cat and mouse between innovators and regulators.

The practice of banks operating outside their traditional balance sheet, often using derivatives to manage risk or generate profits.

A single European banking license allows banks authorized in one EU country to operate in other EU countries without additional authorization.

The principle that the home country of a bank is responsible for its supervision, but local authorities retain responsibility for specific areas like monetary policy or liquidity.

The minimum amount of capital a bank must hold before it can be authorized to operate.

A directive that harmonises accounting and internal control requirements for banks across the EU.

A directive that sets minimum capital requirements for banks to cover market risk in their trading activities.

A principle prohibiting exchange controls on capital movements within the EU.

A directive that harmonises rules for the supervision of financial conglomerates (companies combining banking, insurance, and other financial activities) within the EU.

Harmonised rules and regulations for the supervision of pensions businesses within the EU.

The process by which banks assess the risk associated with different types of loans and borrowers, considering factors like credit history and financial stability.

A standardized approach to measuring credit risk that uses predetermined formulas and industry-wide data.

A method of credit risk assessment where banks develop their own internal models and criteria to evaluate borrowers.

The disclosure of information by banks to the public about their financial health and operations, including their capital adequacy and risk management practices.

The process of evaluating the financial condition and risk management practices of banks to ensure they meet regulatory standards and maintain adequate capital reserves.

The ability of banks to raise capital from investors and lenders, often influenced by their perceived risk and financial strength.

The potential impact of operational inefficiencies, human errors, or fraud on a bank's profits and stability.

The new set of international regulations governing capital adequacy, introduced by the Basel Committee on Banking Supervision.

The BIS is an international organization that promotes cooperation between central banks. It plays a critical role in formulating global financial regulations.

The Basel Accords are a set of international banking regulations aimed at ensuring that banks have enough capital to absorb potential losses. They were developed by the BIS.

Basel I, or the 1988 Capital Accord, was the first major attempt to standardize capital adequacy requirements across different countries. It introduced a risk-asset ratio (RAR) approach to measure capital adequacy. The goal? To ensure that banks have sufficient capital to cover potential losses from lending.

The risk-asset ratio (RAR) is a key metric used to assess a bank's capital adequacy. It measures a bank's capital against its risk-weighted assets. The higher the risk-weighted assets, the more capital a bank needs to hold.

Basel I introduced a minimum capital ratio of 8%. This means banks needed to hold at least 8% of their risk-weighted assets in capital. This minimum ratio is a benchmark for adequate capitalization.

Tier 1 capital is a bank's core capital. It is made up of high-quality assets like common stock and disclosed reserves. Think of it as the backbone of a bank's financial strength.

Tier 2 capital is supplemental capital, including undisclosed reserves, asset revaluation reserves, and other assets. It provides additional support to the bank's capital base. Think of it as additional cushion for the bank's finances.

Basel I focused primarily on credit risk, the risk of borrowers defaulting on loans. Other risks, like market risk, were not fully addressed. This means that Basel I was a starting point in understanding and managing risks that banks faced.

A new set of rules designed to make banks stronger and safer. They focus on increasing capital, managing risk, and improving liquidity.

A portion of a bank's capital held above the minimum requirement, used to absorb losses during economic downturns.

A minimum amount of capital that banks must hold, determined by regulators to cover potential losses.

A percentage of a bank's assets that must be held in liquid assets, like cash or bonds.

An additional buffer of capital that banks must hold during periods of economic expansion, designed to absorb potential higher losses during a future downturn.

A system for coordinating the supervision of banks in the Eurozone, with the European Central Bank (ECB) playing a key role.

An independent body responsible for resolving failing banks in the Eurozone.

The process of preparing a bank for potential failure, making it easier to wind down or sell if needed.

A global set of regulations designed to make banks more resilient and prevent future financial crises like the one in 2007-2008.

Basel III aims to create a stronger banking system by focusing on bank capital adequacy, stress testing, and market liquidity risk.

Basel III tackles issues like insufficient capital reserves, inadequate risk management approaches, and inconsistencies in how capital is defined.

Basel III aims to reduce the chance of future financial crises by strengthening banks' ability to handle financial shocks and improve their risk management practices.

Basel III aims to improve both the individual resilience of banks and the overall health of the banking sector.

The pro-cyclical effects on credit markets refer to the tendency for credit availability to decrease during economic downturns, which can worsen the recession.

Fair value accounting uses current market prices to value assets, while historical cost accounting uses the original purchase price. Using fair value can create volatility during market downturns.

EU directives, like the Capital Adequacy directive, adapted Basel II to the specific needs and regulations of European markets.

A countercyclical buffer is a regulatory tool designed to ensure that banks hold enough capital to withstand potential losses during periods of economic expansion and excessive credit growth.

The Liquidity Coverage Ratio (LCR) is a short-term liquidity standard that requires banks to hold sufficient high-quality liquid assets to survive a 30-day stress scenario.

High-quality liquid assets are those easily convertible to cash even during stressful market conditions. These assets are considered safe and readily accepted by markets.

The Net Stable Funding Ratio (NSFR) is a long-term liquidity standard that encourages banks to rely on more stable sources of funding, such as long-term deposits and capital, to support their activities.

Available stable funding (ASF) refers to the total amount of an institution's capital, preferred stock with long maturities, and liabilities with long maturities that are expected to remain stable during a stress event.

Banks are expected to conduct their own stress tests to assess their liquidity needs beyond the minimum LCR requirements, considering scenarios specific to their individual business operations.

The NSFR aims to promote more medium and long-term funding activities for banks, limiting reliance on short-term wholesale funding that can become unstable in market crises.

The NSFR encourages banks to rely on stable and long-term sources of funding like long-term deposits and capital. This helps banks rely less on potentially risky short-term wholesale funding from the money market.