Banking Regulation Lecture 5 PDF

BANKING I LECTURE 5 BANK REGULATION AND SUPERVISION Dr Robert Suban Department of Banking, Finance & Investments University of Malta  Lecture Outline Chapter 7 CGM Book The rationale for regulation Types of regulation Limitations of reg...

BANKING I LECTURE 5 BANK REGULATION AND SUPERVISION Dr Robert Suban Department of Banking, Finance & Investments University of Malta  Lecture Outline Chapter 7 CGM Book The rationale for regulation Types of regulation Limitations of regulation Causes of regulatory reform EU financial sector legislation Bank capital regulation BANKING I BKF2011 LECTURE 5 2  Introduction Definitions Regulation ……. relates to the setting of specific rules of behavior that firms have to abide by (these can be set through legislation (laws) or be stipulated by the relevant regulatory authority (ex: MFSA in Malta) Monitoring…… refers to the process whereby the relevant regulatory authority assesses (on and off-site) whether these rules are being obeyed Supervision….. refers to the general oversight of the behavior of financial firms. BANKING I BKF2011 LECTURE 5 3 Let us first explore the reasons why we need to regulate banks?  What is the rationale for regulation? 1. Banking and financial sector relies on public confidence 2. A healthy banking and financial system are essential to the well functioning of an economy 3. Because of the nature of banking activities (illiquid assets, short-term liabilities), this sector is more prone to problems compared to other firms/sectors of the economy 4. Because banks are interconnected, the failure of one bank can lead to problems for other banks/financial institutions (bank contagion) 5. Banks are also vulnerable to systemic risk (the risk that a problem in one bank will spread to the whole sector) 6. Possibility of bank runs 7. Due to the nature of bank contracts, an illiquidity problem (lack of short- term cash) can turn into an insolvency problem (value of assets is less than value of liabilities) BANKING I BKF2011 LECTURE 5 5  The rationale for regulation Llewellyn (1999) suggests three main reasons for regulation – To ensure systemic stability (social costs are higher than private costs) – To provide smaller, retail clients with protection (financial contracts are complex and opaque) – To protect consumers against monopolistic exploitation BANKING I BKF2011 LECTURE 5 6  Example of Banks Exploiting Consumers? BANKING I BKF2011 LECTURE 5 7 Let us now see how we go about regulating banks ?  Types of regulation We can classify regulation into three different types Systemic regulation Prudential regulation Conduct of business regulation BANKING I BKF2011 LECTURE 5 9  Systemic regulation Definitions: Regulation concerned mainly with the safety and soundness of the financial system (Goodhart et al. ,1998 ) Objective : to minimise the possibility of bank runs - government safety net based on two features: – deposit insurance; and – lender-of-last-resort function (LOLR) A deposit insurance scheme (Capital Compensation Scheme) provides the guarantee that all or part of the amount deposited by savers in a bank will be paid in the event of a bank failure. This system can be explicit (stipulated by law) or offered privately. In the case of Malta, deposits up to 100,000 Euros are covered. The scheme was amended in August 2009 following the transposition of EC directive 2009/14/EC BANKING I BKF2011 LECTURE 5 10  Prudential regulation Prudential regulation is mainly concerned with consumer protection - It relates to the monitoring and supervision of financial institutions, with a particular focus on asset quality and capital adequacy (Remember Slide 7) The reason behind prudential regulation is that consumers/small depositors are not financial experts and thus are not able to assess whether a bank is financially sound In Malta, this regulation is undertaken by the Malta Financial Services Authority (MFSA) - The regulatory authorities will usually provide to financial institutions/banks rules.... guidelines as to risk management, capital adequacy, etc. (eg. How to advertise...etc.) BANKING I BKF2011 LECTURE 5 11  Conduct of business regulation Conduct of business regulation relates to how banks and other FI conduct their business (information disclosure, honesty, fair business practices, ethics) with the aim to avoid – Consumers receiving bad advice – That contracts turn out to be different from what the customer expected – Fraud and misrepresentation – That Employees of FI act incompetently BANKING I BKF2011 LECTURE 5 12  Limitations of regulation What Problems do you think.... Regulations can create ? BANKING I BKF2011 LECTURE 5 13  Limitations of regulation There are some arguments against regulation Regulation in itself, more particularly the ‘safety net’ arrangements create moral hazard (depositors do not have to worry about the financial soundness of FIs) - the government ‘safety net’, in the form of the LOLR function, will also create incentives for banks to take on more risks – although this as we have seen does not always apply. Too big to fail (TBTF) and too important to fail (TITF) - Not all banks/FIs are equal. Some, due to their size or their strategic importance, can cause much larger problems to other banks/FIs if they fail. Thus the government/central bank will bail out these banks in case of financial difficulty. If you believe that you are such a bank, you might have an incentive to take on more risks Banks may also benefit from regulatory forbearance - Regulatory forbearance (or renegotiation) is an example of time inconsistency. This means that when FIs are in trouble there might be incentives not to apply existing regulations because this could worsen the FI’s problems (Credit Suisse prior failures) Regulation can create problems of agency capture. This is when the actors (FIs) influence the regulation in their own interest and at the expense of the consumer - Costs of compliance will be passed on to consumers (In the USA, Basel rules being applicable only to banks above 100billion USD) BANKING I BKF2011 LECTURE 5 14 Banking Regulation Summary  Bank Regulation: Key concepts Objectives Reasons Rationale Costs Sustain systemic Key position of Market Moral hazard stability banks in the imperfections and financial system failures Maintain the safety Consumer demand Potential systemic Agency capture and soundness of problems financial institutions Protect consumers Monitoring of Compliance costs financial firms Costs of entry/exit Ensuring Control over consumers’ products/activities/ confidence prices BANKING I BKF2011 LECTURE 5 16  Causes of regulatory reform Why Regulatory reform? Why Continuous Rethinking? Why Re-Regulate? BANKING I BKF2011 LECTURE 5 17  Causes of regulatory reform Regulation is a dynamic process and has to evolve in order to reflect changes in the financial and economic environment financial scandals financial crisis - a financial crisis is an indication that the previous regulatory regime had some flaws Internationalisation and globalisation trends - The increased presence of international banking firms raises the question of who should ultimately be responsible for regulating that firm ? Is it the home country or host country regulator ? - Within the EU, should we have minimum or maximum harmonisation (how does that affect competition ?) - If due to globalisation, risks are not anymore confined to national borders then should we have greater cooperation between regulatory authorities ? Financial innovation a major driver of regulatory reform (very often financial innovation is motivated by regulatory avoidance. For example, Eurobond market in the 1960s (to avoid tax (imposed in US) when borrowing), off- balance-sheet activities (derivatives) in the 1980s. Usually the regulators are one step behind (regulatory dialectic) For example the current initiatives to regulate hedge funds (AIFMD), Crypto and MICA, AML and CTF rules BANKING I BKF2011 LECTURE 5 18  Regulatory Dialectic Financial Problem Change in Regulation Change in Behaviour Unintended Consequences BANKING I BKF2011 LECTURE 5 19 How are banks regulated in the EU?  EU financial sector legislation The main objective of EU legislation has been to harmonise rules and regulation aimed at promoting a single market in financial services throughout the EU This was done through the second banking co-ordination directive (1/01/1993). This legislation introduced: – A single European banking license (as long as you are authorised to conduct the business of banking in one EU state, then you can ‘passport’ your institution in any of the other EU countries (automatic recognition) – Home country supervisors principle, but local authorities retain responsibility for measures taken with respect to monetary policy and host country supervisors have responsibility for supervising liquidity and risk This is only possible if there is harmonisation and mutual recognition BANKING I BKF2011 LECTURE 5 21  EU financial sector legislation (cont.) The second banking co-ordination directive also provides for: – Minimum levels of capital required before authorisation can be granted – Supervisory requirements in relation to major shareholders and banks’ participation in the non-banking sector – Accounting and internal control requirements Additional directives were implemented which regulate banks – Solvency Ratio directive (relating to credit risk and capital ratios) – Own Funds directive (defining capital for supervisory purposes) – Capital Adequacy directive (setting out minimum capital requirements for market risks in the trading books of banks and investment firms) BANKING I BKF2011 LECTURE 5 22  EU financial sector legislation (cont.) These directives were implemented in conjunction with other directives which concern the financial sector as a whole – Capital Liberalisation directive (prohibits the imposition of exchange controls on capital movements) – Admissions directive (harmonises requirements for a company to have its shares listed on any EU stock exchange) – UCITS directive (Undertaking for Collective Investment in Transferable Securities) regulates funds (mutual funds (US) unit or investment trusts (UK) – Investment Services directive (MIFID) (single passport for investment firms in the EU) – Conglomerates directive (harmonises rules and regulations for the supervision of financial conglomerates in the EU) – Pensions directive (harmonises rules and regulations for the supervision of pensions business) BANKING I BKF2011 LECTURE 5 23  EU financial sector legislation (cont.) Other legislation was enacted on: Cross-border transactions Credit, notably consumer credit Investments, notably investment funds and rights of shareholders in listed companies Credit rating agencies Payment systems Insurance (all type of products) and solvency II Distance selling and electronic money Remuneration in financial sector Anti-Money Laundering and Counter Terrorism Financing BANKING I BKF2011 LECTURE 5 24 What are the most important factors to regulate in banks? Bank Capital  Bank capital regulation Bank capital is a fundamental element of regulation bank capital and past profits (retained earnings) are the entries from which funds will be taken in case of bank losses Bank losses can be the result of various actions (loan losses, losses on trading activities, fall in value of assets, lower interest margins, fraudulent activity) Bank capital and a bank’s ability to take a ‘hit’ and be able to continue operating is at basis of public confidence and protection of depositors For example, if there are two banks (A and B) with respective capitals of 5 and 25 million Euros. If there is a loss of 3 million Euros both banks will be able to continue operating but if the loss is of 7 million Euros then Bank A would be in serious financial difficulty BANKING I BKF2011 LECTURE 5 26  Bank capital regulation (cont.) This is why bank regulators spend so much time and energy ensuring that banks have adequate amounts of capital The adequacy of a given’s bank capital does not only depend on the value of a bank’s assets but also on the quality of those assets The greater the risk of the assets (risk of defaults or depreciation in the value of these assets) the greater should be the amount of capital to cushion any eventual losses The risk of losses also depends on the nature of the bank’s activities Before, the regulatory authorities used to determine on an individual basis the level of capital (trigger ratio) but banks were expected to have a target capital ratio that would be higher than the trigger ratio This approach has been abandoned in favour of a more harmonised determination of capital in order to ensure that we would have a level playing field and avoid situations in which banks relocate their activities to take advantage of relatively lax regulatory regimes BANKING I BKF2011 LECTURE 5 27 A quick history of Bank Capital regulation The Basel Accord(s)  The 1988 Basle Capital Accord The Basle Committee on Banking Supervision was set up at the end of 1974 by the Bank for International Settlements (BIS). The BIS is a bank for central banks and fosters international monetary and financial cooperation It groups central banks and banks supervisors from major industrialised countries (56 member central banks) The 1988 Capital Accord (the Accord) Known as Basel 1 tried to provide a common approach on how to measure capital adequacy and provide a prescription of minimum capital standards BANKING I BKF2011 LECTURE 5 29  The 1988 Basle Capital Accord (cont.) Basel I established the following: It is based on a risk-asset ratio (RAR) approach - an international standard around a capital ratio of 8 % It focused solely on risks associated with lending (credit risk) and ignored other type of risks (trading, market risks) BANKING I BKF2011 LECTURE 5 30  The 1988 Basle Capital Accord (cont.) Under Basel I, capital consists of two elements - Tier 1 or core capital and Tier 2 or supplemental capital The Bank’s total capital is the sum of Tiers 1 and 2 and constitutes the bank’s capital base – Tier 1 is made up of a) Ordinary paid-up share capital/common stock b) disclosed reserves – Tier 2 is made up of a) Undisclosed reserves b) asset revaluation reserves c) general provisions/general loan loss reserves d) hybrid (debt/equity) capital instruments e) subordinated term debt BANKING I BKF2011 LECTURE 5 31  The 1988 Basle Capital Accord (cont.) The general framework for capital adequacy risk-weighted assets can be summarised as follows There are four risk classes in the weighted-risk systems that reflects credit risk exposure: a) No risk: (0% weight) (cash or equivalents) b) Low risk: (20% weight) (short–term claims maturing in a year or less c) Moderate risk: (50% weight) (mortgages) d) Standard risk: (100% weight) (commercial loans) If the RAR calculated by the bank falls below the minimum ratio stipulated by the regulatory authorities then this means that the bank is not adequately capitalised. It should either raise additional capital or reduce credit exposure BANKING I BKF2011 LECTURE 5 32  The 1988 Basle Capital Accord (cont.) Required Tier 1 core capital is equal to risk weight * 4% of weighted risk assets Required total capital (Tier 1 + Tier 2 – deductions) is equal to risk weight * 8% of weighted risk assets Deductions from total capital consist of investments in unconsolidated banking and financial subsidiaries, reciprocal holdings of capital securities, and other deductions as determined by supervisory authorities BANKING I BKF2011 33 LECTURE 5  The 1988 Basle Capital Accord (cont.) Calculation of capital adequacy: an example One should follow the following four steps – Classify assets into one of four risk categories as described in slide prior to this – Convert off-balance-sheet (OBS) commitments and guarantees on their on-balance sheet ‘credit equivalent’ values and classify them in the appropriate risk category – Multiply the $ amount of assets in each risk category by the appropriate risk-weight – Multiply the risk-weighted assets by the minimum capital percentages, either 4% for Tier 1 capital or 8% for total capital for a bank to be adequately capitalised If a bank has the following assets: Cash = $100 million (0% risk weighting) Loans to other banks = $ 500 million (20% risk weighting) Mortgage loans to owner-occupiers = $ 800 million (50% risk weighting) Commercial loans = $1,500 million (100% risk weighting) The minimum capital ratio under Basel I is Total Risk-Weighted Assets (RWA) = (100 million * 0) + (500 million *0.2) + (800 million *0.5) + (1,500 million * 1) = $0 + $ 100 million + $ 400 million + $1,500 million = 2,000 million Minimum capital requirement is 8% of 2,000 million of which at least 50% needs to be held in the form of Tier 1 capital BANKING I BKF2011 LECTURE 5 34  The 1988 Basle Capital Accord (cont.) The implementation of the Accord was seen as a step forward however there were some criticisms – Capital ratios lacked economic foundation – The risk-weights did not accurately reflect the risk associated with assets – No recognition of asset portfolio diversification – No taking into account of other banks risks As a result most regulatory authorities chose to have higher capital adequacy ratios The 1996 amendments to the 1988 Accord – This amendment introduced a Tier 3 capital which would take into account the risks associated with the trading activity of the bank – Furthermore, the amendment granted the possibility to banks to use their own internal risk-assessment methods However, despite the amendments, Basel I received a lot of criticisms from bankers and academics and was thus reformed to form Basel II implemented by the end of 2006 BANKING BANKINGI BKF2011 I BKF2011 LECTURE 5 35 LECTURE 5 Basel II  The new Capital Accord (Basel II) is built on three main pillars BASEL II REQUIREMENTS Pillar I Pillar II Pillar III Supervisory Review Process Minimum Market Capital Discipline Requirement BANKING BANKINGI BKF2011 I BKF2011 LECTURE 5 37  Pillar I Sets out the minimum capital requirements in respect of the following risks: Credit Risk is the risk of loss due to a debtor's non- payment of a loan or other line of credit –default risk – Standardised Approach -Internal Ratings Based (IRB) Approach (Foundation and Advanced) Operational Risk risk arising from execution of a company's business functions. e.g. fraud risks, legal risks, physical or environmental risks, etc.. Market Risk value of a portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices BANKING I BKF2011 LECTURE 5 38  Pillar I - Credit Risk: Standardised vs IRB (Internal Rating Base) Approach Standardised FIRB AIRB Foundation Advanced Approach Simple Sophisticated Low detail High detail Little sensitivity to risk Higher sensitivity to risk Cost ~ Benefit Analysis BANKING I BKF2011 LECTURE 5 39  Pillar I - Credit Risk: IRB Approach Through this approach Banks may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure, subject to Approval by the Competent Authority Additional disclosure requirements under Pillar III BANKING I BKF2011 LECTURE 5 40  Pillar I - Credit Risk: IRB Approach Other requirements: ➔ need to demonstrate that it has been using the system for internal risk measurement & management purposes for at least 3 years ➔ corporate governance and oversight credit risk control unit responsible for its rating systems which is independent Internal and External audit reviews ➔ unless otherwise approved by the Authority, an Institution would be required to implement the same approach for all exposures BANKING I BKF2011 LECTURE 5 41  Pillar II – Supervisory Review Process Highlights 4 key principles detailing the following requirements: – banks should have an efficient process for assessing their overall capital adequacy (Capital Adequacy Assessment Process) supervisors should review these processes – supervisors should have the ability to require banks to hold capital in excess of the minimum – supervisors should seek to prevent capital from falling below the minimum requirement and to enforce rapid remedial action if capital is not maintained at an adequate level BANKING I BKF2011 LECTURE 5 42  ECB SREP Framework BANKING I BKF2011 LECTURE 5 43  The new Capital Accord (Basel II) Basel II is built on three main pillars Pillar 1 deals with the quantification of new capital charges and relies heavily on banks’ internal risk-weighting models and on external rating agencies Pillar 2 defines the supervisory review process Pillar 3 focuses on market discipline, imposing greater disclosure standards on banks in order to increase transparency The first pillar seeks to amend the old rules by introducing risk weightings that are more closely linked to the borrower’s credit risk standing. For example before there was no distinction between loans to large corporations and a sole trader. It also introduces operational risk Banks can choose between adopting a standardised approach to measuring credit risk or use an internal ratings-based approach as long as they follow strict methodological and disclosure requirements Under Pillar 2 supervisors should review on an on-going basis the position of banks and eventually require them to hold more capital than the minimum required BANKING BANKINGI BKF2011 I BKF2011 LECTURE 5 44 LECTURE 5  Pillar III – Market Discipline The disclosure of information by credit institutions to market participants: contributes to greater financial soundness and stability maintains a level playing field should not conflict with the requirements of accounting standards (IASs) Today banks have to put on their website pillar 3 disclosures (See VLE for example) BANKING I BKF2011 LECTURE 5 45  The new Capital Accord (Basel II) Potential winners and losers under Basel II Winners Losers Large prudent banks (need less capital Weak OECD credits (100/150) and ability to exploit internal systems) Retail banks High-yield loan market (banks need more capital) Highly credit-rated corporations Credit derivatives (lower liquidity) (100/lower) Asset-backed market (100/credit rating) Repos market (lower liquidity) Multilateral development banks (20/0) Asset management (how to implement) High-yield bond market Mortgage banks OECD outsiders (100/20 or 0) The question to answer is how is the risk going to be rated before and after Basel II ? BANKING BANKINGI BKF2011 I BKF2011 LECTURE 5 46 LECTURE 5  The new Capital Accord (Basel II) Costs of implementing Basel II – Several estimates produced a figure of 0.05% of assets which represents a cost of between $100 to $200 million for large banks. Though the actual cost per bank depends on the sophistication of the actual system implemented – No estimates were made as to the cost for regulators for transiting from a rules based approach to a process based on supervision – However, there are also potential indirect costs in the form of: – Pro-cyclical effects on the credit markets (credit rationing) – The latter effects may also be exacerbated by the introduction of ‘fair- value’ accounting as opposed to historic cost financial data. This started in Europe in January 2005 with the adoption of the international accounting guidelines IAS 39 ▪ In order for the EU countries to adopt Basel II, it was incorporated into EU directives (Capital Adequacy directive) but was adapted to the EU market ▪ Following 2007-2008 crisis, do we need to reform regulation ? Basel III ? BANKING BANKINGI BKF2011 I BKF2011 LECTURE 5 47 LECTURE 5  Basel III The latest version of Basel Learning from the Financial Crisis 2007-8  What is "Basel III": A global regulatory standard on: bank capital adequacy stress testing and market liquidity risk Also a set of reform measures to improve: Regulation Supervision Risk management BANKING I BKF2011 LECTURE 5 49  Reasons for Basel III Formulation: ◼ Failures of Basel II being: A. Inability to strengthen financial stability. B. Insufficient capital reserve. C. Inadequate comprehensive risk management approach. D. Lack of uniformed definition of capital. BANKING I BKF2011 LECTURE 5 50  Aims & Objectives of Basel III ◼To minimize the probability of recurrence of crises similar to 2007-8 to greater extent. ◼ To improve the banking sector's ability to absorb shocks arising from financial and economic stress. ◼To improve risk management and governance. ◼To strengthen banks' transparency and disclosures. BANKING I BKF2011 LECTURE 5 51  Targets Are: Bank-level or micro prudential - which will help raise the resilience of individual banking institutions in periods of stress. Macro prudential system wide - Risks that build up across the banking sector as well as the pro-cyclical amplification of these risk over time. BANKING I BKF2011 LECTURE 5 52  Key Elements of Reforms… Increasing the quality and quantity of capital Enhancing risk coverage of capital Introducing Leverage ratio Improving liquidity rules Establishing additional buffers Managing counter party risks Managing Interest Rate Risk in the Banking Book New Authority to regulate banks (EBA + ECB with SSM) New Authority to resolve failing banks BANKING I BKF2011 LECTURE 5 53  Banking Union and Single Supervisory Mechanism (SSM) This is valid for Europe ECB is now involved in supervising banks especially significant institutions (approx 120 in Euro Area) European Banking Authority (EBA) Single Rule Book + EBA Guidelines Real Harmonisation in Europe  Single Resolution Board (SRB) and Single Resolution Mechanism Harmonise practice/approach on how failing banks are resolved to minimise impact on economy and financial stability Help banks prepare for eventual resolution with living wells  Basel III: Strengthening the global capital framework A. Capital reform (see slides 52 to 54). B. Liquidity standards (see slides 55 to 61). C. Systemic risk and interconnectedness (see slide 62). BANKING I BKF2011 LECTURE 5 57  A. Capital Reform ◼ A new definition of capital. ◼ Capital conservation buffer. ◼ Countercyclical capital buffer. ◼ Minimum capital standards. BANKING I BKF2011 LECTURE 5 58  Capital conservation buffer The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred (save for a rainy day principle) A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement. Outside of periods of stress, banks should hold buffers of capital above the regulatory minimum. BANKING I BKF2011 LECTURE 5 59  Countercyclical capital buffer The countercyclical buffer (0 to 2.5%) aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses. BANKING I BKF2011 LECTURE 5 60  B. Liquidity Standards: 1. Short-term: Liquidity Coverage Ratio(LCR) (2013) 2. Long-term: Net Stable Funding Ratio(NSFR) (2014)  1.Short-term:LCR ◼ The LCR is a response from Basel committee to the recent financial crisis. The LCR proposal requires banks to hold high quality liquid assets in order to survive in emergent stress scenario. (to be used if need cash urgently) BANKING I BKF2011 LECTURE 5 62  Short-term:LCR ◼ Must not be lower than 1. ◼ The higher the better. ◼ high quality liquid: liquid in markets during a time of stress and, ideally, be central bank eligible. ◼ Banks are still expected to conduct their own stress tests to assess the level of liquidity they should hold beyond this minimum, and construct scenarios that could cause difficulties for their specific business activities (reverse stress testing). BANKING I BKF2011 LECTURE 5 63  2. Long-term:NSFR Objectives: To promote more medium and long-term funding activities of banking organizations. Ensure that the investment activities are funded by stable liabilities. To limit the over-reliance on wholesale short-term funding(money market) = problem if markets freeze BANKING I BKF2011 LECTURE 5 64  Long-term:NSFR Available stable funding (ASF) is defined as the total amount of an institution’s: capital. preferred stock with maturity of equal to or greater than one year. liabilities with effective maturities of one year or greater. deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution for an extended period a stress event. BANKING I BKF2011 LECTURE 5 65  Required Stable Funding: The required amount of stable funding is calculated as the sum of the value of the assets held and funded by the institution, multiplied by a RSF factor, added to the amount of OBS activity (or potential liquidity exposure) multiplied by its associated RSF factor. BANKING I BKF2011 LECTURE 5 66  Required Stable Funding These components of required stable funding are not equally weighted. 100% of loans longer than one year. 85% of loans to retail clients with a remaining life shorter than one year. 50% of loans to corporate clients with a remaining life shorter than one year. and 20% of government and corporate bonds. off-balance sheet categories are also weighted. BANKING I BKF2011 LECTURE 5 67  C. Systemic risk and interconnectedness (Counterparty risk) Capital incentives for using CCPs (central counterparty – central clearing) for OTC. Higher capital for systemic derivatives. Higher capital for inter-financial exposures (exposures between financial firms) Contingent capital (MREL debt that converts into equity when there is a crisis or when certain triggers are met). Remember Credit Suisse Capital surcharge for systemic banks (they are systematically important Banks). (Too-big-to-fail) BANKING I BKF2011 LECTURE 5 68  Example of a Contingent Capital Bond BOV 2024 BANKING I BKF2011 LECTURE 5 69  Managing Interest Rate Risk in the Banking Book (IRRBB) Banks hold bonds (mainly government bonds) in their treasury book Given that the value of bonds can change when interest rates move Banks have to take into account the eventual losses that they might suffer as a result of interest rate changes This is being done by the IRRBB It takes into account potential losses and monitors this metric Why is this important? Because if banks come under liquidity pressure they might have to sell these bonds at a loss (Remember SVB) BANKING I BKF2011 LECTURE 5 70  Things to Remember What is the difference between regulation, supervision and monitoring ? Why do we need regulation ? What are the different types of regulation ? What are the limits of regulation ? Why do we need to reform regulation ? EU financial legislation Why is Bank Capital so important ? Basel I, Basel II and Basel III BANKING I BKF2011 LECTURE 5 71