unit12.pdf

Introduction to Financial Markets Unit 12 Regulation and Supervision Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 30  Banking i...

Introduction to Financial Markets Unit 12 Regulation and Supervision Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 30  Banking is Risky Business Section 1 Banking is Risky Business Prof. Dr. M. De Ceuster Introduction to Financial Markets 2 / 30  Banking is Risky Business Classifying risks Investment risk Credit risk (default risk, counterparty risk) i.e. failure of a debtor to satisfy the contractual obligations on time. Price risk or market risk (interest rate risk, credit spread risk, stock price risk, commodity price risk, inflation risk, forex or currency risk) Reinvestment risk (e.g. in callable bonds) Liquidity risk Prof. Dr. M. De Ceuster Introduction to Financial Markets 3 / 30  Banking is Risky Business Classifying risks Business Funding risk Financial leverage risk (leverage measured by a debt ratio or a debt-equity ratio) Funding liquidity risk Timing risk Fixed-floating financing risk Systemic risk Prof. Dr. M. De Ceuster Introduction to Financial Markets 4 / 30  Banking is Risky Business ROE and Leverage Prof. Dr. M. De Ceuster Introduction to Financial Markets 5 / 30  Banking is Risky Business ROE and Leverage Prof. Dr. M. De Ceuster Introduction to Financial Markets 6 / 30  Regulators Section 2 Regulators Prof. Dr. M. De Ceuster Introduction to Financial Markets 7 / 30  Regulators Regulators On the international level soft law is created Financial Stability Board (FSB) Founded by the G20 Hosted by the BIS Basel Committee on Banking Supervision (BCBS) Founded in 1973 Hosted by the BIS Comittee on Payments and Market Infrastructure International Organisation of Securities Commissions (IOSCO) Prof. Dr. M. De Ceuster Introduction to Financial Markets 8 / 30  Regulators Financial Stability Board Composition Ministers of Finance (G20) Representatives of the central banks and the supervisory institutions Representatives of international financial organizations (e.g. IOSCO) Tasks Evaluate and identify weaknesses in the financial system, Coordinate the exchange of information between DAs, Monitor market evolutions, Issue guidelines for supervisory institutions, Contingency planning for cross border crisis management, Cooperate with IMF in the Early Warning Exercises, Monitoring best practices with respect to issued guidelines. Prof. Dr. M. De Ceuster Introduction to Financial Markets 9 / 30  Regulators Basel Committee on Banking Supervision ( B C B S) High-level guidelines Reports to the Group of Central Bank Governors and Heads of Supervision Complied the Core Principles for Eflective Banking Supervision (in 2012) Most known for the capital adequacy regulation. Prof. Dr. M. De Ceuster Introduction to Financial Markets 10 / 30  Regulators Short history 1988 : Basel I 1996 :Ammendment for market risk 2004 : Basel II 2009 : Basel 2.5 2012 : Basel III 2017 : Basel IV Prof. Dr. M. De Ceuster Introduction to Financial Markets 11 / 30  Regulators Basel Risk Classification Credit risk Market risk Operational risk Liquidity risk Prof. Dr. M. De Ceuster Introduction to Financial Markets 12 / 30  Regulators Credit Risk Credit risk is the risk that the obligor of a financial instrument will fail to fulfill is obligation on the due date or at any time thereafter. Settlement risk is the risk that during the settlement process, the transfer fails to take place as expected. (This can be counterparty risk or liquidity risk.) Counterparty risk is the risk that a counterparty fails to satisfy its obligation. Prof. Dr. M. De Ceuster Introduction to Financial Markets 13 / 30  Regulators Liquidity risk Prof. Dr. M. De Ceuster Introduction to Financial Markets 14 / 30  Regulators Operational risk Operational risk encompasses all risks other than those captured by credit and market risk. Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. Prof. Dr. M. De Ceuster Introduction to Financial Markets 15 / 30  Regulators Operational risk Prof. Dr. M. De Ceuster Introduction to Financial Markets 16 / 30  Regulators Basel’s Three pillar approach Prof. Dr. M. De Ceuster Introduction to Financial Markets 17 / 30  Regulators Capital adequacy in Basel III in a nutshell Pillar 1 defines how much regulatory capital a bank needs. At any moment, a bank is required to hold at least 4.5% CET-1 6% tier-1 capital 8% total capital of the RWA. Buffers Capital conservation buffer: 2.5% CET-1 Countercyclical buffer: can be imposed up to 2.5% CET-1 SIFI buffer of 1 % to 2.5% CET-1 Prof. Dr. M. De Ceuster Introduction to Financial Markets 18 / 30  Regulators Basel III capital definitions Tier 1 capital (going concern capital) Common Equity Tier 1 (roughly shareholder’s equity) Additional Tier 1 (AT1) capital (i.e. perpetual preferred stock, coco’s,...) Tier 2 capital (supplementary capital - gone concern capital) In addition to the RWA based minimum requirements, Basel III also imposes an absolute leverage ratio. Prof. Dr. M. De Ceuster Introduction to Financial Markets 19 / 30  Regulators Liquidity requirements in Basel III Liquidity coverage ratio Net stable funding ratio ILAAP Basel IV introduces changes that limit the reduction in capital that can result from banks’ use of internal models Prof. Dr. M. De Ceuster Introduction to Financial Markets 20 / 30  Regulators Soft law becomes hard law European Union projects 1957-1973 : liberalisation of capital and service flows 1973-1983 : harmonisation of national legislation (accounting, banks, insurance,...) through directives 1983-1992 : completion of European internal market Prof. Dr. M. De Ceuster Introduction to Financial Markets 21 / 30  Regulators Important directives Capital requirements directive and the Capital requirement regulation (CRD-IV) Bank recovery and resolution directive (BRRD) MIFID Solvency-II directive Payment services directive 2 (PSD2) Packaged retail and insurance based investment products (PRIIPS) Prof. Dr. M. De Ceuster Introduction to Financial Markets 22 / 30  S upervision Section 3 Supervision Prof. Dr. M. De Ceuster Introduction to Financial Markets 23 / 30  Supervision Regulation and supervision “Banking, I would argue, is the most heavily regulated industry in the world. Regulations don’t solve things. Supervision solves things.” Wilbur Ross, Past Minister of Economic Affairs Prof. Dr. M. De Ceuster Introduction to Financial Markets 24 / 30  Supervision Supervisors bite Prof. Dr. M. De Ceuster Introduction to Financial Markets 25 / 30  Supervision European Banking Union Prof. Dr. M. De Ceuster Introduction to Financial Markets 26 / 30  Supervision Single Supervisory Mechanism S S M wants to reduce the probability that banks fail. The system of microprudential supervision is composed by the ECB and National competent authorities. SRM wants to reduce the likelihood that governments have to bail out banks if they should fail. Prof. Dr. M. De Ceuster Introduction to Financial Markets 27 / 30  Supervision European Architecture of Prudential Supervision Prof. Dr. M. De Ceuster Introduction to Financial Markets 28 / 30