Regulatory Risks and Financial Crisis PDF

5 REGULATORY RISKS, FINANCIAL CRISIS Introduction Globalisation of Regulations in Europe Introduction The Basel Committee q In 1974 an international financial regulation committee called "Basel Committee for Banking Supervision", whose meetings take place at the headquarters of the Bank for Internat...

5 REGULATORY RISKS, FINANCIAL CRISIS Introduction Globalisation of Regulations in Europe Introduction The Basel Committee q In 1974 an international financial regulation committee called "Basel Committee for Banking Supervision", whose meetings take place at the headquarters of the Bank for International Settlements - BIS - in Basel, Switzerland q The mission of this committee is to strengthen the regulation of banks and promote and disseminate better banking practices. Its main objective is to ensure the stability of the financial system on a global scale. To this end, it establishes international standards in the area of prudential supervision of banks and constitutes a forum for international cooperation on these issues. q The Basel Committee is made up of representatives of the banking supervisory authorities and central banks of 27 developed and emerging countries, including France, the United Kingdom, Germany, Italy, Spain, Japan, Switzerland, Brazil, Russia and the United States q The Basel Committee has no supranational authority. Also, the decisions taken in its enclosure are not mandatory. To ensure the implementation of its mandate, the Basel Committee must rely on the ability of its members to pass the standards it has enacted through their domestic jurisdiction A FROM BASEL I TO BASEL III: THE BASEL COMMITTEE'S RESPONSE TO THE FINANCIAL CRISES Genesis of prudential rules: Basel 1 Fall of the Breton Woods agreements and Bankruptcy of Herstatt Bank The Bretton Woods agreements were signed after the end of the war in order to structure the world monetary organization and set up a Fixed exchange system as early as 1944. The Bretton Woods system finally fell in March 1973 with the adoption of the floating exchange rate regime. In 1974, the German Bank Herstatt specializing in foreign exchange business went bankrupt. Its bankruptcy creates a severe crisis in the foreign exchange market causing a paralysis of the interbank market and a risk of bankruptcy of many financial institutions (systemic risk in the banking market). Genesis of prudential rules: Basel 1 Genesis of prudential rules: Basel 1 Focus on Herstatt Bankrupcy q This bank was the 35th largest bank in Germany at the time specializing in foreign exchange business q On 26 June 1974, German regulators forced the troubled Bank Herstatt into liquidation Yes, but what happened next? q That day, several banks had released payment of Deutsche Marks to Herstatt in Frankfurt in exchange for US dollars that were to be delivered in New York q The bank was closed at 16:30 German time, which was 10:30 New York time. Because of time zone differences, Herstatt ceased operations between the times of the respective payments q When it closed its doors on 26 June 1974, counterparty banks (mainly in New York) had not received their USD payments due to them because of time-zone differences This is known as Settlement risk or Herstatt risk Genesis of prudential rules: Basel 1 The reaction in response to systemic banking risk: The Cooke ratio The bankruptcy of the system led to the establishment under the aegis of Peter Cooke Responsible for Central bank of England of a Committee of Central Banks (G-10 Central Bank Governors) and banking supervisory bodies called the Basel Committee in 1974. The first recommendations of the Basel Committee were consolidated under the name of Basel I. Basel I Cooke Ratio sets minimum equity ratio versus 8% weighted risks: q It focused only on credit risk. q It was completed in 1996 to take into account market risks q It made it possible to contribute to the two fundamental objectives of the Comitee: § Increase the strength of the international banking system § Strengthen the level playing field between banks. Nick Leeson Scandal: Road to Basel II The incredible story of Nick Leeson : The crazy trader of Barings A story of several years of choices, first unhappy, then fraudulent and illicit. Early promoted to the title of General Manager in the future markets of the Singapore International Monetary Exchange: a native of Watford, he started his career at 18 and then joined Morgan Stanley at 20. He was only 24 when Barings, with whom he had worked for three years, propelled him to a strategic position. A detail of alert for the British institution: the departure of Nick Leeson to Singapore is due to the refusal of the British authorities to grant him a broker license for a fraud in his application file. Fraud practice from its first months of activity at SIMEX: it frees itself from regulations for risky speculative operations, but which bring in significant profits to Barings The incredible story of Nick Leeson : The crazy trader of Barings Encouraged by his performance, he multiplies operations. With less success but does not admit its failures to its management and finds a flaw: an "Error account", account used for corrections of sets of writings by the bankers, which it uses to hide its losses. At the end of 1992, account 88888 posted losses estimated at £ 2 million. Considerable in comparison with the figures usually linked to these "error accounts". But low compared to the losses measured two years later: £ 208 million The management of Barings will make a fatal error because, contrary to current practice, he is authorized to remain a chief trader while obtaining supervision of his own trading operations. There is no longer any monitoring of his actions and he can easily hide his losses on account 88888.. Month after month, he got more and more fails from 95 that lead him to impossible situation and Nick Leeson then tried a last bet: Bet on the rise of the Asian stock markets, via derivatives with strong leverage. January 17, 1995: Earthquake in Kobe - Japan. Impact on the Asian stock markets which abruptly unscrew and all the indices including the Nikkei plunge Losses reach £ 860 million on account 88888, twice the bank's available equity From Basel I to Basel II Basel I Basel II Ø Credit risk only Ø Static vision Ø Does not take into account the quality of the counterparties Ø Insufficient consideration of the nature of lines and guarantees Ø Quantitative approach Ø Understand all the risks Ø Dynamic vision Ø Takes into account the intrinsic quality of the debtor Ø Integrates the nature of the lines and the guarantees Ø Dynamic approach: seeks to anticipate risks The Basel II Update The emerging limits of Basel I At the beginning of the 2000s, Basel I was no longer adapted to the new environment: q It gave a rough measure of the economic risk and did not allow to significantly differentiate the risks. q Significant risks were not taken into account: operational risk, interest rate risk on the banking book, liquidity risk, etc. The Basel II solution Basel II is validated by the Basel Committee in 2004. Other items were added to the Basel I rules: q Taking into account operational risk in weighted risks q The definition of three fundamental pillars for the prudential system A few months after its operational implementation, Basel II revealed its weaknesses undergoing the crisis Bâle II Sustainably marks the banking industry with increased demands. Device based on 3 "Pillars": First Pillar : Capital also takes into account credit risks, market and operational risks. The credit risk quality induces the notion of rating or counterparty. Second Pillar : Prudential monitoring system for risks will have to be put in place in banks. Third Pillar : Market discipline and improvement of financial communication. A few months after its operational implementation, Basel II revealed its weaknesses undergoing the crisis Focus on Subprime Crisis The Transgression of the conservative lending policy (1/2) Ø Decline in key rates of the FED to revive the US economy in late 2001 after the burst of the Internet bubble and the attacks of September 11 (historical decline of up to 1%) Ø Government Ownership Policy Encourages Banks to Apply Very Aggressive Loans to Low-Credit Households Ø Granting of subprime loans, loans whose variable rates were indexed to changes in the interest rates of the FED and the evolution of the price of real estate and secured by mortgages (Mortgage) Ø Since real estate prices have never fallen since the war, mortgages were considered as real guarantees Ø Borrowers can abandon their debts by selling their property Focus on Subprime Crisis The Transgression of the conservative lending policy (2/2) Ø Sudden rise in key rates applied by the FED from 2004 to 2006, rising 17 times from 1% to over 5% Ø Sudden and rapid increase in monthly payments and financial charges on these "fragile" households Ø Influx of the supply of real property assets and heavy fall in the market price value of 20% Ø Mass payment default and mortgage without any value Ø Acceleration in sales by banks to redress their balance sheets compounding the fall of real estate prices Ø Emergence of a deep liquidity crisis Focus on Subprime Crisis Securitization, the Global contagion Ø Securitization consists of transforming loans distributed by a bank into debt securities (bonds) that an investor can buy and sell at any time. Ø Misappropriation of solvency ratios by banks by removing subprime assets from their balance sheets Ø Moral hazard / lack of vigilance, because of risk transfer and motivation to make more quantity credits Ø Mix of consolidations in credit portfolios securitized by investment funds Ø Risk of default assumed to be lower than loans taken one by one and independent of each other which explains the very good rating of credit rating agencies on these obligations Ø But risks were interdependent because they are all related to the US real estate market Ø Falling US real estate prices have led to a collapse in the value of vehicle assets scattered in banks around the world Ø Snowball effect on all global banks Ø Panic and arrival of a great crisis of confidence The emergence of Basel III Transitional step for a solution to be found urgently Creation of BASEL 2.5 in 2009 and implementation in 2010 Strengthening the requirements of market risks, securitization, large risks Creation of BASEL 3 in 2010 and implementation in 2014 Strengthening the quality and level of capital, liquidity and leverage ratios, counterparty risk B BASEL III FUNDAMENTAL PRINCIPLES Banking industry challenged: Capital under pressure Bank margins under pressure Low interest rate environment Weak global economic growth Challenging competition Strict regulatory framework Tax pressure High capital requirement centrally and locally Rules of increased compliance Basel 3 : What is the impact for a huge bank? 2008 2009 2010 2011 FINANCIAL CRISIS ECONOMIC CRISIS GROUP SHARE OF NET INCOME 2012 2013 2014 SOVEREIGN DEBTS CRISIS 2015 2016 2017 EU ECONOMIC DOWNTURN 7.8 3.0 5.8 7.8 6.1 6.6 6.1 6.2(1) 6.7 7.7 53.8 53.3 69.5 74.6 75.4 85.9 87.6 89.4 96.3 100.7 19.6% 6.6% 10.8% 12.3% 8.8% 8.9% 6.1% 7.7% 8.3% 9.3% Bn€ EQUITY Bn€ RETURN ON EQUITY* ROE below market expectations of 10% Basel 3 : A paradigm change in capital management Regulator, Counterparties and rating agencies Shareholders To offer shareholders (and the market) the maximum profit possible To assure the sustainability and stability of the company Without increasing the Share capital, in order to reduce the probability of dilution Return on Equity To comply with the regulatory requirements by owning a level of the equity at least equal to the legal minimum, so as to protect the investors To reassure lenders and rating agencies of the ability to refund debts Solvency Basel 3 – Global regulation (1/5) Capital Pillar I Pillar II Pillar III Minimum requirements in Capital and Liquidity Risk Management and Supervision Market Discipline General constraints on solvency ratios Micro & multidimensional supervision by the regulator (individual and national) Publication requirements Liquidity Liquidity global Standard and Close monitoring Basel 3 – Global regulation (2/5) Ø Implementation of Basel III in the EU through package ‘CRD 4’ : Ø Capital Requirements Directive (2013/36/EU) (CRD) that must be implemented through national laws Ø Capital Requirements Regulation (575/2013) (CRR) which is directly applicable for EU companies Ø Date of entry into force: 1st January 2014 Ø Includes increasing regulatory Capital requirements with a national margin of appreciation (Possibility to adapt the regulation by national regulators). Ø Defines the minimum capital required to face different types of risks : Ø Credit Risk Ø Market Risk Ø Operational Risk Ø Counterparty Risk Ø Currency Risk (FX) Ø Equity Risk Ø New ratios submitted by Basel 3 Ø Higher solvency ratio required Ø Liquidity ratio Ø Leverage ratio of the total balance sheet Basel 3 – Global regulation (3/5) Regulatory Definition Capital (CET1 + AT1 + Tier 2) ≥ Risk Weighted assets Generated by : Ø Ø Ø Ø Ø Ø Ø Solvency minimum ratio Credit Risk Market Risk Operational Risk Other Risky Assets Counterparty Risk Currency Risk (FX) Equity Risk Basel 3 – Global regulation (4/5) Ø Numerator: Regulatory Capital Ø Ø Includes CET1, AT1 and Tier 2 - CET1= Regulatory capital + reserves + annual result - AT1 = Hybrid debt (Subordinated securities) - Tier 1 = CET1 + AT1 - Tier 2 = Qualified subordinated debts Includes various deductions Ø Denominator: Reflects the Risk weighted assets Ø Ø Ø Ø Ø Ø Credit risk Market risk Operational Risk Counterparty risk Currency risk (FX) Equity risk Ø Core Equity Tier 1 (CET1) ratio : CET 1 / RWA Basel 3 – Global regulation (5/5) Structuration of Equity according Basel 147 Basel 3 – Global regulation (5/5) Capital conservation buffer Outside of periods of stress, banks should hold buffers of capital above the regulatory minimum. When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, share-backs and staff bonus payments. Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital. A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement. 148 Basel 3 – Global regulation (5/5) Countercyclical buffer Losses incurred in the banking sector can be extremely large when a downturn is preceded by a period of excess credit growth. These losses can destabilise the banking sector and spark a vicious circle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. 149 Basel 3 – Global regulation (5/5) Countercyclical buffer The countercyclical buffer regime consists of the following elements: National authorities will monitor credit growth and other indicators that may signal a build up of system-wide risk and make assessments of whether credit growth is excessive and is leading to the build up of system-wide risk. Based on this assessment they will put in place a countercyclical buffer requirement when circumstances warrant. This requirement will be released when system-wide risk crystallises or dissipates; Basel 3 – Global regulation Synthesis of Equity Requirement according to Basel 3 Basel 3 – Trends Impact and evolution for French banks