© K.Cuthbertson and D.Nitzsche LECTURE REGULATION OF FINANCIAL INSTITUTIONS 1/9/2001 FINANCIAL...

© K.Cuthbertson and D.Nitzsche

LECTURE REGULATION OF FINANCIAL INSTITUTIONS

1/9/2001

FINANCIAL ENGINEERING:DERIVATIVES AND RISK MANAGEMENT(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche


REASONS FOR REGULATION

TYPES OF RISK

REGULATORY FRAMEWORK

WHAT IS “CAPITAL” ?

TYPES OF RISK

BASLE (1988) ACCORD - CREDIT RISK

TOPICS


1. MARKET FAILUREa)externalities

eg. bank run, credit crunch = systemic risk

b)market powereg. fixed commissions

monopoly/cartels (eg Japanese Banks)



2. OTHER REASONS

protection of payments system(BoE)

protection from fraud (FSA)

promotion of competition (FSA)

protection of small depositors (FSA)

education (FSA)



3. INFORMATION PROBLEMS

asymmetric information leads to deposit insurance

Fixed rate deposit insurance leads to problems of

adverse selection (eg. motor insurance, too many risky drivers)

moral hazard (eg. drives recklessly because he’s insured)

Regulator has principal-agent problem(can’t fully monitor behaviour, eg. drinking and driving, after providing insurance).



WHAT IS “CAPITAL” ?

Capital(Equity) =Shareholder’s funds + past retained profits

Capital

acts as like a “deductible” or “excess” on an

insurance policy

It is a financial “cushion” for the “bank”

Bank’s equity represents the amount the bank’s

assets may fall, such that the depositors could in

principle still sell off the remaining ‘good’ assets and

obtain the full face value of their deposits


STYLISED BALANCE SHEET(S)HIGHLY (LOW) CAPITALISED BANK

ASSETS LIABILITIES

1.Cash Reserves

10 (10) Deposits 10 (90)

2.Securities 30 (30) Capital 90 (10)

3.Loans 60 (60)

100 (100) 100 (100)


What Drives Financial Markets ?Rational Behaviour or :

PIGS


TYPES OF RISK

Legal Risk : the risk that a contract is not enforced as expected

Liquidity Risk : lack of a counterparty to trade with in the time scale desired

Credit Risk : lack of funds available by the counterparty who then defaults

Operational Risk : origination, settlement and clearing of trades is mishandled (eg. faulty IT, fraud).


Assimilation Risk : participants do not fully understand how assets are priced

Incentive Risk : remuneration packages which encourage excessive risk taking.

Market Risk : risk due to a fall in asset prices which involves ~

Model and estimation risk = Choosing the wrong model or the wrong estimation technique to estimate the ‘risk model’ (eg. assume niid returns)

TYPES OF RISK


Nikkei Future (Leeson Loses)

12000

14000

16000

18000

20000

22000

24000

Buy

Close out\Sell

“ Five eights make $1.4bn ?“

Leeson’s Futures Trades on Nikkei225


FINANCIAL “SCANDALS”

South Sea Bubble, Tulipmania Pensions Mis-selling (£1bn+) \ Maxwell(£400m)Barlow Clowes (Gov.Bonds)BCCI-1991 ( Drug Money / Laundering)Proctor and Gamble (Int Rate Derivatives)Orange County (Int Rate Derivatives, $7bn)Metallgeschellschaft (oil derivatives >$1bn)Barings ( Leeson -Derivatives, $1.4bn)Sumitomo ( Copper $1bn )Morgan Grenfell ( Asset Management, £240m) Nat West/UBS ( Derivatives £100m)LTCM ($4.4bn- Sept 98)


OPEN PRISON ?


Basle (1988) “Accord”

on Credit Risk


TOPICS

BASLE (1988) ACCORD

Risk Weights

Equity-Assets Ratio/ Risk Adjusted Asset Ratio

Bank Capital: Tier I and II


Basle (1988) Risk Weights

Risk Weights (0 ot 100%) given to all types of counterparty (e.g. OECD governments, corporates etc) and asset (e.g. bank loans, securities held)

Equity capital required for ‘credit risk’ is set at a min. = 8% of value of (risk weighted) total assets


“RELATIVE RISK WEIGHTS

Zero %

20%

50%

100%

cash and gold bullion

claims on OECD central banks

claims on development banks

claims on other OECD banks

mortgages on residential property

claims on private sector (eg. bank loans)

claims on governments outside OECD


RISK-ADJUSTED ASSETS RATIO, RAR

Risk Weights of wi= 10, 20 or 50 and 100% Ai = market value of bank’s assets

Risk Weighted Total Assets [1] RWTA = (wi/100) Ai

Risk Adjusted Assets Ratio, RAR [2] RAR = (Equity Capital /RWTA) x 100

Basle Accord requires RAR to be greater than 8%

The more Equity capital E, you hold (as proportion of total assets), the bigger “cushion” against potential losses


SOLVENCY AND THE BASLE RATIO

Solvency requires:Tot Assets(TA)- Bad Debts(BD) >Deposits (D) TA - BD > D

But balance sheet gives TA=D +E

Hence solvency requires: E > BD or (E/TA) > (BD/TA)

(BD/TA)= proportion of Bad Debts (g)(E/TA) = Equity assets ratio


SOLVENCY AND THE BASLE RATIO

Solvency requires:

The equity-assets ratio, EAR (= E/TA), exceeds the proportion of bad debts, g.

Risk Adjusted Assets Ratio RARReplace ‘equity-assets ratio’ with RAR

Solvency requires:

RAR > g (latter set at 8% by Basle)

g = proportion of bad debts


BASLE/EC : BANK CAPITAL

Tier I Capitala) share capital/common stockb) cumulative retained earningsc) non-cumulative perpetual preference

sharesTier 2 Capitala) cumulative perpetual preference sharesb) undisclosed reserves b) revaluation reserves +hybrid debt/equity +

subordinated term debtNote: deductions for investments in other

banks and ‘goodwill’


Basle 2000 Suggestions

Table B20.1 : Proposed Basle Credit Risk Weights (%)

CLAIM ON: AAA toAA-

A+ to A- BBB+ toBBB-

BB+ to B- BelowB-

Unrated

Sovereigns

Banks – Option 1*

Option 2†

Corporates

0

20

20

20

20

50

50

100

50

100

50

100

100

100

100

100

150

150

150

150

100

100

50

100

* Based on risk weighting of sovereign in which the bank is incorporated† Based on the assessment of the individual bank Claims on banks of a short original maturity e.g. less than six months, would receive a

weighting that is one category more favourable

Source: Basle Committee on Banking Supervision (Economist 5/12/99)


OFF-BALANCE-SHEET ACTIVITIES

1. INCOME FROM FEESa) commissions on FX transactions

b) servicing mortgage-backed security c) guaranteeing debt securities d) backup lines of credit

2. NET POSITION IN FORWARD FOREIGN EXCHANGE


ENDS LECTURE

© K.Cuthbertson and D.Nitzsche LECTURE REGULATION OF FINANCIAL INSTITUTIONS 1/9/2001 FINANCIAL...

Documents

Transcript of © K.Cuthbertson and D.Nitzsche LECTURE REGULATION OF FINANCIAL INSTITUTIONS 1/9/2001 FINANCIAL...