international banking and the Basel accords

Chapter 7
International Banking and the
Basel Accords

Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
Objectives
• To find out why banks are assigned special
importance and why banking is more regulated than
other business
• To consider the types of risk a bank is exposed to
• To consider the pros and cons of banking regulation
7-2
(cont.)

Objectives (cont.)
• To outline the regulatory functions and the forms of
banking regulation
• To evaluate the Basel I and Basel II accords
7-3

Why banks are important
• Banking regulation centres on the objective of
minimising the possibility of bank failure because
banks command more importance than other
financial and non-financial firms
• The failure of banks creates more turmoil in the
economy than perhaps any other kind of firm
7-4

Reasons for the special importance of banks
• The difference between the degrees of liquidity of
their assets and liabilities, which makes them highly
vulnerable to depositor withdrawal and bank runs in
extreme cases
• Banks are at the centre of the payment system (they
are the creators of money, the medium of exchange)
7-5
(cont.)

(cont.)
• They face an asymmetric loss function, which is a
consequence of handling other people’s money
• The sheer size of the interbank market, resulting
from the fact that banks deal with each other on a
massive scale
7-6
(cont.)

(cont.)
• The failure of banks leads to a reduction in credit
flows to the rest of the economy, and hence adverse
economic consequences
• The levels of turnover and product innovation are
high, making it unlikely that employees would
experience full business and product cycles
7-7

The kinds of risk facing banks
• Financial risk
Credit risk
Market risk
• Interest rate risk
• Foreign exchange risk
• Equity price risk
• Commodity price risk
• Energy price risk
• Real estate price risk
7-8
(cont.)

The kinds of risk facing banks (cont.)
• Non-financial risk
Operational risk
Other kinds of non-financial risk
7-9

Examples of operational risk
• Liquidity risk
• Herstatt risk
• Compliance risk
• Processing risk
• System risk
• Human resources risk
7-10
(cont.)

Examples of operational risk (cont.)
• Crime risk
• Disaster risk
• Fiduciary risk
• Model risk
• Legal risk
7-11

Examples of other non-financial risk
• Business risk
• Reputational risk
• Macroeconomic risk
• Business cycle risk
• Country risk
• Political risk
• Sovereign risk
• Purchasing power risk
7-12

Operational risk
• The risk of loss resulting from the failure of people,
processes, systems or from external events.
• It is more diverse than either credit risk or market risk
7-13

Types of operational loss events
Event Definition Example
Internal fraud Losses due to acts of fraud
involving at least one
internal party.
Bribes, credit fraud and theft
External fraud Same as internal fraud
except that it is carried out
by an external party.
Computer hacking and forgery
Employment
practices and
workplace safety
Losses arising from
violation of employment
and health and safety
laws.
Discrimination
Clients, products
and business
practices
Losses arising from failure
to meet obligations to
clients or from the design
of a product.
Product defects and misuse of
confidential information
Damage to
physical assets
Losses arising from
damage inflicted on
physical assets by a
natural disaster or another
event.
Terrorism, vandalism and
natural disasters
Business
disruption and
system failures
Losses arising from
disruptions to or failures in
systems,
telecommunication and
utilities.
Hardware, software and
telecommunications
Execution,
delivery and
process
management
Losses arising from failed
transaction processing
with counterparties such
as vendors
Negligent loss or damage of
client assets and unapproved
access to accounts
7-14

Operational risk in the FX market
• One reason for the increasing level of operational
risk encountered in executing foreign exchange
transactions is increasing diversity of the foreign
exchange market, which is no longer dominated by
commercial banks
7-15
(cont.)

Operational risk in the FX market (cont.)
• The level of operational risk in the foreign exchange
market has risen also because the increasing
complexity and size of the market have made it
necessary to introduce regular changes in trading
procedures, trade capture systems, operational
procedures and risk management tools
7-16

Justification for banking regulation
• Banking regulation can be justified on the basis of
market failure such as externalities, market power,
and asymmetry of information between buyers and
sellers
• The second justification for banking regulation is the
inability of depositors to monitor banks
7-17

Arguments against banking regulation
• Some economists dispute the arguments typically
presented in favour of bank regulation
• There is significant scepticism about the role of
regulation as a means of achieving financial stability
• Regulators do not take into account the fact that risk
creates value and that profits come from taking risk
7-18

Regulation in the post-crisis era
• While the proponents of banking regulation argue
that their views have been vindicated by the global
financial crisis, those who hold opposite views still
argue otherwise
• Some proponents of free banking assert that the
impact of the crisis would have been worse if it were
not for deregulation
7-19

Regulatory functions
• Macroprudential supervision is intended to limit
financial system distress that might damage the
economy
• Microprudential supervision focuses on the solvency
of individual institutions rather than the whole system
• Conduct-of-business regulation is also justified in
terms of consumer protection
7-20

Segregation of regulatory functions
• The segregation of regulatory functions (for example,
between APRA and the RBA in Australia) is a
controversial issue on which there is no consensus
• Some would argue that one lesson learned from the
global financial crisis pertains to the segregation of
supervisory roles, particularly between central banks
and other supervisors
7-21

Forms of banking regulation
• Deposit insurance: Arguments against are moral
hazard and adverse selection
• Operations regulation, including loans (highly
leveraged activities), investment in securities and off-
balance sheet transactions
7-22
(cont.)

Forms of banking regulation (cont.)
• Regulation of the accounting process, which became
necessary following the accounting scandals at
Enron and WorldCom
• In 2002, the Sarbanes-Oxley Act was implemented
in the United States to make corporate managers,
board members and auditors more accountable for
the accuracy of the financial statements of their firms
7-23
(cont.)

Forms of banking regulation (cont.)
• Capital-based regulation requires banks to be
subject to capital requirements, holding a minimum
capital ratio, which is the ratio of capital to total
assets
• This is the basis of the Basel accords
7-24

Global banking regulation
• The Basel accords
• The US International Banking Act of 1978
• The Single European Act of 1987
7-25

Capital and related concepts
• Capital is simply the arithmetic difference between
assets and liabilities, which is also known as net
worth or shareholders’ equity
• Thus, a bank is solvent if the difference between
assets and liabilities is positive and vice versa
7-26
(cont.)

Capital and related concepts (cont.)
• Economic capital is the capital that a firm must hold
to protect itself against insolvency with a chosen
level of certainty over a given period of time
• Regulatory capital is determined by regulators, for
example, as a given percentage of the risk-weighted
value of assets
7-27
(cont.)

• Capital adequacy refers to the requirement that banks
hold adequate capital to protect themselves against
insolvency
7-28
(cont.)

• The capital ratio and the risk-adjusted capital ratio
are calculated as follows:
A
K
k 
A
K
k








 n
i
i
n
i
i
i
w
A
w
A
1
1
7-29
(cont.)

• The risk-adjusted rate of return on capital is
calculated as:
K
RAROC


7-30
(cont.)

• Regulatory capital arbitrage is a process whereby
banks exploit differences between a portfolio’s true
economic risk and regulatory risk by, for example,
shifting the portfolio’s composition towards high-
yield, low-quality (or high-risk) assets
7-31

The Basel Committee
• The BCBS was established in 1974 following the
collapse of Bankhaus Herstatt
• The BCBS does not have any supranational
authority with respect to banking supervision, and
this is why its recommendations and standards do
not have legal force
7-32

Functions of the Basel Committee
• Defining the role of regulators in cross-jurisdictional
situations
• Ensuring that international banks do not escape
comprehensive supervision by the domestic
regulatory authority
• Promoting uniform capital requirements so that
banks from different countries may compete with
each other on a ‘level playing field’
7-33

The Basel I Accord
• In 1988, the BCBS established the Basel I Accord
for measuring capital adequacy for banks
• The objective of Basel I were:
(i) to establish a more ‘level playing field’ for
international competition among banks
(ii) to reduce the probability that such competition
would lead to bidding down of capital ratios to
excessively low levels
7-34

Requirements of Basel I
• Banks are required to hold as capital an amount of
no less than 8% of their risk-weighted assets
• The capital ratio, k, can be calculated as:
08
.
0


CR
K
k
7-35

Criticism of Basel I
• It has very limited sensitivity to risk, giving rise to a
gap between regulatory capital as assigned by the
regulators, and economic capital as required by
market forces
7-36
(cont.)

Criticism of Basel I (cont.)
• Failure to differentiate between high-quality and low-
quality assets within a particular asset classes (such
as commercial and industrial credit) contributed to a
steady increase in the credit risk of bank loan
portfolios
7-37
(cont.)

• Adding up the credit risks of individual assets
ignores gains from diversification across less-than-
perfectly correlated assets
7-38
(cont.)

• The initial exclusion of market risk from capital
requirements and high regulatory costs induced
banks to shift their risk exposure (via securitisation)
from priced credit risk to unpriced market risk
7-39
(cont.)

• It completely ignores operational risk. This sounds
odd when it has become a consensus view that
operational risk can be detrimental to the wellbeing
of a bank or any business firm for that matter
7-40
(cont.)

• The Accord gives very limited attention to credit
risk mitigation despite the availability of risk
management tools such as credit derivatives
7-41
(cont.)

• Basel I did not have the provisions to adequately
measure credit risk in the mortgage market,
creating disincentives for banks to purchase
mortgage insurance and encouraging the issuance
of uninsured mortgages
7-42

The Basel II Accord
• In response to the criticism of the Basel I Accord and
to address changes in the banking environment that
the 1988 Accord could not deal with effectively, the
BCBS decided to create a new capital accord, Basel II
7-43

Requirements
• While retaining the key elements of the Basel I
Accord, including the general requirement that
banks ought to hold a regulatory capital ratio of at
least 8% of their risk-weighted assets, Basel II
provides a range of options for determining capital
requirements, allowing banks to use approaches
that are most appropriate for their operations
7-44

The capital ratio under Basel II
• Because Basel II accounts for operational risk, the
capital ratio formula becomes:
08
.
0




OR
MR
CR
K
k
7-45

The pillars of Basel II
• The Basel II Accord has three pillars:
(i)minimum regulatory capital requirements
(ii) the supervisory review process
(iii) market discipline through disclosure requirements
7-46

Calculating capital against credit risk under
Basel II
• The standardised approach is structurally similar to
what is found in the 1988 Accord. Banks are
required to classify their exposures into broad
categories, such as the loans they have extended
to corporate and sovereign borrowers and other
banks
7-47
(cont.)

Calculating capital against credit risk under
Basel II (cont.)
• Under the internal-ratings based approach, banks
may use their own internal estimates of credit risk
to determine the regulatory capital for a given
exposure
• Internal models are designed to estimate or predict
the constituent components of credit risk:
(i) probability of default (PD)
(ii) loss given default (LGD)
(iii)exposure at default (EAD)
7-48

Calculating capital against market risk under
Basel II
• Two approaches are used to measure market risk:
(i) the standardised approach
(ii)the internal models approach
• To be eligible for the use of internal models, a bank
must satisfy certain conditions
7-49

Calculating capital against operational risk
under Basel II
• Under the basic indicators approach, banks must
hold capital against operational risk that is equal to
the average of the previous three years of a fixed
percentage of positive annual gross income:
n
y
K
n
i
i


 1

7-50
(cont.)

under Basel II (cont.)
• Under the standardised approach, regulatory capital
for the whole bank is calculated as a three-year
average of the simple sum of capital charges of
individual business lines in each year:
3
0
3
1
8
1
 
 

t j
jt
j ]
,
y
max[
K

7-51
(cont.)

The Betas of business lines
7-52

• According to the advanced measurement approach
(AMA), regulatory capital is calculated by using the
bank’s internal operational risk models
7-53
(cont.)

• The Basel II Accord allows three alternative
approaches under the AMA:
(i) the loss distribution approach (LDA)
(ii) the scenario-based approach (SBA)
(iii)the scorecard approach (SCA), which is also
called the risk drivers and controls approach
(RDCA)
7-54
(cont.)

• A bank’s regulatory capital can be calculated from
the capital charges of individual business units by
adding them up under the assumption of zero
correlation. Otherwise, the loss data can be
combined to calculate regulatory capital for the
whole bank from a single loss distribution, in which
case we assume perfect correlation
7-55

Criticism of Basel II
• Basel II represents inappropriate or inadequate
financial supervision. While capital adequacy
requirements are designed to protect banks from
insolvency, the problems faced by banks during the
onslaught of the global financial crisis were illiquidity
and leverage
7-56
(cont.)

Criticism of Basel II (cont.)
• Banks should not be regulated in the same way as
they are managed. The objective of aligning
regulatory capital with economic capital (which
implies running the bank the same way as regulating
it) is way off the mark
7-57
(cont.)

• The resulting risk-sensitive capital requirements
enhance procyclicality of the banking system
• Over-reliance on the ratings of the rating agencies to
determine the riskiness of assets sounds ludicrous in
the post-crisis era
7-58
(cont.)

• Business and reputational risks, which are not
recognised by Basel II, may be more significant than
the direct operational losses that the banking
industry has been asked to monitor
• By increasing its complexity, pillar 1 does not
necessarily make the regulation more accurate
7-59
(cont.)

• As far as operational risk is concerned, pillar 1 is
criticised on the grounds that operational risk
modelling is not possible in the absence of
comprehensive databases
• The basic indicators approach is criticised for the
calculation of the capital charge as a percentage of
gross income
7-60

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