Banking and Regulation
Banks play a key role as an intermediary in the financial system as they allow individuals to safely deposit their savings, provide loans to both individuals and organisations, and they are responsible for the payments system. This module discusses the role of several financial institutions and the role of the Central Bank. This module explores the different risks that are present in the financial markets. Lastly, the module discusses the need for Banking regulation and the Basel requirements (i, ii and iii).
- Main Financial Institutions
- Commercial Banks
Commercial banks typically provide a ‘full’ range of services via an extensive branch network (Fight, 2004). The main activities of a commercial bank are taking deposits, making commercial and personal loans, mortgage financing, trade finance, foreign exchange and asset financing. Commercial banks also act as payment agents within a country and between nations.
- Investment Banks
An investment bank is a financial intermediary that performs services for businesses and governments. The range of services offered by an investment bank is considerably small than that offered by commercial banks. There are four main activity areas of an investment bank - asset management, broking, investment banking or corporate finance, and trading. Investment banks manage assets of retail and wholesale investors for fees, which is typically based on volume of assets under management. Investment banks help sellers and buyers of assets, such as stocks and bonds, in completing transactions.
- Insurance Companies
The main role of an insurance company is to help individuals and organisations manage risk and preserve wealth. Insurance companies collect risk-insurance premiums from individuals and organisations who want to protect themselves against losses, such as fire, floods, illness, accident or death. By insuring a large number of people and companies, insurance companies are able to pay out claims and also aim to generate profits for owners of insurance firms. This is based on the assumption that not all insurance owners will seek claim at the same time.
- Management Investment Companies
Management investment companies manage a portfolio of securities on behalf of their investors to achieve their investment objectives. These companies allow their investors to indirectly invest in a large number of companies, and thus benefit from diversification.
- Central Banks - Role and Monetary Policy
“A central bank is a public institution that manages the currency of a country or group of countries and controls the money supply” (ECB, 2016, p. 1). The two important functions of a central bank are monetary stability and financial stability (Mayes and Wood, 2010). The mission of the Bank of England is “to promote the good of the people of the UK by maintaining monetary and financial stability” (BoE, 2016, p. 1). Central banks have gained more autonomy which gives them more independence to them in achieving their objectives without any political intervention.
The key roles of a central bank are listed below:
- Central banks’ role as ‘bank of issue’ means that they are responsible for managing the supply of money and credit. This is because only a central bank can issue banknotes in a country.
- Banks can fail through loss of capital or loss of liquidity (Mayes and Wood, 2010). The global financial crisis in 2008 caused a sharp reduction in liquidity for banks, thereby causing central banks to step into their role of the lender of last resort. The Bank of England acts as market maker of last resort at times of financial stress (BoE, 2016). The Bank of England may buy and sell assets to ensure that there is enough liquidity in the financial markets.
Central banks manage the payment systems in a country.
Financial institutions face risks from a number of sources, which are discussed below along with some of the instruments that can be used to manage these risks.
- Interest rate risk
Interest rate risk arises from a change in interest rates, and impacts net asset values due to the mismatch between the interest rate profiles of assets and liabilities. A gap analysis, which is the difference between interest rate sensitive assets and liabilities for a given time interval, can be used to evaluate the exposure of its assets and liabilities to changes in interest rate. The gap is positive if rate sensitive assets are more than rate sensitive liabilities.
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A business can use internal and/or external hedging to manage interest rate risk. Internal hedging techniques include duration-matching, which involves matching the maturity of assets and liabilities to minimise the interest rate risk. A positive duration gap means that maturity of assets is longer than liabilities, and thus an increase in interest rate will lower the net asset value, since asset values have an inverse relationship with interest rates. The longer terms of loans make it difficult to reduce duration gap for banks. External interest rate hedging instruments are futures, forwards, swap and options, which can be used to convert variable interest rate liabilities into fixed interest rate liabilities and thus, reduce their interest rate risk.
- Credit risk
Credit risk is the risk arising from an unexpected deterioration in the credit quality of the counterparty. Lenders face credit risk when borrowers may not repay the entire principal and interest owed (Getter, 2015). Financial instruments, such as credit default swaps and credit default obligations, are often used to manage credit risk.
- Operational risk
It is the direct or indirect loss resulting from inadequate internal processes and unknowable actions by employees or from external events. Operational risk can be high as seen in the loss suffered by the Societe Generale Bank due to a rogue trader in 2008 (Clark and Jolly, 2008). Operational risks can be minimised by proactive and regular testing of internal systems.
- Systematic or market risk
Systematic risk is the risk inherent to an entire market segment from a source or sources (Fraixas et al.,2000). An example of systematic risk is interest rate risk because a substantial and unexpected change, especially an increase, will impact the entire market (Chatterjee et al., 2003). Other examples of market risk are currency risk and commodity risk.
- Capital adequacy
The stability of the lending and financial trading institutions is vital for economic growth. The credit risk and risk from operations mean that banks should have sufficient capital in order to avoid bankruptcy, as high interactions among banks could turn a single bankruptcy into a systematic risk. National regulators have established capital adequacy norms for banks to ensure that they maintain a minimum amount of capital for the size and type of their assets. Minimum capital requirements work as a buffer in case of losses to prevent a bank from going bankrupt.
IV. Moral hazard, corporate governance and Banking Regulation
The ‘moral hazard hypothesis’ created by the too-big-to-fail culture increases greed and it encourages the management of a large financial institution to take higher risks during economic upturns with a hope to generate high returns and therefore, earn higher bonuses (Fisher, 2010). Banking firms rewarded employees on the basis of up-front fees generated which encouraged risk taking take without taking into account the long-term consequences of fee generation methods (Wignall et al., 2008). This incentivised employees to maintain or increase risk through trades that make steady income over years but do have a potential to make very high losses periodically (Taleb, 2009).
Failure of corporate governance
Solomon (2007, p. 13) defines corporate governance as the “process of supervision and control intended to ensure that the company’s management acts in accordance with the interests of shareholders”. The banking crisis in 2008 was a result of the failure of corporate governance systems as they failed to safeguard against excessive risk taking activities by many financial institutions (Kirkpatrick, 2009).
Banking Regulation and Requirements
Banks play an important and vital role in an economy because of their function as financial intermediaries in arranging finance for companies and individuals, thereby implying that the failure of a large bank can cause massive issues for an economy. The high importance of banks for an economy means that its stability should be maintained either by proactive steps by banks and/or through regulations. The failure of many banks suggests that self-designed control measures have not performed as expected in preventing banks from taking on high risks, and therefore banking regulations are required.
Capital acts as a cushion against financial losses and shocks, which if not provided for may lead to insolvency of a bank. The criticality of maintaining adequate capital in the banking system for the stability of an economy resulted in the Basel Committee on Banking Supervision (BCBS) creating the first Basel Capital Accord, Basel I (Getter, 2015).
Basel I was published in 1988, and defined two types of capital in a bank:
- “A Tier 1 capital component made up of mainly common shareholders’ equity (issued and fully paid), disclosed reserves, most retained earnings, and perpetual non-cumulative preferred stock” (Getter, 2015, p. 4).
- “A Tier 2 capital component, which includes allowances for loan and lease losses, set aside for anticipated loan losses” (Getter, 2015, p. 4). The allowances for loan and lease losses were included in capital only up to 1.25% of risk-weighted assets of a bank.
Basel I prescribed that banks maintain a minimum capital risk adjusted ratio (CRAR) of 8% of the risk weighted assets (Banerjee, 2012). The CRAR of the UK banks increased after the implementation of Basel I (Jablecki, 2009), which suggests that norms reduced risk in the banking sector.
The main problem with Basel I was in the asset risk weighting system which allowed banks to increase lending-to-capital ratios by reducing risks of their assets. Assigning lower risks to some asset classes helped banks reduce the size of risk-weighted asset, thereby allowing them to increase lending.
Basel II accords were designed to allow banks and financial institutions more flexibility in estimating their capital requirements in line with the risk profile of assets owned by them. Basel II norms allow banks to measure credit risk capital under the standardised approach and internal ratings based (IRB) approach. The standardised approach uses the credit ratings given by credit ratings agencies to assets in determining the capital required by banks for those assets. One of the main features of Basel II was the Internal Ratings Based approach which allowed major banks to use their own ratings system to determine risk of various asset classes. To further emphasise the importance of risk management, IRB allows two approaches - Foundation and Advanced. Banks can only estimate the probability of default, but the rest of the risk measures are preset in the Foundation approach. In the Advanced approach, banks can estimate all risk parameters itself, which means that regulators put more faith in banks to allow them to calculate their capital requirement. The IRB approach was allowed for large banks only, and is based on the assumption that they will have sophisticated risk measurement systems in place.
The problem under the IRB approach was checking the credibility of credit risk models. Without proper regulation of the credit risk models, a bank runs the risk of under capitalisation if the inputs used in the credit risk model are not accurate. Changes in dynamics and correlations between different asset classes over time means that historic credit risk models may not be useful in the future. Additionally, the financial crisis in 2007-08 showed that the credit risk models failed to capture extreme tail events, and therefore greater capital was required than held by banks. The financial crisis in 2008 stemmed from the high-risk derivatives issued under the subprime mortgage lending process in the U.S. spread across nations, thereby highlighting weaknesses in the global banking system. The global financial crisis also pointed to the weaknesses in the Basel Accord for Banking Regulation. The Basel II had stipulated regulatory capital ratios, but the financial crisis showed that many banks lacked capital of sufficient quality to absorb losses during the crisis (CML, 2013).
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Basel III regulatory framework was produced in 2010 by the BCBS at the BIS (Getter, 2015), mainly to overcome shortcomings of the Basel II which resulted in the financial crisis in 2008. The main features of Basel III are to revise the definition of regulatory capital and increase capital requirements of banks (Getter, 2015), thereby reducing insolvency risk of banks. It will help in limiting the negative impacts of credit default by increasing collateral (PwC, 2010).
Another benefit of Basel III is that it will provide a more standard risk adjusted model for calculating capital of banks, thereby allowing investors and regulators to better compare risk-adjusted performance of banks (PwC, 2010).
Banks and other financial institutions have used off balance sheet transactions to increase their exposure, which was one of the causes of the financial crisis in the US in 2008. The treatment of off balance sheet areas under Basel III means that they are converted into credit exposure by using credit conversion factors (Liang, 2011), which will limit the usefulness of off balance sheet transactions to banks in increasing their exposure and hence, reduce risk of banks.
The increase in collateral capital means that banks will either have to raise long-term debt or equity to fund loans or reduce the size of their loan book (Allen et al., 2010). This can reduce economic growth as banks are the main providers of debt to businesses. It may also result in change in balance sheet structure of banks as they may increase lending to more liquid, that is, government bonds, and reduce lending to less liquid long-term assets, such as corporate loans (Allen et al., 2010).
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