Financial Regulation

and Capital Adequacy

Arthur Centonze
FIN644 - Slides 6

U.S. Financial Regulatory System

Decentralized: no single regulator

Overlapping:
- institutional regulators, e.g. bank regulators
- functional regulators, e.g. securities trading regulators

Outdated

Filled with gaps, loopholes, and inefficiencies

U.S. Financial Regulatory System

Commercial Banks
state chartered banks: FDIC, OCC, States
national chartered banks: Fed, FDIC, OCC, States
holding company banks: Fed, FDIC, OCC, States
Bank Holding Company

Bank Investment
Bank

Securities
Firm

Insurance

Foreign

Company Subsidiaries
3

U.S. Regulatory Supervision

Savings Banks: FDIC, OCC, States

Credit Unions: NCUA, States

Investment Banks, Securities Firms, Exchanges: SEC, SRO

Futures Market: CFTC, SRO
Insurance: State insurance regulators

Mortgage Lenders: State banking authorities

Hedge Funds: None

With all these Regulators, How Did

They Miss the Financial Crisis?

Humans tend to view an economic growth as an indicator of

success, of good decision-making

Structural changes (securitization, shadow banking,) in the US

financial system occurred slowly

Regulatory architecture did not reflect the way the financial system
operates
- regulators tended to live in silos
- there was no systemic risk regulator to ensure safety across
financial institutions and markets
5

Regulation Era 1927 - 1980

McFadden Act (1927):
- prohibits US banks from branching across state lines
Glass-Steagall (1933):
1. separates banking from other financial activities
2. prohibits interest payments on checking accounts
applies interest rate ceilings on savings deposits
3. creates FDIC
International Banking Act (1978):
1. ends interstate branching for foreign banks
2. requires foreign banks to hold reserve requirements

Deregulation Era 1980 - 2010

Why? Competition, financial innovation, globalization
Depository Institutions Deregulation Act (1980):
1. phases out interest rate ceilings on deposits
2. increases deposit insurance ceiling from $40,000 to $100,000
Depository Institutions Act (1982):
1. introduces MM accounts with checking privileges
2. allows savings institutions (e.g. S&Ls) to:
- merge
- expand into commercial, consumer, commercial RE lending,
Came at the worst possible time
7

U.S. Savings and Loan Crisis

Early 1980s:
- inflation interest rates
- yields on ST deposit liabilities but not on LT asset base NIM
- S&Ls needed to increase returns on LT assets
- started making outrageously risky loans

Bank managers and regulator (FSLIC) were not prepared for the
scope and complexity of the new business model

By mid-1980s: 50% of S&Ls are insolvent

- zombie banks
8

Bank Failures in the United States

19342013

Source: www.fdic.gov/bank/historical/bank/index.html.
9

Deregulation Era 1980 - 2010

Financial Institutions Reform, Recovery and Enforcement Act

(1989):
- creates the Resolution Trust Corporation (RTC
- gives FDIC authority over savings banks

Interstate Banking and Branching Act (1994):

- removes barriers to interstate banking
- creates basis for national banking system

Financial Services Modernization Act (1999):

- repeals Glass-Steagall
- BHCs can engage in any activity financial in nature
10

Number of Insured Commercial Banks in the United

States, 19342014 (Third Quarter)

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

11

Size Distribution of Insured Commercial Banks

June 30, 2014

12

Ten Largest U.S. Banks

June 30, 2014

13

Mega-Mergers Mega-Size Banks

1. Legislative deregulation
2. Foreign competition
- Complete Separation: Japan, US with Glass Steagall
- Universal Banking: no separation (Germany, Netherlands, Switzerland)
- British Universal Banking: separate legal subsidiaries (UK, Canada, Australia, US)
3. Economies of scale lower costs
- by exploiting technological innovations and operational efficiencies
4. Economies of scope higher revenues
- by providing a greater array of financial products to a broader client base

Result: banks became bigger, more complex, more interconnected TBTF

14

Deregulation Created Need For a

Financial Safety Net
To protect investors and customers
To protect banks against ST liquidity problems
1. Central Bank: lender of last resort (LOLR)
- provides collateralized loans to solvent but illiquid banks
2. Deposit insurance
- reduces likelihood of panic and contagion

15

Safety Net Negatives

Moral hazard banks take on more risk than normal

- highly leveraged: D/E 10:1
- maintain lower LLR

Governments will not allow biggest, most connected, most

systemically important banks to fail
- deposit insurance is meaningless
- large banks are insulated from market discipline more risk
- small banks at competitive disadvantage

Safety net DOES NOT protect against systemic risk

16

Capital = Assets - Liabilities

860.4 = 9751.3 8890.9: C / A = 8.8%
109.1 = 9000.0 8890.9: C / A = 1.2%
-190.9 = 8700.0 8890.9: C / A = Zombie

17

Strategies to Avoid Crisis

1. Supervision: to enforce banking rules, standards, and risk
management
2.

Examination: to ensure bank compliance with regulations

3. Disclosure: of standardized information to customers and

financial markets, e.g. financial statements, information on rates
4.

Regulation:
- micro-prudential regulation to protect investors and customers
against idiosyncratic risk
- macro-prudential regulation to protect the economy against
systemic risk
18

2010 Return to Regulation - Dodd-Frank Act

Key Features
Adopts micro-prudential and macro-prudential regulation
Limits the activities of large financial institutions
Creates Financial Stability Oversight Council
Treasury

FED

FDIC

SEC
FHFA

CFTC
CFPB

OCC
NCUA
19

Financial Stability Oversight Council

Charged with:
1. Providing macroprudential oversight to identify and respond to
systemic risk
2. Supervising Systemically Important Financial Institutions (SIFI):
- large BHCs, investment banks, hedge funds, asset managers,
insurance companies, consumer finance companies, payment
companies..
3. Writing and enforcing rules for capital, liquidity, leverage, and
risk management
- Volcker Rule
20

Volcker Rule
Prohibits US Banks from:
1. engaging in short-term proprietary trading of securities for their
own account
2. owning, sponsoring or having certain relationships with hedge
funds or private equity funds
Allows US banks to:
1. make markets in financial instruments for clients
2. hedge the risks of market-making
3. trade in US government and certain foreign government
securities for their own account
Allows foreign banks in the US to:
- trade as long as the principal risks are held outside the US
Why the need for a Volcker Rule?
21

Whats Missing from Dodd-Frank?

A reform of:
- the complex and fragmented regulatory structure
- Fannie Mae and Freddie Mac
- key markets prone to runs, e.g. money markets, derivatives,
- the shadow banking system
- the credit rating agencies

22

Capital Adequacy
Sufficient equity to sustain a loss in
asset values and earnings
and
Sufficient loan loss reserves
to sustain a loss from loan defaults
23

Capital Adequacy

1980s: rise of global deregulation + global banking

Capital adequacy rules became a competitive concern globally:

- countries had different capital requirements: some strong, some
weak, some none at all
- banks with low capital requirements had a competitive advantage
over banks with high capital requirements

So: movement to create global regulations on capital adequacy

24

Bank for International Settlements

Basel, Switzerland

Created 1930: to collect/distribute German reparation payments

Today:
- fosters monetary and financial cooperation among central banks
- about 60/175 central banks are members
- no formal authority reach consensus on best practices

Basel Committee on Banking Supervision: developed uniform

capital adequacy and risk management framework for large,
internationally active banks

25

Basel Capital Accord I: 1988

Traditional measurement:

Basil I:

Total Capital = Tier I (core) and Tier II (supplementary)

C = Total Capital 8% 10%

Total Assets

C = Total Capital
8% 10%
Risk Weighted Assets

26

Tier I and Tier II Capital

Tier I: common stock, qualifying preferred stock, minority interest
in equity of consolidated subsidiaries,
- Tier I Capital Ratio =
Tier I Capital
Risk Weighted Assets

4%

Tier II: LLR, other preferred stock, hybrid capital, subordinated

debt,
- Tier II Capital Ratio =
Tier II Capital
Risk Weighted Assets

4%

1996 amendment: added 8% capital requirement against the

equivalent value of its off-balance sheet exposures
27

Basel I Capital Adequacy

(Tier I + Tier II)
Total Risk-Based Ratio

Well Capitalized*
Adequately Capitalized
Undercapitalized**
Significantly Undercapitalized**
Critically Undercapitalized***

10%+
8%+
<8%
<6%
<2%

*Benefits: reduced regulatory oversight, greater operational freedom

expedited approval for an M&A, etc
** prompt corrective action: stop dividends, restrict asset growth,
*** receivership

28

How are Assets Risk Adjusted?

Assets are assigned weights that correspond to their risk:

- 0%: cash; govt securities of own country,
- 10%: loans to, or securities of public sector entities,
- 20%: loans to, or securities of OECD banks,
- 50%: residential mortgage loans,
- 100%: loans to corporations and consumers,

The sum of all the risk-weighted assets (RWA), when multiplied

by 8%, produces the minimum level of capital required

The sum of all the risk-weighted assets (RWA), when multiplied

by 10%, produces the well-capitalized level of capital required

29

Basel I Calculation: US Bank

Asset

Amt

RW

T-Bills

$20b

0%

Res Mort

$40b

50%
100%

Corp Loans $100b

Total

$160b

RW
Min
Asset CapReq
0

Cap
Req

8%

$0

$20b

8%

$1.6b

$100b

8%

$8.0b

$120b

8%

$9.6b

30

Basel I: Issues
Did not sufficiently differentiate the risk among assets
- developed country bonds vs. emerging market country bonds
- AAA bonds vs. junk bonds
Banks gamed the system: shifted high risk assets into low risk
categories which required less capital, e.g. loan securitization
Bank mergers in the 1990s potential for greater risk
100% weight on business and consumer loans high capital
cost to banks, a disincentive to give loans

Basel II (2004) amends Basel I

31

Basel II
Refines the Estimation of Risk Adjusted Assets to More
Accurately Reflect Actual Risks

cash: 10%
corporate bonds: 0%, 20%, 50%, 100%, 150%
sovereign bonds:0%, 20%, 50%, 100%, 150%
bank debt: 20%, 50%, 100%, 150%
home mortgages: 35%
commercial RE mortgages: 50%, 100%
off-balance sheet items: 20%, 50%, 100%

2% of the minimum 4% Tier I capital has to be common capital

Requires banks to hold capital against:

- operational risk: tech breakdown, external event, fraud,
- trading risk: decrease in the value of assets, rogue trader,
32

Risk Estimation Issues

Allows banks to use credit agency ratings:

- builds in need for AAA ratings to lower capital requirements
- creates market for synthetic debt

Allows banks choice of risk models to assess risks:

- Standardized Approach
- Internal Ratings Based Approach

33

Basel II
Requires Stronger Oversight of Bank Risk Management
Processes

Fed conducts stress tests on 18 largest US BHCs + 12 other

large US and foreign financial institutions to ensure:
1. they have adequate quantity and quality of capital
2. they can withstand serious default and trading losses
- e.g. stress test against multiple variables

Criteria for adequately capitalized in stress tests:

- Tier I capital: 6% of RWA (up from 4%)
- Tier I common capital: 5% of RWA (up from 2%)
34

35

Stress Tests in the EU

36

How Can Banks Add to Capital?

Issue new stock: common or preferred

Seek new investors: private or sovereign wealth funds

Increase retained earnings:, e.g. decrease dividends,

Decrease the asset base: e.g. sell assets, stop renewing loans,

Issue hybrid securities: e.g. contingent convertible bonds

37

Basel III: Key Reforms

Microprudential
- increase capital requirements to reduce idiosyncratic risk

Macroprudential
- impose capital buffers and surcharges to reduce systemic risk

38

Macroprudential Capital Buffers

Countercyclical capital buffer: 0 - 2.5% (determined by country)
- built up in expansions if banks over lend
- drawn down in recessions if banks under lend
Countercyclical common equity buffer: 2.5%
- built up in expansions
- drawn down in recessions
Common equity surcharge for 30 GSIBs: 1 2.5% (US: 1-4.5%)
(Global Systemically Important Banks)
39

Basel III Capital Requirements

Basel II
Minimum % of RWA
Tier I Capital
Including Common Equity of:
Tier II Capital

Basel III
Minimum % of RWA

4
2

6
4.5

Total Capital for Adequacy

Countercyclical Buffers
Common Equity
Capital

2.5
0 - 2.5

GSIB Common Equity Surcharge

1 - 2.5 (US: 1-4.5)

40

Basil II vs. Basel III Maximum

Capital Requirements (%)
Adequately Capitalized
Well Capitalized

Common Capital

Basil II
8

Basil III
15.5

US
17.5

10

17.5

19.5

9.5

11.5

41

New Macroprudential Ratios for GSIBs

Total Loss Absorbing Capacity (TLAC)
Designed to allow the 30 largest banks in the world to fail and be resolved
without government or taxpayer support
If a bank losses all its capital bond investors would be required to absorb the
remaining losses
- the debt they hold would be converted to equity
Total Capital + LT Debt 18% 20%
Risk Weighted Assets
Total Capital + LT Debt 6.75%
Total Assets

42

Problem

Calculate the capital required under Basel II for this EU bank to be adequately capitalized
for each asset class and total.
RW
Min
Cap
Asset
Amount ()
RW (%)
Asset ()
Cap Req (%) Req ()
Cash
10b
A Bonds
30b
CCC Bonds 20b
Com RE
50b
110b

10
20
150
50
Total ()

Calculate the amount of Tier I capital this bank must hold under Basel II.

Calculate the amount of Tier I capital this bank must hold under Basel III.

43

Study Questions

What are the problems associated with the US safety net?

What was the Glass-Steagall Act and why was it repealed?
What were the contributing factors to the S&L Crisis?
What is the relevance of economies of scale and scope to the US
banking system?
What are the opportunities and challenges of the size and
composition of the US banking industry.
What is the Financial Stability Oversight Council and what are its
key responsibilities?
How do macro-prudential regulations work to limit systemic risk in
the financial system?
What is Basel III attempting to do, and how, that Basel II did not?
44

Summary for Midterm Exam

Text and slides

Assigned readings on syllabus

Problems and their underlying theoretical framework

Material from classes 1 through 6

Current events in financial economics

NOTE: Ink only

Bring a calculator (you cannot use a phone)
Use restroom before exam
45