© 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

© 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

© K.Cuthbertson and D.Nitzsche 1. MARKET FAILURE a)externalities eg. bank run, credit crunch = systemic risk b)market power eg. fixed commissions monopoly/cartels (eg Japanese Banks) REASONS FOR REGULATION

© K.Cuthbertson and D.Nitzsche 2. OTHER REASONS protection of payments system(BoE) protection from fraud (FSA) promotion of competition (FSA) protection of small depositors (FSA) education (FSA) REASONS FOR REGULATION

© K.Cuthbertson and D.Nitzsche 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 hes insured) Regulator has principal-agent problem (cant fully monitor behaviour, eg. drinking and driving, after providing insurance). REASONS FOR REGULATION

© K.Cuthbertson and D.Nitzsche WHAT IS CAPITAL ? Capital(Equity) = Shareholders funds + past retained profits Capital acts as like a deductible or excess on an insurance policy It is a financial cushion for the bank Banks equity represents the amount the banks 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

© K.Cuthbertson and D.Nitzsche STYLISED BALANCE SHEET(S) HIGHLY (LOW) CAPITALISED BANK

© K.Cuthbertson and D.Nitzsche What Drives Financial Markets ? Rational Behaviour or : PIGS

© K.Cuthbertson and D.Nitzsche 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).

© K.Cuthbertson and D.Nitzsche 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

© K.Cuthbertson and D.Nitzsche Buy Close out\Sell Five eights make $1.4bn ? Leesons Futures Trades on Nikkei225

© K.Cuthbertson and D.Nitzsche 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)

© K.Cuthbertson and D.Nitzsche OPEN PRISON ?

© K.Cuthbertson and D.Nitzsche Basle (1988) Accord on Credit Risk

© K.Cuthbertson and D.Nitzsche TOPICS BASLE (1988) ACCORD Risk Weights Equity-Assets Ratio/ Risk Adjusted Asset Ratio Bank Capital: Tier I and II

© K.Cuthbertson and D.Nitzsche 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

© K.Cuthbertson and D.Nitzsche 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

© K.Cuthbertson and D.Nitzsche RISK-ADJUSTED ASSETS RATIO, RAR Risk Weights of w i= 10, 20 or 50 and 100% A i = market value of banks assets Risk Weighted Total Assets [1] RWTA = (w i /100) A i 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

© K.Cuthbertson and D.Nitzsche 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

© K.Cuthbertson and D.Nitzsche 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 RAR Replace equity-assets ratio with RAR Solvency requires: RAR > g (latter set at 8% by Basle) g = proportion of bad debts

© K.Cuthbertson and D.Nitzsche BASLE/EC : BANK CAPITAL Tier I Capital a) share capital/common stock b) cumulative retained earnings c) non-cumulative perpetual preference shares Tier 2 Capital a) cumulative perpetual preference shares b) undisclosed reserves b) revaluation reserves +hybrid debt/equity + subordinated term debt Note: deductions for investments in other banks and goodwill

© K.Cuthbertson and D.Nitzsche Basle 2000 Suggestions

© K.Cuthbertson and D.Nitzsche OFF-BALANCE-SHEET ACTIVITIES 1. INCOME FROM FEES a) 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

© K.Cuthbertson and D.Nitzsche ENDS LECTURE