Instructor: Thomas L. Thomas Week-9 Bank Regulation Money and Banking Econ 311 Tuesdays 7 - 9:45 Instructor: Thomas L. Thomas

Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners (equity holders) of the bank Regulatory requirement – Regulatory Capital – Tier 1 and Tier 2 Basle Rules Economic Capital - What is this

Capital Adequacy Management: Returns to Equity Holders

Traditional Economic Capital Value-At-Risk (VaR) View Frequency of Occurrence / Probability Mean/Average Expected Losses (m) Unexpected Losses @ 99.9% confidence Level (s) Economic Capital Reserves Before we can develop adequate credit stress testing we need to understand the differences between traditional credit loss measures and what stress tests incorporate. Aside form standard concentration and coverage analysis, a standard portfolio credit risk analysis typically employs a Value-at-Risk view. Credit risk in this view generally follows a positive skewed distribution (by definition one cannot have negative defaults and thus a normal distribution is not applicable). Reserves ALLL generally cover average expected losses over a horizon. In reality these are usually allocated to general reserves since most ALLL have two components: general reserves and specific reserves for known credits that are detraining. Economic capital functions as a cushion against unexpected loss up to some confidence level. In this case 99.9% or a single “A” rating is the regulatory standard (once every 10,000 years) In addition to a loss cushion economic capital represents the amount of the firm’s equity that is at risk which requires a return sufficient to cover the associated risk. The shape of the curve or tail will then reflect the underlying credit risk of the portfolio or product. However this view has some assumptions that can miss important risk elements. The distribution is generally based on one variable PD in this case and does necessarily fully account for other correlated factors that when combined either change the tail or increase the likelihood of default. Second, while the event may be rare, this methodology does not tell how severe or the magnitude of the event when it occurs beyond the confidence level prescribed for economic capital. Value-at-Risk VAR

Old Measure: New Ones RAROC - Risk Adjusted Return on Capital EVA - Economic Value Added. Hurdle Rate – What is it. How is it measured?

Time Line of the Early History of Commercial Banking in the United States

Historical Development of the Banking System Bank of North America chartered in 1782 Controversy over the chartering of banks. National Bank Act of 1863 creates a new banking system of federally chartered banks Office of the Comptroller of the Currency Dual banking system Federal Reserve System is created in 1913.

Asymmetric Information and Financial Regulation Bank panics and the need for deposit insurance: FDIC: short circuits bank failures and contagion effect. Payoff method. Purchase and assumption method (typically more costly for the FDIC). Other form of government safety net: Lending from the central bank to troubled institutions (lender of last resort). Example TARP Funds Form of Purchase Assumption.

Bank Share of Total Nonfinancial Borrowing, 1960–2011 Source: Federal Reserve Flow of Funds; www.federalreserve.gov/releases/z1/Current/z1.pdf. Flow of Funds Accounts; Federal Reserve Bulletin.

Financial Innovation and the Decline of Traditional Banking (cont’d) Decline in cost advantages in acquiring funds (liabilities) Rising inflation led to rise in interest rates and disintermediation Low-cost source of funds, checkable deposits, declined in importance Decline in income advantages on uses of funds (assets) Information technology has decreased need for banks to finance short-term credit needs or to issue loans Information technology has lowered transaction costs for other financial institutions, increasing competition What are banks, credit unions and thrifts main competitive advantage today?

Financial Innovation and the Decline of Traditional Banking As a source of funds for borrowers, market share has fallen Commercial banks’ share of total financial intermediary assets has fallen In 1970 banks accounted for 40% of non-financial financing By 2011 Banks accounted for only 25%. Thrifts declined from 20% of market share to less than 3% today. No decline in overall profitability Increase in income from off-balance-sheet activities

Size Distribution of Insured Commercial Banks, March 30, 2011

Ten Largest U.S. Banks, December 30, 2010

Banks’ Responses Expand into new and riskier areas of lending Commercial real estate loans Corporate takeovers and leveraged buyouts Pursue off-balance-sheet activities Non-interest income Concerns about risk Examples include repos, interest rate and currency swaps, futures, CDOs, credit default swaps

Banks’ Responses

CDS If a credit event occurs, the CDS contract is terminated and the termination “payment” takes place in one of two forms: •Physical settlement is the first where the protection buyer presents the defaulted asset to the protection seller to obtain the “termination payment.” If physical settlement is required, the termination payment becomes the full face value of the reference asset. In this scenario, the protection seller tries to obtain some type of recovery from the underlying asset. •Cash settlement is the second option. In this case the protection buyer keeps the asset. However the termination payment is the difference between the reference asset’s insured notional value, and predetermined recovery value. Obviously correctly determining the recovery value is key to this calculation. Consequently, the reference asset’s current market value, and its recovery value after default, are normally assessed by an independent assessor. •The Recovery Rate in either settlement then becomes a primary driver in LGD and consequently the accuracy of expected losses and capital calculations.

Bank Consolidation and Nationwide Banking The number of banks has declined over the last 25 years Bank failures and consolidation. Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f 1994. Economies of scale and scope from information technology. Results may be not only a smaller number of banks but a shift in assets to much larger banks.

Benefits and Costs of Bank Consolidation Increased competition, driving inefficient banks out of business Increased efficiency also from economies of scale and scope Lower probability of bank failure from more diversified portfolios Costs Elimination of community banks may lead to less lending to small business Banks expanding into new areas may take increased risks and fail

Separation of the Banking and Other Financial Service Industries Erosion of Glass-Steagall Act Prohibited commercial banks from underwriting corporate securities or engaging in brokerage activities Section 20 loophole was allowed by the Federal Reserve enabling affiliates of approved commercial banks to underwrite securities as long as the revenue did not exceed a specified amount U.S. Supreme Court validated the Fed’s action in 1988

Separation of the Banking and Other Financial Service Industries (cont’d) Gramm-Leach-Bliley Financial Services Modernization Act of 1999 Abolishes Glass-Steagall States regulate insurance activities SEC keeps oversight of securities activities Office of the Comptroller of the Currency regulates bank subsidiaries engaged in securities underwriting Federal Reserve oversees bank holding companies

British-style universal banking Separation of Banking and Other Financial Services Industries Throughout the World Universal banking No separation between banking and securities industries British-style universal banking May engage in security underwriting Separate legal subsidiaries are common Bank equity holdings of commercial firms are less common Few combinations of banking and insurance firms

Financial Innovation and the Growth of the “Shadow Banking System” Financial innovation is driven by the desire to earn profits A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable Financial engineering Remember the Dialectic Process!!!

Responses to Changes in Demand Conditions: Interest Rate Volatility Adjustable-rate mortgages Flexible interest rates keep profits high when rates rise Lower initial interest rates make them attractive to home buyers Financial Derivatives Ability to hedge interest rate risk Payoffs are linked to previously issued (i.e. derived from) securities. Interest Rate Swap Example

Responses to Changes in Supply Conditions: Information Technology (cont’d) Securitization To transform otherwise illiquid financial assets into marketable capital market securities. Securitization played an especially prominent role in the development of the subprime mortgage market in the mid 2000s. Structure of special purpose vehicles. Cash Pass Through Syndicated loans

Avoidance of Existing Regulations: Loophole Mining Reserve requirements act as a tax on deposits Restrictions on interest paid on deposits led to disintermediation – people moving their money out of the banking system. Money market mutual funds Sweep accounts

Government Safety Net Moral Hazard Adverse Selection Depositors do not impose discipline of marketplace. Financial institutions have an incentive to take on greater risk. Adverse Selection Risk-lovers find banking attractive. Depositors have little reason to monitor financial institutions.

Government Safety Net: “Too Big to Fail” Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee Uses the purchase and assumption method Increases moral hazard incentives for big banks Larger and more complex financial organizations challenge regulation Increased “too big to fail” problem Extends safety net to new activities, increasing incentives for risk taking in these areas (as has occurred during the global financial crisis

Restrictions on Asset Holdings Attempts to restrict financial institutions from too much risk taking Bank regulations Promote diversification – Concentration Management Prohibit holdings of common stock Capital requirements Minimum leverage ratio (for banks) Minimum Capital levels for Tier1 and Tier 2 Basel Accord: risk-based capital requirements Regulatory arbitrage

Capital Requirements Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions There are two forms: The first type is based on the leverage ratio, the amount of capital divided by the bank’s total assets. To be classified as well capitalized, a bank’s leverage ratio must exceed (Get new leverage ratio) A lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank The second type is risk-based capital requirements

Financial Supervision: Chartering and Examination Chartering (screening of proposals to open new financial institutions) to prevent adverse selection Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk CAMAL Reports Filing periodic ‘call reports’

Financial Supervision: Chartering and Examination CAMEL Ratings 1- 5 (5 being best): Four elements measured: Oversight provided by management and board Policies and limits for all significant risk activities Quality of measurement and monitoring systems Internal controls to prevent fraud and abuse MRAs and recommendations - now common MIRAs mean trouble.

Disclosure Requirements Requirements to adhere to standard accounting (GAP) principles and to disclose wide range of information The Basel 2 accord and the SEC put a particular emphasis on disclosure requirements The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board – Board and Management must sign-off on accuracy. Mark-to-market (fair-value) accounting Issues of measurement Assumes liquidation value on non-liquid assets.

Macroprudential Vs. Microprudential Supervision Before the global financial crisis, the regulatory authorities engaged in microprudential supervision, which is focused on the safety and soundness of individual financial institutions. The global financial crisis has made it clear that there is a need for macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate.

The Dodd-Frank Bill and Future Regulation The system of financial regulation is undergoing dramatic changes after the global financial crisis Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: The most comprehensive financial reform legislation since the Great Depression

The Dodd-Frank Bill and Future Regulation (cont.’d) The Dodd-Frank Bill addresses 5 different categories of regulation: Consumer Protection  Resolution Authority  Systemic Risk Regulation – Systemically important financial institutions – 19 CCAR banks  Volcker Rule – banks limited on proprietary trading.  Derivatives – limits OTC transactions must be traded on exchanges and cleared through clearing houses to reduce the risk of one counterparty going bankrupt ( Use of Margin Calls).

Four Suggested Effective Stress Testing Principals Principal 1: A banking organization’s stress testing framework include activities and exercises that are tailored to and sufficiently capture the banking organization’s exposures, activities, and risks. Principal 2: An effective stress testing framework should use multiple conceptually sound stress testing activities and approaches. Principal 3: An effective stress testing framework is forward looking and flexible. Principal 4: Stress test should be clear, actionable, well supported and inform decision making. With respect to these elements, our goal today is to concentrate and relate these elements to credit risks and credit stress testing. Should be applied at various levels of the bank Product / business Lines Portfolio and Risk Type Enterprise Basis Each should be tailored to the relevant level of aggregation. Capture critical risk drivers. Determine internal and external elements that influence risk. Should capture the interplay among different exposures, activities, and risks and their combined effects. By flexible is should be able to readily incorporate changes in the organization’s on and off-balance sheet activities. In addition, while stress testing should utilize historical information, it should look beyond the standard assumptions. It should carefully consider the incremental and cumulative affects of stressed conditions. Moreover, in addition to conducting formal and routine stress tests, it should be flexible to conduct new or ad hoc stress test in a timely manner. While it is obvious that stress tests should be well documents regarding assumptions, methodologies, and results, the most important fact is they need to be actionable. Similar to liquidity or contingency planning stress testing should set similar limits and actions for economic stresses or scenarios.

Responses to Changes in Supply Conditions: Information Technology Bank credit and debit cards Improved computer technology lowers transaction costs Electronic banking ATM, home banking, ABM and virtual banking Junk bonds Commercial paper market

Stressed Scenario View Small Loss Attacks Profits Medium Loss Dips into Retained Earnings Large Loss Attacks ALLL Major Loss Wipes out Economic Capital Erodes Excess Capital Encroaching Into Debt Expected Loss Economic Capital Loss Distribution Loss Buffers Stressed Losses $ Losses Frequency Stress Test should reflect losses that impact ALLL and Excess Capital 99.9% Confidence Level Stress analysis tries to fill in the gap by assessing the potential magnitude of events that fall outside the confidence level established by a VaR analysis . In that way it complements but does not replace the standard VaR analysis. In this view there are various buffers to cover losses and the point of the analysis is to estimate the type of stress, event, that will consume each buffer until the bank is effectively un-operable. The point where losses consume one buffer and move to the next are called “Stress Points” The guidance suggests 4 basic tests/methodologies to determine these stress points.

Four Basic Stress Testing Approaches Sensitivity Analysis - refers to the assessment of exposures, activities, and risks when certain variables, parameters, and inputs are “stressed” or “shocked.” Scenario Analysis - is a type of stress testing which a banking organization applies historical or hypothetical scenarios to assess the impact of various events including extreme ones. Reverse Stress Testing – is a tool that allows a banking organization to assume a known adverse outcome, such as suffering a credit loss that breaches a regulatory ratio, and then deducing the types of events that could lead to that outcome. Enterprise-wide Stress Testing – involves assessing the impact of certain specific scenarios to the banking organization as a whole, particularly on capital and liquidity. Scenarios usually involve some kind of coherent logical story as to why certain events, and circumstances are occurring and in which combination and order as to why they occur such as a severe recession or failure of a major counterparty. Note, some additional analysis must be conducted to tie these events or circumstances to risks elements of the bank. Moreover, stress scenarios should reflect CNB’s unique vulnerabilities to factors that affect exposures, activities and risks. Sensitivity analysis differs from scenario analysis in that it involves changing variables, parameters, or inputs without an explicit underlying reason or narrative, in order to explore what occurs under a wide range of inputs at extreme of highly adverse level. Not there is no assignment of the likely hood of occurrence. Rather like ALM Rate shocks it help risk managers determine the range and impact at various levels to income, losses, liquidity, and capital adequacy. Enterprise-wide stress testing like scenario analysis involves robust scenario designs and the effective translation of scenario into impact measures. This type of testing is designed to help assess the impact of a full set of risk variables under adverse circumstances, but should be supplemented with other stress tests and risk measurement tools given the inherent difficulties in capturing all the risks and adverse outcomes on a company-wide basis. Reverse stress testing may help the bank to identify and consider scenarios beyond it normal business expectations and see the impact of severe systemic effects. Note, both the Federal Reserve Bank and the Basle Bank made some observations based on the recent stress testing by large banks. Both the Federal Reserve and the Basel Bank made some significant observations regarding current stress testing practices. First, most stress tests did not produce large loss numbers in relation to the capital buffers going into the recent crisis or their actual loss experience. In many cases, stress tests relied on historical relationships. These models assume risks are driven the same statistical processes that were experience in the past and that these historical relationships “constituted a good basis for forecasting the development of future risk.” However, most stress tests were not designed to capture extreme events or “even broadly match what actually developed.”   A common theme was the lack of management “buy-in.” According to Basel risk managers at many banks found it difficult to obtain senior management approval of more severe scenarios. These scenarios were considered too extreme or innovative and thus were regarded as implausible. As a result, both the Basel Bank and the Fed suggest as best practice that banks simulate shocks that have not previously occurred. In addition, stress tests should include “severity rages capable of generating the most damage whether though the size of the loss or through reputation.” This is often referred to as “Worst Case Scenario Analysis.”  

Four Basic Stress Testing Approaches   Source Price Waterhouse Coopers