1. 4 WEEK FOUR GLOBAL REGULATION OF BANKS

2.  Introduction  Meaning of Bank Regulation  The Principles and Requirements of Bank Regulations  Types of Bank Regulation  International Regulations  Prudential Regulation  Basel I  Basel II  Basel III  Drawbacks of Regulation  Conclusion OUTLINE

3.  Outline the rational for banking regulation  Appreciate the different types of regulation  Explain the causes of the persistent changes in bank regulations  Identify the general principles and requirement of bank regulation  Assess the shortcomings and costs of bank regulations OBJECTIVES

4.  This lecture focuses on the rationale for the regulation of both national and international banks.  The banking industry is relatively the most regulated.  Prudential Regulation  Basel I, II, and III  The lecture focuses on the nature and types of bank regulation and the pros and cons of such regulations INTRODUCTION

5.  Bank Regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines.  These government regulations or controls are stricter than those on business in generals.  The justification for stricter controls is that; bank failures may disrupt the rest for the financial system in a way that can affect other businesses.  Bank provide intermediation services serves as the backbone of every economy.  The failure of this function will have rippling effects on the economy hence the tight regulation. MEANING OF BANK REGULATION

6.  The regulator is normally a bank and therefore a participant in the market. This is very uncommon in the regulation of other businesses.  The business of banking gives birth to a contractual relationship between the bank and customers. Agency issues or problems with this relationship makes it imperative for government to regulate the market. THE RATIONALE FOR REGULATION

7.  The Rationale:  To protect the bankers and customers  To ensure prudence in the banking industry  To reduce systemic risk  To avoid misuse of banks (Money laundering activities, terrorist financing etc)  To protect the banking confidentiality  To allocate credit to most needed sector of the economy  To check the abuse of Oligopolistic and Monopoly powers THE RATIONALE FOR REGULATION

8.  General principles of bank regulation are the canons upon which bank regulation is carried out. These have been developed over time by the Basel Committee on Banking Supervision.  These are:  Minimum Capital Requirements  Supervisory Review  Market Discipline GENERAL PRINCIPLES OF BANK REGULATION

9.  Minimum Capital  This requirement is normally imposed to promote the objective of the regulator.  The requirement differs for different classes of financial institutions.  The requirement cut across all issues relating to capital of banks  Minimum Capital  Minimum Capital Ratio  Approval of banks business plan  Shareholders’ requirements  etc GENERAL PRINCIPLES OF BANK REGULATION

10.  Supervisory Review Requirement  Licensing requirements prior to commencement of business  Giving directives  Imposition of penalties for breaching laws  Market Discipline  Disclosure of financial and relevant non-financial information  This enables the regulator to assess the financial health of the commercial banks.  It also helps other stakeholders to reasonably make investment decisions on the basis of the risk profile of the banks GENERAL PRINCIPLES OF BANK REGULATION

11.  Capital Requirements  Reserve Requirements  Corporate Governance Requirement  Financial Reporting and Disclosure Requirements  Credit Rating Requirements  Large Exposure Requirements  Related Party Exposure Restrictions REQUIREMENTS OF BANK REGULATION

12.  Structural (or Systemic) Regulation  Prudential Regulation  Conduct of Business Regulation  Structural (Systemic) Regulation:  Concerned with safety and soundness of the financial system.  Considers all public policy regulation designed to avoid bank runs  Normally in the form of government safety nets:  Deposit insurance  Lender of Last Resort TYPES OF BANKING REGULATION

13.  Prudential Regulation  Concerned with consumer protection  Involves the regulations of deposit-taking institutions  Supervision  Risk-taking limits etc  Conduct of Business Regulation  Focuses on how banks and other financial institutions conduct their business  Relates to Information disclosure  Fair business practices  Competence TYPES OF BANKING REGULATION

14.  The growth of banks and emergence of banks that operate in multiple jurisdictions have called for bank regulation on a global scale.  Key issues in this arena include:  The complexity of international banking regulation  The level of oversight required  The regulatory body  How should the implementation be done and where?  Prudential Regulation  Basel Accord INTERNATIONAL BANKING REGULATION

15.  Prudential Regulation in the International Arena:  Prudential regulation is an appropriate legal framework for financial operations which is a significant contributor to preventing financial sector problems.  There is the need for global coordination of prudential banking regulation as a result of:  Policy makers, bank management, and regulators recognition of the fact that the stability of the global financial system can compromised  Where a branch is located in other jurisdiction, who has supervisory authority?  Global regulation, when implemented will standardize bank operations and level the competitive playing field INTERNATIONAL BANKING REGULATION

16.  Basel Accord  Basel I  Basel II  Basel III  Basel I  A round table of central bankers from around the world in 1988  The Basel Committee was formed in response to the messy liquidation of a Cologne-based bank (Herstatt) in 1974.  The deliberations were lead by the Bank of International Settlements (BIS) in Basel, Switzerland. INTERNATIONAL BANKING REGULATION

17.  Basel I, Main Framework  Focused on credit risk  Assets of banks were grouped into five categories with risk weights  0%, 10%, 20%, 30%, 40%, to 100%  Banks with international presence are required to hold capital equal to 8% of risk weighted assets  Implemented progressively among G-10 nations.  Several other countries including Ghana adopted the core principles of the Basel Accord  Purpose of Basel I  Strengthen the stability of international banking system  To set up a fair and consistent international banking system in order to decrease competitive inequality among international banks INTERNATIONAL BANKING REGULATION

18.  Basel I, Major Achievement  A working definition of bank capital ratio  This definition of bank capital has been universally accepted  Basel I – Capital Requirement  Capital Ratio by definition was categorized into two tiers;  Tier 1  Tier 2 INTERNATIONAL BANKING REGULATION

19.  Basel I – Capital Requirement: Step One (Definition of Capital)  Tier 1 Capital (Core Capital)  Include stock issue and declared reserves.  Tier 2 (supplementary Capital)  Includes gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (excess allowances for losses on loans and leases) INTERNATIONAL BANKING REGULATION

20.  Basel I – Capital Requirement: Step Two (Risk Weighting of Capital)  Defined bank capital in terms of credit risk exposure of the bank  The level of credit risk exposure is determined by the risk weighted assets of the banks.  The accord identifies three types and level of credit risk exposure  On-balance sheet risk  Trading Off-balance sheet risk  Non-trading off-balance sheet risk INTERNATIONAL BANKING REGULATION

21. RISK WEIGHTSASSET CLASS 0%Cash and gold held in the bank 20%Claims on OECD banks Claims issued by U.S government agencies Claims on municipalities 50%Residential Mortgages 100%All other claims such as corporate bonds, less-developed countries debt. Claims on non-OECD banks, equities real estate, plant and equipment INTERNATIONAL BANKING REGULATION

22.  Example on risk weights INTERNATIONAL BANKING REGULATION Asset categoryRisk weight Capital ratio AmountRWACapital Treasury bond0%8%$1000$0 Municipal bond20%8%$1000$200$16 Residential mortgage 50%8%$1000$500$40 Unsecured loan100%8%$1000 $80

23.  Revision of Basel I in 1996  To include Market Risk  Market risk emanates from four economic variables  Interest rates  Foreign exchange  Equities  commodities  This risk is calculated in two different ways:  Standardized Basel Model  Value at Risk (VaR) INTERNATIONAL BANKING REGULATION

24.  Pitfalls in Basel I  Limited Differentiation of Credit Risk  Static Measure of Default risk  No recognition of term structure on credit risk  Simplified calculations of potential future counterparty risk  Lack of recognition of portfolio diversification effects  The culmination of these factors lead to the introduction of the Basel II INTERNATIONAL BANKING REGULATION

25.  Basel II  Second of the Basel Accords published in 2004  Aimed at:  Ensuring that capital allocation is more risk sensitive  Separating operational risk from credit risk, and quantifying both risks  Aligning economic and regulatory capital more closely to reduce the scope for regulatory arbitrage INTERNATIONAL BANKING REGULATION

26.  Basel II in Operation  Fundamentally based on three pillars, same as those contained in Basel II, but deeper in term of coverage  Minimum capital Requirements (1), Supervisory (2) Review, and Market Discipline (3)  Basel I dealt with only one aspect of these pillars.  Basel II introduces more dimensions to each of the canons or pillars. INTERNATIONAL BANKING REGULATION

27.  Pillar 1  Maintenance of Regulatory Capital  This is calculated for three major risks: Credit Risk, Operational Risk, and Market Risk INTERNATIONAL BANKING REGULATION Risk Measurement Credit RiskStandardized Approach, Foundation IRB and Advanced IRB Operational RiskBasic Indicator Approach, Standardized Approach Market RiskValue At Risk

28.  Pillar 2  Deals with regulatory response to Pillar 1.  Provides a framework for dealing with residual risks: systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk, and legal risk.  Introduced more forward looking approach to capital supervision by encouraging banks to identify potential risks they may face in the future and try to mange them. INTERNATIONAL BANKING REGULATION

29.  Basel III  These are ongoing new updates to the Basel Accord  The draft Basel III include:  Tighter definition of tier 1 capital  The introduction of leverage ratio  A framework for counter-cyclical capital buffers  Measures to limit counter-party credit risk, and  Short and medium term quantitative liquidity ratio INTERNATIONAL BANKING REGULATION

30.  Regulation comes at a cost despite its benefits. These include:  Cost of administering and monitoring  Cost of supervision  Poor record keeping  Control of interest rates  Capital requirements  Impediment to growth and economic development DRAWBACKS OF REGULATIONS

31.  This lecture reviewed the issue of bank regulation  Began with a rationale for bank regulation  Focused on regulation in the local context  Focused on regulation in the international arena CONCLUSIONS

32. 4 END OF LECTURE FOUR QUESTIONS?