Seminar 1:
Questions:
1. What did the global financial crisis reveal about the dominant theories of financial market
operation and financial instability?
a. Self regulation and interconnectedness.
2. Why is capital and leverage regulation vital to the stability of the banking system? What did
the Global Financial Crisis reveal about leverage levels?
a. Leverage levels were too high (50x) too much interconnectedness meant 1 banks
collapse could end all banks
3. What has been the regulatory response to the events of 2008 in the context of bank capital and
liquidity regulation and how has it been evaluated by industry and academics?
a. Higher Capital requirements (3x) but still not sufficient to prevent another collapse,
promotes inefficiency?
How much equity capital should UK banks have? - 2016
No policy parameter is more important than the minimum level of equity capital that banks must have
in relation to the size of their overall exposures.
Global Crisis caused so much havoc - banks had leverage of 40 or 50x. With a thin equity buffer.
Stronger capital buffers are therefore fundamental to banking reform.
Equity is costly to the extent that banks are risky. It is in the public interest to contain risks from
banks - especially those providing core services such as current accounts -which is best done by more
capital not less.
Policy framework: Blue is min bank must always have; purple is a buffer to absorb loose while a
stressed bank keeps going and repairs itself. - comes from the international Basel III. - add to 8.5% of
capital relative to RWAs, or 7% in terms of common equity capital. Brown is an add-on regulator may
apply to some banks on an individual basis. Red has to do with macro-prudential regulation.
,Risk-weighting failed hopelessly in the run-up to the Crisis but is being greatly improved.
Cap on overal leverage (i.e. with no risk-weighting) is being put in place internationally. Capital must
be more than 3% of total assets.
Leverage can be no more than 33x
Dangerous amount of leverage.
Yellow slab is the systemic importance buffers.
Right-fencing and the ICB.
Ring-fencing is a structural reform that was recommended by the UK’s independent Commission on
Banking.
Right-fencing is a form of separation between retail banking and investment banking.
Core retail banking activities (domestic retail deposit-taking) must be conducted in an independent
ring-fenced bank with its own capital requirements, which may not carry out various investment
banking activities.
Ring-fencing aims to give retail banks a layer of insulation from global shocks.
ICB recommended that any ring-fenced bank with RWAs greater than 3% of UK GDP should have a
systemic risk buffer of 3% of RWAs in terms of equity on top of Basel 7% - total 10% capital buffer.
ICB wanted to have more than 3% requirement.
Bank of England:
Recent policy proposal:
, Ring-fenced bank with assets less than 175 bill (10% GDP) would have no systemic risk
buffer at all.
o Northern Rock in 2007.
3% increment would apply only to ring-fenced banks with assets above 755 billion (40%
GDP).
BoE reasons for its downward revision of bank capital policy:
1. Better supervision
2. Use of countercyclical capital buffer
3. More effective resolution arrangements (with bail-in debt)
a. No substitute for effective loss-absorbency in the 1st place.
4. Structural separation in the form of ring-fencing.
.Goodhart, Ratio Controls need reconsideration: (2013)
What is the purpose of Capital Adequacy Ratios (CARs)?
Basel Committee on Banking Supervision (BCBS) was established as an informal group of mainly
Central Bank regulators set up by agreement amongst the G-10 Central Bank Governors at the Bank
for International Settlements (BIS) at Basel. The BCBS felt it had no international legal powers to
impose sanctions on banks failing to meet the regulatory ratios set out in the Accord.
Equity could provide:
Skin in the game, to deter risk-taking and gambling for resurrection;
A buffer to absorb unexpected losses for a going concern;
A bugger to protect other more senior creditors, should the bank fail and become a gone
concern.
A required minimum ratio can’t satisfy a buffer against unexpected losses. Banks focus more on
Return on Equity (RoE) meaning the higher required holding of equity, the lower the buffer over that
minimum requirement that bankers would voluntarily hold.
Skin in the game was eroded by the substitution of other forms of hybrid, or quasi-debt, capital for
pure equity in the calculation of required capital to meet the Basel requirements.
That left the final function, as protection for other creditors in default.
Federal Deposit Insurance Corporation Improvement Act(FDICIA) of 1991 (USA) attempted to make
a min capital ratio into a trigger for Prompt Corrective Action (PCA), to require banks either to
recapitalise or to close down, with the hope that this could be done before they became insolvent. This
failed in 2008 - accounting measures of capital are subject both to lengthy lags and manipulation.
Possible principles for setting CARs:
As banks are integral to the financial system and the economy if they fall below a trigger point, which
indicates they are too fragile to survive there should be intervention forcing the immediate equity
recapitalisation, to encourage a merger, to liquidate or to take into temporary public ownership.
Several problems with the FDICIA trigger to intervention:
1. Several Ways the distance to default can be calculated
a. Volatility can be estimated over some past and somewhat arbitrary period of catual
date or implied by current market valuations or by credit default swap
2. One wants to set the trigger at a point which minimises a combination of type 1 errors (not
intervening to close down the operation of a bank which subsequently would fail) and type 2
errors (closing a bank which would have survived well enough on its own).
Questions:
1. What did the global financial crisis reveal about the dominant theories of financial market
operation and financial instability?
a. Self regulation and interconnectedness.
2. Why is capital and leverage regulation vital to the stability of the banking system? What did
the Global Financial Crisis reveal about leverage levels?
a. Leverage levels were too high (50x) too much interconnectedness meant 1 banks
collapse could end all banks
3. What has been the regulatory response to the events of 2008 in the context of bank capital and
liquidity regulation and how has it been evaluated by industry and academics?
a. Higher Capital requirements (3x) but still not sufficient to prevent another collapse,
promotes inefficiency?
How much equity capital should UK banks have? - 2016
No policy parameter is more important than the minimum level of equity capital that banks must have
in relation to the size of their overall exposures.
Global Crisis caused so much havoc - banks had leverage of 40 or 50x. With a thin equity buffer.
Stronger capital buffers are therefore fundamental to banking reform.
Equity is costly to the extent that banks are risky. It is in the public interest to contain risks from
banks - especially those providing core services such as current accounts -which is best done by more
capital not less.
Policy framework: Blue is min bank must always have; purple is a buffer to absorb loose while a
stressed bank keeps going and repairs itself. - comes from the international Basel III. - add to 8.5% of
capital relative to RWAs, or 7% in terms of common equity capital. Brown is an add-on regulator may
apply to some banks on an individual basis. Red has to do with macro-prudential regulation.
,Risk-weighting failed hopelessly in the run-up to the Crisis but is being greatly improved.
Cap on overal leverage (i.e. with no risk-weighting) is being put in place internationally. Capital must
be more than 3% of total assets.
Leverage can be no more than 33x
Dangerous amount of leverage.
Yellow slab is the systemic importance buffers.
Right-fencing and the ICB.
Ring-fencing is a structural reform that was recommended by the UK’s independent Commission on
Banking.
Right-fencing is a form of separation between retail banking and investment banking.
Core retail banking activities (domestic retail deposit-taking) must be conducted in an independent
ring-fenced bank with its own capital requirements, which may not carry out various investment
banking activities.
Ring-fencing aims to give retail banks a layer of insulation from global shocks.
ICB recommended that any ring-fenced bank with RWAs greater than 3% of UK GDP should have a
systemic risk buffer of 3% of RWAs in terms of equity on top of Basel 7% - total 10% capital buffer.
ICB wanted to have more than 3% requirement.
Bank of England:
Recent policy proposal:
, Ring-fenced bank with assets less than 175 bill (10% GDP) would have no systemic risk
buffer at all.
o Northern Rock in 2007.
3% increment would apply only to ring-fenced banks with assets above 755 billion (40%
GDP).
BoE reasons for its downward revision of bank capital policy:
1. Better supervision
2. Use of countercyclical capital buffer
3. More effective resolution arrangements (with bail-in debt)
a. No substitute for effective loss-absorbency in the 1st place.
4. Structural separation in the form of ring-fencing.
.Goodhart, Ratio Controls need reconsideration: (2013)
What is the purpose of Capital Adequacy Ratios (CARs)?
Basel Committee on Banking Supervision (BCBS) was established as an informal group of mainly
Central Bank regulators set up by agreement amongst the G-10 Central Bank Governors at the Bank
for International Settlements (BIS) at Basel. The BCBS felt it had no international legal powers to
impose sanctions on banks failing to meet the regulatory ratios set out in the Accord.
Equity could provide:
Skin in the game, to deter risk-taking and gambling for resurrection;
A buffer to absorb unexpected losses for a going concern;
A bugger to protect other more senior creditors, should the bank fail and become a gone
concern.
A required minimum ratio can’t satisfy a buffer against unexpected losses. Banks focus more on
Return on Equity (RoE) meaning the higher required holding of equity, the lower the buffer over that
minimum requirement that bankers would voluntarily hold.
Skin in the game was eroded by the substitution of other forms of hybrid, or quasi-debt, capital for
pure equity in the calculation of required capital to meet the Basel requirements.
That left the final function, as protection for other creditors in default.
Federal Deposit Insurance Corporation Improvement Act(FDICIA) of 1991 (USA) attempted to make
a min capital ratio into a trigger for Prompt Corrective Action (PCA), to require banks either to
recapitalise or to close down, with the hope that this could be done before they became insolvent. This
failed in 2008 - accounting measures of capital are subject both to lengthy lags and manipulation.
Possible principles for setting CARs:
As banks are integral to the financial system and the economy if they fall below a trigger point, which
indicates they are too fragile to survive there should be intervention forcing the immediate equity
recapitalisation, to encourage a merger, to liquidate or to take into temporary public ownership.
Several problems with the FDICIA trigger to intervention:
1. Several Ways the distance to default can be calculated
a. Volatility can be estimated over some past and somewhat arbitrary period of catual
date or implied by current market valuations or by credit default swap
2. One wants to set the trigger at a point which minimises a combination of type 1 errors (not
intervening to close down the operation of a bank which subsequently would fail) and type 2
errors (closing a bank which would have survived well enough on its own).
