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Banking Law and Regulation > Microprudential Regulation: Basel and Capital Adequacy > Flashcards

Microprudential Regulation: Basel and Capital Adequacy Flashcards

1
Q

What is Microprudential Regulation?

A

The pursuit of health and stability in the banking sector, with the ultimate goal of avoiding bank failure.

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2
Q

What is Capital Adequacy Regulation?

A

The imposition of minimum levels of adequate capital to chill reckless risk-taking and limit the potential losses thereof.

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3
Q

What is the Intended Effect of Capital Adequacy Regulation?

A

To hamstring, “the moral hazard of excessive risk taking,” which is exacerbated by the LOLR Function and Despoit Insurance Schemes.

Razeen Sappideen, The Regulation of Credit, Market, and Operational Risk Management under the Basel Accords (2004) 59 Journal of Business Law 72.

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4
Q

What is Capital Adequacy Regulation’s main Weakness?

A

Inexactness. Such rules tend only to be edcuated estimations, because regulators don’t want to suffocate bank activity.

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5
Q

What was the Purpose of Basel I in 1988?

A

To harmonize the capital adequacy rules governing international banks.

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6
Q

As laid out in Basel I, what were its Fundamental Objectives?

A
  1. To strengthen the soundness and stability of the international banking system through harmonization; and in doing so,
  2. Decrease regulatory arbitrage.
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7
Q

What were the Achievements of Basel I?

A
  • Defined and Calibrated the notion of Credit Risk for banks.
  • Harmonized minimum capital adequacy requirements.
  • Defined the notion of Capital.
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8
Q

What is Credit Risk?

A

The risk that a Borrower will default on its payment obligations.

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9
Q

How was Credit Risk measured under Basel I?

A

Through the Risk-Weighting Methodology.

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10
Q

Why is standardized Risk-Weighting a prudential good?

A
  • Increases the consistency and accuracy of credit risk analysis.
  • Chills banks’ incentive to lend to riskier borrowers for profit.
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11
Q

Under Basel I, what were the Five Categories of Risk-Weight?

A
  1. 0%.
  2. 10%.
  3. 20%.
  4. 50%.
  5. 100%.
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12
Q

How did the Risk-Weighting Methodology operate?

A

Asset Value × Risk-Weighting = Risk-Weighted Asset Value.

Gross Risk-Weighted Asset Value × 8% (Minimum Capital Buffer) = Minimum Capital Requirement.

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13
Q

What were the Advantages of the Risk-Weighted Methodology under Basel I?

A
  • Fairer standard of comparison for international banking systems.
  • Accounted for off-balance-sheet risk exposure.
  • Incentivized banks to hold low-risk liquid assets.
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14
Q

What were the Disadvantages of the Risk-Weighted Methodology under Basel I?

A
  • Blunt and tactless at times, e.g. private-sector risk analysis.
  • Arguably disincentivized corporate borrowing.
  • Did not incorporate diversification of lending into risk analysis.
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15
Q

Northern Rock and Lehman Brothers had Risk-Asset Ratios of 11.2% and 16.1%, respectively. How does this undermine the 8% prescription?

A

It shows that either:

  • 8% is an insufficient floor;
  • The quality of minimum capital held was low; and/or that
  • Additional factors need be incorporated into risk analysis.
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16
Q

What were the Two Tiers of Capital under Basel I?

A

Tier One, which comprised:

  • Equity reserves; and
  • Disclosed reserves, i.e. retained earnings.

Tier Two, which comprised:

  • Undisclosed reserves;
  • Revaluation reserves;
  • General loan-loss reserves;
  • Hybrid debt instrumets; and
  • Subordinated term debt.
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17
Q

What was mandatory minimum ratio of Tier One : Tier Two Capital?

A

50% : 50%.

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18
Q

Why distinguished Tier One Capital from Tier Two Capital?

A

Visibility, Permanence, and Stability.

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19
Q

What are Undisclosed Reserves?

A

Unpublished reserves which have nevertheless passed through the Bank’s profit and loss account.

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20
Q

What are Revaluation Reserves?

A

The sum value of the positive discrepancies between a Bank’s assets’ real value and previously-recorded book value.

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21
Q

What are General Loan-Loss Reserves?

A

Reserves guarding against losses from any potential asset.

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22
Q

How was Basel I implemented in the EU and UK?

A

Through the now-obsolete Own Funds Directive and repealed Solvency Ratio Directive.

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23
Q

Why did the Basel Committee introduce the Market Risk Amendment in 1996?

A

To address the evolving shortcomings of Basel I, namely the:

  • Universalization of banks;
  • Normalization of the insufficient 8%; and
  • New prominence of interest rate, currency, and market risk.
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24
Q

What was the Central Objective of the Market Risk Amendment 1996?

A

To introduce a Non-Standard Risk Assessment Methodology which incorporated Market Risk.

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25
Q

Under the Amendment, How would Market Risk be calculated?

A

Using either a Standardized or Internal Model.

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26
Q

What did the Standardized Approach to Measuring Market Risk pertain to?

A

The measurement of:

  • Interest rate risk;
  • Foreign Exchange risk;
  • Trading risk; and
  • Commodities risk.
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27
Q

Was the Standardized Approach intended to be Harmonizing?

A

No. It was purposed as a rough guideline, thus stressing the importance of developing precise and bespoke risk-measurement models.

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28
Q

What is Interest Rate Risk?

A

The risk of interest rate fluctuations over a facility’s term decreasing profits or causing losses.

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29
Q

How was Interest Rate Risk addressed under the Standardized Model?

A

Loans were to be weighted against their Specific and General Risk. The former is borrower creditworthiness, and the latter is term duration.

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30
Q

What is Foreign Exchange Risk?

A

The risk that fluctuations in the foreign exchange markets will render a given position unprofitable or losing.

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31
Q

How was Foreign Exchange Risk addressed under the Standardized Model?

A

It was weighted at 8% against net long and short currency positions and net gold positions.

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32
Q

What are Trading and Commodities Risk?

A

The risk that market fluctuations, volatility, or illiquidty will render a position unprofitable or losing.

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33
Q

How was Trading Risk addressed under the Standardized Model?

A

It was weighted at either 4% or 8% (based on diversification) against net long and short equity and derivatives positions + 8% general market risk.

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34
Q

How was Commodities Risk addressed under the Standardized Model?

A

It was weighted at 15% against net long and short commodities positions + 3% capital charge on all gross positions.

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35
Q

What permitted Deviation from the Standardized Model by Banks?

A

Approval by the National Regulator.

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36
Q

To seek approval of an Internal Model, what would a Bank have satisfy?

A

The National Regulator’s Qualitative and Quantitative Criteria.

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37
Q

What did the Regulator’s Qualitative Criteria pertain to?

A

The quality of a bank’s internal risk management systems, as verified by rigorous and regular stress-testing.

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38
Q

How would a Bank go about satisfying the Qualitative Criteria?

A

Through the creation of a dedicated risk management department, which oversaw prudential policy design, execution, enforcement, and review (preferably by external audit).

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39
Q

What did the Regulator’s Quantitative Criteria pertain to?

A

The credibility of the risk factors used in measuring and weighting the Amendment’s outlined market risks.

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40
Q

Granting authorization, how did Banks implement an Internal Model?

A

Using a Value-at-Risk (VaR) Methodology.

41
Q

What is the Value-at-Risk Methodology?

A

The computation of, “the maximum amount of loss a bank could incur in its portfolio,” over a given tenor without failure, based on historical data.

42
Q

How was Market Risk Weighted under the Internal Model?

A

At 12.5%. Therefore:

(Gross Risk-Weighted Asset Value + Gross Risk-Weighted Market Risk) × 8% (Minimum Capital Buffer) = Minimum Capital Requirement.

43
Q

The Amendment introduced the category of Tier Three Capital. What did this comprise?

A

Short-term Subordinated Debt.

44
Q

Compared to Tier One or Two Capital, what was the Value of Tier Three Capital?

A

2.5× less.

45
Q

What was the Purpose of Basel II 2004?

A

To introduce a flexible and negotiated, but sophisticed, standardized approch for capital adequacy, replacing Basel I.

46
Q

What were the Three Pillars of Basel II?

A
  1. Minimum Capital Requirements.
  2. Regulatory Supervision and Compliance.
  3. Market Discipline and Disclosure.
47
Q

What was the Intention behind the Three Pillars?

A

Pillar 1 combatted credit risk with capital adequacy. Pillars 2 and 3 ensured that Internal Models would be sufficiently scrutinized and transparent.

48
Q

How does Basel II’s Standardized Approach to Capital Adequacy differ from Basel I?

A

It comprised three individual frameworks so as to better differentiate between the risk profiles of specific assets.

49
Q

What are the Basel II Standardized Approach’s Three Alternative Frameworks?

A
  1. Credit Ratings, from CRAs.
  2. Risk Scores, from CRAs.
  3. Risk Weighting, from the Basel Committee.
50
Q

What Purpose did Basel II’s Alternative Framework serve?

A

Flexibility. They gave National Regulators greater discretion regarding microprudential regulation.

51
Q

How did Basel II contribute to the Global Financial Crisis?

A

It incentivized banks to game the system using securitization to gain favorable credit ratings and decrease their capital adequacy obligations.

52
Q

It is clear the Basel II’s new Standardized Approach was not intended as a standalone. What, then, was recommended be done with?

A

Adaptation into a more sophisticated Internal Model. Basel II offered two such models, namely the: Foundational and Advanced Internal-Based Ratings Approaches (F-IRBs & A-IRBs).

53
Q

What did Basel II’s IRBs refer to?

A

Banks’ internal models for risk assessment and management.

54
Q

Why was the Internal Approach regarded as Superior to the Standardized Approach?

A

Its bespoke nature allowed for:

  • Greater efficiency through precise customization;
  • Greater incorporation of low-instance risk exposures;
  • Utilization of proprietary information held by banks about borrowers for regluatory purposes.
55
Q

What differentiated a Bank which was permitted to use the Advanced Approach from one which was not?

A

Sophistication of internal risk assessment and management systems.

56
Q

What Risk Components did both IRBs share?

A
  • Probability of Default (PD);
  • Loss-Given Default (LGD);
  • Exposure at Default (EAD); and
  • Effective Maturity (M).
57
Q

How do both IRBs Fundamentally measure Credit Risk?

A

PG × LGD × EAD (adjusted for M) = Expected Loss

Expected Loss + Unexpected Loss = Total Loss

Total Loss = Credit Risk (Risk Weight of Given Exposure)

58
Q

What is the Difference between the Foundational and Advanced IRBs?

A

Under the former, only PD is internally generated. Under the latter, everything is internally generated.

59
Q

What became of the Market Risk Amendment after Basel II?

A

It was incorporated into the Accord and updated.

60
Q

How did Basel II update the Market Risk Amendment?

A

Stipulated the incorporation of credit ratings into the determination of market risk-weighting for all trading-book securities.

61
Q

Basel II introduced the notion of Operational Risk into Capital Adequacy Regulation. What is this?

A

“The risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.”

Textbook, P.362.

62
Q

Under Basel II, how was Operational Risk measured?

A

With reference to either the:

  • Basic Indicator Approach (Standardized);
  • Standardized Approach (Standardized); or
  • Advanced Measurement Approach (Internal).
63
Q

How did the Basic Indicator Approach operate?

A

It generally equated the cost of operational risk to 15% of three-year average gross revenue. Therefore:

(Gross Risk-Weighted Asset Value + Gross Risk-Weighted Market Risk + Operational Risk) × 8% (Minimum Capital Buffer) = Minimum Capital Requirement.

64
Q

How did the Standardized Approach operate?

A

It differentiated beween eight lines of business, and attributed to each an operational risk-weighting of either 12%, 15%, or 18%.

65
Q

How did the Advanced Measurement Approach operate?

A

It permitted banks to develop internal operational risk assessment and management systems, subject to domestic regulatory approval.

66
Q

When would a Bank receive Authorization to employ the Advanced Measurement Approach?

A

When it satisfies the National Regulator’s Qualitative and Quantitative criteria.

For more, see: Textbook, P. 365-366.

67
Q

Regarding Pillar 2 of Basel II, what were its Four Underlying Principles?

A
  1. Effective Managerial Oversight.
  2. Regular Supervisory Review.
  3. Strict Supervisory Policy.
  4. Proactive Regulation.
68
Q

Elaborate on Underlying Principle 1 of Pillar 2.

A

It obligated Regulators to ensure Banks actively oversaw and managed their risk profiles and appetites at the senior-most levels, i.e. had sound and strong internal control systems.

69
Q

Elaborate on Underlying Principle 2 of Pillar 2.

A

It obligated Regulators to regularly review and evalute Banks’ internal control systems, and take action where necessary.

70
Q

Elaborate on Underyling Principle 3 of Pillar 2.

A

It obligated Regulators to proactively set domestic capital adequacy requirements beyond those of Basel II.

71
Q

Elaborate on Underyling Principle 4 of Pillar 2.

A

It obligated Regulators to adopt a forward-looking proactive approach to intervention regarding substandard compliance.

72
Q

What was the Effect of Pillar 3 of Basel II?

A

It obligated Banks to disclose their risk exposure, risk assessment systems, and capital adequacy levels, as well as quantitaive and qualitative information of various sorts.

73
Q

With hindsight, was Basel II’s ‘Flexible and Negotiated’ Approach wise?

A

No. It proved morally hazardous. Due to their incentives, Banks chose to develop minimally-demanding internal control systems while pursuing profit-maximizing, and thus risky, behaviors.

74
Q

Did Basel II’s Internal Approach yield superior Adequate Capitalization in comparison to its Standardized Approaches?

A

No. Indeed, the converse it true.

Paul H. Kupiec, Financial Stability and Basel II (2006) FDIC Center for Financial Research Working Paper No. 2006-10.

75
Q

In light of the shortcomings of Internal Model, why did Basel II’s Second Pillar prove underwhelming?

A

They were blunted by the fact that capital adequacy had effectively become a self-regulatory exercise, hindering regulatory capacity for technical or judgment-based decision-making.

76
Q

In light of the shortcomings of Internal Model, why did Basel II’s Third Pillar prove underwhelming?

A

Investors’ priorities were grossly misestimated. By dint of their profit-maximizing incentive, their discipline spurred competition, not prudence, as was hoped.

Peter O Mülbert, Corporate Governance of Banks after the Financial Crisis – Theory, Evidence, Reforms (2010) ECGI Law Working Paper No. 130/2009.

77
Q

How did the Global Financial Crisis undermine Basel II?

A

It underscored the:

  • Insufficency of its CA regime.
  • Degree to which regulation could be gamed by banks.
  • Insufficiency of the 8% threshold.
  • Need for more microprudential tools other than CA.
78
Q

How did Basel III seek to address the problem of Too-Big-To-Fail?

A

By developing special standards for the regulation of Globally Systemically Important Banks (G-SIBS).

79
Q

How did Basel III seek to Address Basel II’s shortcomings?

A

By curtailing banks’ excessive discretion to self-regulate through a return to standardization and supplementing the 8% risk-asset ratio with new tools, e.g. capital buffers or liquidity coverage ratios.

80
Q

What are Capital Buffers?

A

Supplementary capital reserves to be held financial institutions for stability purposes.

81
Q

What Capital Buffers did Basel III introduce?

A
  • Capital Conservation buffer.
  • Counter-Cyclical buffer.
  • Systemic Risk buffer.
  • Institution-Specific Countery Cyclical buffer.
  • Pillar 2 buffer.
82
Q

What are the Two Types of Capital Buffer?

A

Absolute, which apply universally, and Institution-Specific, which apply discretionarily.

83
Q

Why did Basel III introduce Capital Buffers rather than just increase the 8% risk-asset ratio?

A

Flexibility. Capital buffers are more precise and can be adjusted much quicker by regulators. Banks also lobbied against the increase of 8%.

84
Q

What is the Capital Conservation Buffer?

A

An absolute buffer comprising 2.5% of risk-weighted assets as mandatory capital conservation.

See: Art. 129, CRD IV and Regulation 5, UK Capital Requirements Regulations 2014.

This effectively increases 8% to 10.5%.

85
Q

What is the Counter-Cyclical Buffer?

A

A discretioary buffer to combat market exuberance of up to 2.5% of risk-weighted assets as mandatory capital conservation. The FPC is responsible for setting the rate quarterly.

See: Art. 135-136, CRD IV and Regulation 4, UK Capital Requirements Regulations 2014.

This potentially increases 10.5% to 13%.

86
Q

What is the Systemic Risk Buffer?

A

A discretioary buffer to combat systemic risk of 1-3% of risk-weighted assets as mandatory capital conservation.

See: Art. 133, CRD IV; Bank of England, The Financial Policy Committee’s Framework for the Systemic Risk Buffer.

87
Q

What are Institution-Specific Counter-Cyclical Capital Buffers?

A

A absolute buffer of up to 2.5% of risk-weighted assets as mandatory capital conservation, which only applies to banks above a certain threshold of credit exposure in a number of jursidictions.

See: Art. 130, CRD IV and Regulation 19, UK Capital Requirements Regulations 2014.

The Regulator has the discretion to exempt small-and-medium-sized firms frmo this buffer, and typically does so. This buffer is rather aimed at G-SIBs and is purposed with bulwarking their stability.

Regarding how it is calculated, see Art. 140, CRD IV.

88
Q

What are the PRA’s Pillar 2 Capital Requirements?

A

Additional discretionary capital adequacy requirements intended to counter-balance banks’ risk profiles.

See: Art. 104, CRD IV; PRA, The PRA’s Methodologies for Setting Pillar 2 Capital.

The PRA performs its assessment on a yearly basis.

89
Q

What does PRA Pillar 2A regulate?

A

Credit, market, operational, and other such financial risks which are somewhat neglected by Basel III’s standardized models. Its impositions are supplementary to Basel III.

90
Q

What does the PRA Buffer regulate?

A

Overall capital adequacy given an institution’s risk management and internal controls. Its impositions are supplementary to Basel III, but can be drawn down in times of stress.

91
Q

What is the Counter-Cyclical Leverage Buffer?

A

An additional UK capital adequacy requirement for banks with over £50b in deposits from individuals and households.

92
Q

How are G-SIBs classified and what is the G-SIB Buffer?

A

According to their systemic risk profile, as determined by the FSB:

  • Bucket 1: +1% loss-absorbent capital on top of other requisites.
  • Bucket 2: +1.5% loss-absorbent capital on top of other requisites.
  • Bucket 3: +2% loss-absorbent capital on top of other requisites.
  • Bucket 4: +2.5% loss-absorbent capital on top of other requisites.
  • Bucket 5: +3.5% loss-absorbent capital on top of other requisites.

See: Art. 131, CRD IV and Regulations 29-34, UK Capital Requirements Regulations.

93
Q

How are D-SIBs classified and what is the D-SIB Buffer?

A

According to their systemic risk profile, as determined by the national regulator.

94
Q

What is the D-SIB (or OSII) Buffer?

A

A discretioary specific buffer of up to an extra 2% of risk-weighted assets as mandatory capital conservation.

See: Art. 131, CRD IV.

95
Q

Must a Bank sustain both G-SIB and D-SIB Buffers?

A

No. Only the higher of the two if it is classified as both.

96
Q

How has Basel III addressed concerns regarding Capital Quality?

A

It abolished Tier 3 capital and mandated that all new capital buffers be satisfied using Common Equity Tier 1 Capital.

97
Q

How did Basel III alter the Common Equity Tier 1 category?

A

It increased the minimum risk-asset ratio from 4% to 6%, as well as the common equity component from 2% to 4.5%.

98
Q

What are the Consequences of increasing the Proportion of Common Equity that Banks must now hold?

A

Deleveraging, which could adversely affect global economic growth due to less credit being available. Conversely, increased social welfare could result from lower levels of leverage and volatility in the long-run.

See: P. 387.

Banking Law and Regulation (6 decks)

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