Review central banks / bank regulations and bank risk management

Role of central banks

(1) Implement a monetary policy that provides consistent growth and maximises employment. Central banks
can set interest rates.
(2) Promote stability of the financial system.
(3) Manage the production and distribution of the nation’s currency.
(4) Inform the public of the overall state of the economy by publishing economic statistics.

Europe – European Central Bank (ECB), European Money Union (EMU)

USA – Federal Reserve System (FED)
Singapore - Monetary Authority of Singapore (MAS)

Fiscal policy – Government use (1) Tax rates and (2) Government spending to control inflation

For example, stimulating a stagnant economy by increasing spending or lowering taxes runs the risk of causing
inflation to rise.
This is because an increase in the amount of money in the economy, followed by an increase in consumer demand,
can result in a decrease in the value of money - meaning that it would take more money to buy something that has
not changed in value.

Islamic Banking
1) Interest free – implicit markup
2) Ethically responsible – Shari’ah compliant
3) Riskless

1) Mudaraba – PnL sharing system via joint partnerships/ventures (similar to VC financing)

a. Trust based partnership, bank contributes capital, other party provide labor
2) Murabaha – Sale with predetermined markup (money as medium of exchange)
a. Bank must own inventory and pay for purchase, buyer defers payment, immediate delivery
3) Musharaka – Type of equity financing and the relationship between a financial institution and a partner in
business
a. Both parties contribute capital and labor
4) Istisna – Consumer financing
5) Ijarah – Project financing

Bank regulations
Uniform Financial Institutions Rating System (UFIRS) assigns a composite rating
CAMELS based on SIX essential components
(1) Capital adequacy
(2) Asset Quality
(3) Management
(4) Earnings
(5) Liquidity
(6) Sensitivity to market risk
Rating from 1-5
1. Best – Institution sound in all aspects
2. Fundamentally sound, but modest weakness which can be easily corrected during normal business
3. Financial, operational or compliance weaknesses are present
4. Immoderate volume of financial weakness
5. Immediate or near term failure is likely

Basel I (1988) – First minimum standards for bank capital ratios

Basel II (aft 1992) – 3 pillar framework.
(1) Capital ratios
(2) Supervisory review
(3) Market discipline through disclosure

Basel III
 Increase in minimum capital requirements at individual banks
 Improvement of quality of capital and risk coverage at individual banks
 Internationally harmonised leverage ratios at all individual banks
 Improvements to supervisory processes at national level
 Counter cyclical buffers of increasing buffers in good times

Criticisms of Basel III

One set of minimum standards for all lenders with different situations
Highly reliant on limited number of rating agencies
Complexity of metrics increased manifold
Tougher capital requirements – restricts bank lending – restricts economic growth due to the freeze up of assets

Basel IV
Changes the approaches for the calculation for RWA
Reforms of the standardised approach for credit risk

Dodd-Frank Wall Street Reform and Consumer Protection Act

SEC – ensure accuracy of credit ratings

Title I – Financial Stability Oversight Council (FSOC)

Title II – Federal Deposit Insurance Corporation (FDIC)
 To resolve failed institutions that are systemically important FIs
Title VI – Volcker Rule: separation of investment and commercial functions of banks to limit speculative trading
and eliminate proprietary trading. Banks cant be involved with hedge funds or PE firms. Purpose is to reduce risk.
Title X – Consumer Financial Protection Bureau (CFPB)

Regulating derivatives.
Setting up centralized exchanges for swaps trading to reduce for possibility for counterparty default.
All hedge funds to register with SEC

Criticism of Dodd-Frank
 Hurts competitiveness and economic growth
 Costly to enforce these acts
 Financial Choice Act – Repeal many of the protections in Dodd Frank. Repubs passed on June 8 2017

Bank risk management

1) Interest rate risk – mismatch of maturities of assets and liabilities. When FI holds longer-term assets (loans)
than liabilities (deposits), RSL>RSA, CGAP –ve. When interest rate increase, NII decrease as CGAP is –ve.
Use interest rate swaps to hedge risks – client wants fixed rate but bank wants floating asset.
2) Credit risk – borrower defaults
FIs need to monitor and collect information about firms whose assets are in their portfolios.
Bank’s managerial efficiency and credit risk management strategies shape the loan return distribution.
Effective credit risk management takes into account that credit risks will rise with unexpected change in interest rate
and market conditions.
3) Foreign exchange risk – undiversified foreign expansions expose FIs to foreign exchange risk in addition to
credit risk and default risk
4) Country or sovereign risk – more serious than domestic credit risk. A foreign FI may be unable to pay even if it
would like to. During times of crisis, government may prohibit cash outflow and limit payments due to currency
shortage and political reasons.
5) Off-balance sheet risk – letters of credit, loan commitments, mortgage servicing contracts, forwards, futures,
swaps, options, derivatives that are not reflected in the balance sheet.
6) Technology and operational risk – when investment in new technology is unsuccessful or underwhelming.
Mergers with the potential to improve technology synergies fail to generate success or cost savings
Operational risk – related to people or technology risk and can arise whenever existing technology is inefficient in
supporting operations and creates new risk because of risk underestimation. Human errors in risk calculations.

7) Liquidity risk – whenever a FI’s liability holders demand immediate cash for financial claims or when there is an
unexpected demand in new loans. FIs must be able to meet borrower’s demands.
When their supply is restricted or unavailable,
Banks have to liquidate less liquid items at a loss to finance their lending
Solvency problem and cause a bank run
Effective liquidity risk management ensures a bank’s ability to meet cash flow obligations, which are uncertain as they
are affected by external events and agent’s behaviour.

3) Private Equity
Private placement - A private placement is the sale of securities to a relatively small number of select investors as a
way of raising capital. Investors involved in private placements are usually large banks, mutual funds, insurance
companies and pension funds. A private placement is different from a public issue, in which securities are made
available for sale on the open market to any type of investor.

Leveraged buyouts
A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to
meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans,
along with the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make
large acquisitions without having to commit a lot of capital.
As the debt usually has a lower cost of capital than the cost of capital, the returns on equity increasing
with increasing debt. The debt acts as a lever to increase returns.
BREAKING DOWN 'Leveraged Buyout - LBO'
In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds
issued in the buyout are usually are not investment grade and are referred to as junk bonds. Further, many people
regard LBOs as an especially ruthless, predatory tactic. This is because it isn't usually sanctioned by the target
company. Further, it's seen as ironic in that a company's success, in terms of assets on the balance sheet, can be
used against it as collateral by a hostile company.
Reasons for LBOs
LBOs are conducted for three main reasons. The first is to take a public company private; the second is to spin-off a
portion of an existing business by selling it; and the third is to transfer private property, as is the case with a change
in small business ownership. However, it is usually a requirement that the acquired company or entity, in each
scenario, is profitable and growing.
Venture capital

Mezzanine capital
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the rights to convert to an
ownership or equity interest in the company in case of default, after venture capital companies and other senior
lenders are paid.

Distressed investments

3) Public equity
IPO
IPO Firm Commitment (for high quality companies):
 Underwriter GUARANTEES the sales
 Shares that are not sold are bought by the underwriter
 For high quality companies

IPO Best Efforts (for newer and unseasoned companies):

 Underwriter agrees to do his best to sell
 Sets a MINIMUM LEVEL of sales
 If minimum level is not reached the sale is cancelled
Financial Institutions
Depository Institutions

Local Banks (6 in name, 3 effectively)

1) DBS
2) OCBC
a. Bank of Singapore
b. Singapore Island Bank
3) UOB
a. Far Eastern Bank

Qualified Full Bank (QFB) – 9 as of July 2017

Commercial Banks – 19 full banks (subsidiaries of foreign banks without QFB license)
Wholesale banks
Offshore banks
Savings banks (eg. POSB)

Depository receipts
 Broker buys shares in home country and deposits shares in bank, bank issues DRs
 Traded in foreign exchanges
 Dividends paid in local currencies
 Exposed to political and forex risk
 Price of ADRs closely tracks stock in home market

Non Depository FIs

Mutual funds
 Collective investment vehicle
 Open end – issue NEW shares to investors
 Closed end – fixed number of shares

Unit Trusts
 Passive
 Buy and hold
 Lower transaction costs
 Holds a fixed portfolio

ETFs
 Open-ended investment funds which track indices
 Provide access to a wide range of asset classes

REITS
 Raise capital to purchase real estate assets
 Generate income for unit holders of the fund
 Allows individual investors to indirectly invest in property and share the benefits and risks
 Distribute income at regular intervals
 Less volatile than equities
 Less correlation with other financial assets
 More dividends than ordinary stocks

1) Central Bank
2) Bank regulations / bank risk management
3) Mortgage valuations
4) Bond valuations
5) In general, financial asset valuation
-Understanding that financial asset value is the present value of future CFs, where the discount rate captures
market conditions, an opportunity costs political uncertainty etc. (different types of stocks, different types of
bonds, different types of loans)