Topic 5-1

Review Exercise 5
Regulations of Banks
Review Exercise 5
Review Exercise 5-Regulations of Banks

1 Critically examine the view that unregulated banking is better for banking stability than2013-4a-ZA
regulated banking. (12 marks)
2 Explain free (unregulated) banking and discuss the advantages and disadvantages in2015-3a-ZA
relation to the stability of the banking system. (13m)
3 Discuss the arguments for bank regulation. (13 marks) 2007-5a-ZB
4 Discuss the reasons for and against the prudential regulation of banks. (15m) 2006-3a-ZA
5 Discuss the arguments for and against the regulation of banks. 2012-3a-ZB
6 Discuss the arguments for and against regulating banks. (12 marks) 2012-4a-ZA
7 Critically examine the reasons used to explain why banks are subject to prudential 2013-4a-ZB
regulation. (12 marks)
8 Discuss the advantages of the prudential regulation of banks and discuss the2015-3a-ZB
problems created by excessive regulation(13m
9 What is the CAMEL system? (5 marks) 20083eZAB
10 Explain why banks are vulnerable to liquidity problems.2010-4a-ZB
Explain how a shortage of liquidity in the banking system as a whole can be mitigated. (8
marks)
11 Discuss the moral hazard problems caused by the provision of ‘safety net’2015-3b-ZAB
arrangements for banks and examine solutions. 12m
12 Discuss the reasons for the lender of last resort facility provided by central banks and2014-4b-ZB
2
discuss the problems with the provision of this facility. (7 marks)
Principles of Banking and Finance Ex5-pg1

Review Exercise 5
13 What are the mechanisms of deposit insurance adopted in the and in the ? (4 marks) 2008-3a-ZAB
14 Explain the role of deposit insurance in the regulation of a banking system and discuss2010-4b-ZB
the solutions to the moral hazard problem created by deposit insurance. (11 marks)
16 4(b) Explain the role of deposit insurance in the regulation of a banking system and2010-4b-ZB
discuss the solutions to the moral hazard problem created by deposit insurance. (11
marks)
17 Discuss the role of a deposit insurance scheme within a system of bank regulation. (102006-3b-ZA
marks)
18 Identify the possible solutions to the moral hazard problem arising from a system of2008-3c-ZAB
100% insurance of deposits. (6 marks)
19 What are the methods used to handle a failed bank in the USA? (6 20083bZAB
20 What is the solution to the moral hazard problem arising from the “too big to fail”2008-3d-ZAB
policy? (4 marks)
21 Examine the ‘too big to fail problem’ in banking and discuss possible solutions to this2012-4b-ZA
problem. (13 marks)
22 Explain the `too big to fail problem' in relation to banking. Explain why this has become2013-4b-ZA
a problem in banking and discuss solutions to this problem. (13m)
23 Discuss the causes, consequences & possible solutions to the2014-4-ZA
‘too big to fail’ problem in banking. (25 marks)
24 How can bank regulation reduce the bank’s incentive to take risks? 2007-3a-ZAB
25 Identify typical aspects of a banks capital requirement as imposed by2008-5c-ZA
regulators. (5 marks)
26 Explain the importance of capital in preventing bank failures. (7 m) 2011-3a-ZA
27 Define what a bank’s capital is and explain why bank capital is important in2010-4a-ZA
protecting depositors from loss. (8 marks)
28 Explain the risk-assets ratio under Basel 1 & discuss the main problems that have been2008-5d-ZAB
identified with it. How will it change under 2? (13 marks)
29 Explain how the risk assets’ ratio under 1 was constructed and discuss the2011-3b-ZA
problems with this construction. (10 marks)
30 Explain the changes to the construction of the risk assets’ ratio under 2 &2011-3c-ZA
and discuss to what extent the changes address the problems with the 1
construction.(8 marks)
31 Explain the risk assets ratio introduced under the 1 capital adequacy regime2010-4b-ZA
and outline the main problems with this 1 ratio. (9 marks)
32 Explain the risk-assets ratio under 1 and discuss the main problems that2006-5b-ZA
have been identified with it. ( 13marks)
33 3(c) Explain the risk-assets ratio under 1 and discuss the main problems that have been20073c-ZAB
identified with it. How will it change under Basel2 ? (13 marks) 4

Review Exercise 5
34 Discuss the main changes to the assessment of capital adequacy of banks2012-3b-ZB

proposed under 3. (13 marks)
35 Discuss the reasons for the proposed changes in capital regulation under Basel2014-4c-ZB
3. (12 marks)
36 Outline the 2 capital adequacy regime and 2010-4c-ZA
discuss to what extent it addresses the problems with the 1 regime. (8m)
37 Discuss the differences between micro-prudential regulation and macro-2013-4b-ZB
prudential regulation and explain why macro-prudential regulation has been
given greater emphasis since 2008. (13 marks)
38 Discuss the monitoring of liquidity in banking, with particular reference to the2008-5c-ZB
UK. (5 marks)
39 Discuss the importance of disclosure in relation to bank regulation. (10 marks) 2011-4b-ZB
40 Discuss the role of market discipline in the regulation of banks. (6 marks) 2010-4c-ZB
41 Discuss the role of market discipline in regulating banks. (6 marks) 2014-4a-ZB
42 With reference to examples discuss the relationship between 2011-4a-ZB
bank regulation and financial crises. (15 marks)
43 Discuss the lessons of the 2007/8 global financial crisis for bank regulators.(252013-1-ZA
marks)
5
Free Banking
= un____________________ financial (banking) systems (x Regulated banking system)
= financial system with no c_____ b___/ no financial regulator/ no government intervention.
operate freely, subject to market forces & the rules of ‘normal’ commercial and contract law.
e.g. financial laissez-faire. Free banking era:
Scotland (1716–1845)
• consists of banks whose deposits are largely repayable on demand
Canada (1820–1935)
• no central bank, no supervision, no restriction on the activities of banks, and
Switzerland (1830s & 1840 - 1881)
• no state deposit insurance scheme. USA (1838-1863)
• Free banks issue distinct p m (i.e. bankHK notes) (1935–64)

which are perpetual, non-interest bearing debt claims that redeemable on demand.
• Credit default risk exists on bank notes.
• unstable because market failures, monopolies & information symmetry.
Arguments against private money issuance
a) banks can over-issue their currency, making the conversion impossible (i.e. w______ banking).
b) Transaction costs increase when thousands of distinct bank notes circulate in a given
geographical area (e.g. 3 thousand in USA & Canada in their periods of free banking)
Free banking problems: c____________, w__________ banking, f____________ banking,

7
over-issue of b_____ n____ & over-expansion by banks.

Review Exercise 5
Free Banking Problems

Free banks are prone to failures & lead to s_______ banking instability, so need banking regulation.
Free banking failures: e.g. In__________, Wisconsin & Min___________.
Banking system is more heavily regulated than other sector of the economy. Financial crisis 2007–09 revealed banking
regulation deficiencies. Regulatory failure to prevent the 2007-2009 banking crisis has raised doubts about the ability of
regulators to maintain a stable banking system. Some economists are still in favour of free banking.
Advantages of free banking system

a) Money supply competition forces banks to maintain their reputation or convertibility of their liabilities
(bank notes or deposits) into species or real commodities, to prevents banks from over-issuing money.
b) S___________ mechanism non-exists under a monopolised government money supply.
so free banking is (more/ less) stable than central banking.
Depositors are aware that if bank failed they would lose their deposits. They require greater reassurance that their deposits are safe.
• The higher the bank capital, the better the bank’s ability to maintain its solvency in the event of losses.
Capital is costly (as need to pay shareholders dividends). Market forces determine the optimal capital
under free banking system. Depositors will place deposits in banks with high capital if they want high
levels of reassurance. Free banking aims to encourage good & discourage imprudent, behaviour
(Dowd,1996)
10
4(a) Critically examine the view that unregulated banking is better for banking
stability than regulated banking. (12 marks) ZA2013-4a
• See the subject guide, Ch5, sections on `Free banking' and `The regulation of banks'.
Approaching the question
• Unregulated (free) banking involves no regulation and no central bank providing safety net
facilities. The supporters of free banking argue that such a system is stable as banks would
need to reassure depositors under such a system by disclosing information and holding high
levels of capital. Such high levels of capital would lead to stability.
• Critics of free banking argue that such a system is inherently unstable as the nature of the
deposit contract makes banks subject to significant liquidity risk. Such liquidity risk can be
contagious leading to systemic problems in the banking system. Attempts to recover from
illiquidity (by a `re sale' of assets) could lead banks to become insolvent. Therefore, it is argued
that banks need to be regulated to provide reassurance to depositors. Banks need to be
regulated to stop them taking excessive risk and to hold sufficient capital.
13

Review Exercise 5
3. (a) Explain free (unregulated) banking and discuss the advantages and disadvantages
in relation to the stability of the banking system. (13 marks) 2015-3a-ZA
• See subject guide, Chapter 4, pp.90–96.

• Free (unregulated) banking refers to a situation where banks are
not regulated by a central bank or similar authority. In effect, the market will regulate.
This will lead to banks disseminating more information to potential lenders and holding
more capital (signal of safety).
• Advantages – low cost, low moral hazard, more competition.
• Problems – instability (contagion) – hence systemic risk.
• Better answers would explain what the market regulating the banks means. A better
answer would also weigh up the advantages and disadvantages of a free banking
system – in doing so, would identify the weight given to particular issues by policy
makers.
Importance of Bank Regulations

Bank regulation mechanisms
a) disclose i_______________ (e.g. audited accounts)
b) prudent l_______________ policies
c) adequate c_____________
Argument for bank regulation:

a) to protect d_____________,
b) to assure the s__________ & s__________ of banks,
c) to avoid (or limit) the effects of bank f_____________,
d) to maintain monetary st______________,
e) to protect the p___________ system and
f) to encourage efficiency & competition in the financial system & economy.
Argument for banking regulation:

a) F________________ of banks
b) S________________ risk 16
c) protection of d_____________

Review Exercise 5
Arguments for Bank Regulation -(1) Fragility of Banks

• Bank p__________ have been common in Europe & USA (& emerging countries).
When banks use demand deposits to finance illiquid loans, public loss confidence in
the banking system will lead to bank panics. Banks privately developed cooperative
systems to protect their reputation.
• Central banks use these system to control banking systems. Central banks are the
‘l_______ of l______ r______” in times of financial crises, i.e. Central banks are the
ultimate supplier of liquidity to bank(s) threatened by a l____________ crisis.
Central banks have led lifeboat rescues, healthy banks take over the deposits of the
troubled banks.
Banks are fragile because:

1) bank provide liquidity i________________ to households
• Banks pool liquidity from households who deposit funds as insurance against shocks that affect their
consumption needs. Fraction of the deposits are used by banks to finance illiquid investments (i.e.
fractional reserve system). Banks are fragile if many depositors withdraw their funds.
2) A source of mitigation of fragility
• Banks screen & monitor borrowers to produce accurate firm valuation & select good credit risks (i.e
banks are specialized in produce information). Banks are vulnerable to bank runs due to the financial
19
structure of banks: with liquid liabilities (deposits) & illiquid assets (loans)
Argument for Bank Regulation- (2) Systemic Risk

S_____________ Risk = risk that the a failure bank spreads to other solvent banks
when depositors are unable to distinguish between good & bad banks.
• Central bank & bank regulation always try to prevent systemic risk. One bank run will
lead to solvent banks run due to asymmetric information problem. A solvent bank facing
a run will quickly run out of liquidity to meet deposit withdrawals because most of its
assets are long term & illiquid (i.e. fragility of bank).So may ‘fire-sale’ its assets (i.e. to
sell assets cheaply) to generate liquidity which bank’s total assets value will reduce. i.e.
a solvent bank will ended insolvent if attempts to generate liquidity.
Classical bank r_____=retail depositors lose confidence in their bank’s ability to remain
solvent or see problems at other banks & join a run at their bank.
• Liquidity is provided by (i) r____ deposits (ii) w_______ deposits (inter-bank & repo markets).
Banks depend heavily on wholesale market funding & securitization funding
• 2007 banking crisis showed that bank runs happened in the wholesale markets when
i_______-bank lending drains away & lenders demand higher c______________.
Banks are highly interconnected & banking system problem spread quickly. Banks are
important financial intermediaries & in underpinning economy, the consequences of 22
banking systemic failure is catastrophic. So, banks need to be regulated.

Review Exercise 5
Arguments for Bank Regulation -(3) Protection of depositors

Bank regulation can (i) p_______ the depositors & (ii) ensure the p______ system are safe.
• Need bank regulations as depositors lack of expertise & knowledge to assess the bank’s quality.
• The differentiation of retail & wholesale (investment) banking became an issue following in the 2007-09
financial crisis. Many banks are both retail & wholesale banks.
• The ending of Glass-Steagall in the USA allowed retail banks to engage in investment banking activities.
R_________ bank fairly rigorous control (i.e. more regulation) as retail depositors are less
knowledgeable than wholesale depositors. Regulators are reluctant to fail retail
banks due to the failure consequences.
W________ bank lighter prudential control
U_________bank Difficult to regulate in Europe as retail banking is intertwined with investment
(= retail + banking.Many universal banks have serious financial difficulties due to the
investment speculative activities of their investment banking operations. Universal banks
banking) are rescued with state funds to protect depositors’ funds in their retail
operations & to prevent systemic risk.
In________ bank inherently riskier than retail banking.
25
Arguments for Bank Regulation - (3) Protection of depositors

Consequences of bank failures (if no bank regulation)
1) Very costly to the failing bank’s depositors, stockholders, borrowers & other banks
2) bank’s important role in the payment system
Bank failures are serious to the economy because:

i) Bank’s creditors = d______________ = bank customers
Non-financial firm’s creditors= bank; banks’ creditors =householders (unable to monitor banks activities)
ii) Depositors have insufficient information & expertise to differentiate between safe &
risky banks important to regulate banks to protect depositors
• Banks managers would not choose the optimal solvency ratio. Self-regulation have conflicts of interest
between managers, stockholders & bondholders of bank. For a self-regulated bank, the managers tend
to choose risky investment. Need bank regulation to protect the depositors who have insufficient
financial information (Dow, 1996).
28

Review Exercise 5
20075a
5(a) Discuss the arguments for bank regulation. (13 marks)
• refer to pages 67–69 of the subject guide.

• the main reasons for prudential regulation:
1. The fragility of banks – mainly due to their provision of liquidity to the financial
system (i.e. vulnerability to runs). A source of mitigation of fragility is the role of
banks in screening and monitoring borrowers who cannot obtain direct finance
from financial markets (6 marks)
2. Systemic risk – the contagion effect exacerbated by asymmetric information
3. Depositor protection
• explain the main consequences of bank failures in the absence of any regulation
32
3(a) Discuss the reasons for and against the prudential regulation of banks. (15 marks)
2006-1a-ZA
• a balanced, essay format discussion which included the main reasons for and against prudential
which include:
– The fragility of banks – mainly due to their provision of liquidity to the financial system, that
is, vulnerability to runs.
– Systemic risk – the contagion effect exacerbated by asymmetric information.
– Depositor protection.
– The pivotal position of banks in the financial system and the social cost of bank failures.
• Main reasons that students could include which are against prudential regulation include:
– Compliance costs – both the cost of the regulator and the cost of the bank’s own compliance
with regulations.
– Reduction in competition – may lead to inefficiencies.
– Introduces moral hazard.
• Other relevant reasons and examples were rewarded with extra marks.
35

Review Exercise 5
3. (a) Discuss the arguments for and against the regulation of banks. (12 marks)
Main reasons for regulating banks are: 20123a

i. fragility of banks
ii. systemic risk
iii. protection of depositors.
Main arguments against include:

i. cost
ii. restrictions on innovation and competition
iii. moral hazard.
See subject guide, pp.92–96.

• Better answers would discuss the relative importance of the different costs and benefits to
arrive at the conclusion that benefits of regulation outweigh costs and that is why most
banking systems are extensively regulated.
38
4. (a) Discuss the arguments for and against regulating banks. (12 marks)
ZA-2012-4a
• See subject guide, pp.94–96.
Arguments for include:
1. fragility of banks
2. systemic risk
3. protection of depositors.
Arguments against include:

1. cost
2. restrictions on innovation and competition
3. moral hazard created.
• Better answers will discuss the relative weights attached to the arguments for and
against and hence attempt to explain why most banking systems are regulated (i.e.
arguments for outweigh arguments against). 41

Review Exercise 5
4(a) Critically examine the reasons used to explain why banks are subject to
prudential regulation. (12 marks)
2013-4a-ZB
• See the subject guide, Chapter 5, section on `Why do banks need regulations'.
The three main reasons for regulation are:
1) Fragility of banks.
2) Systemic risk.
3) Protection of depositors.
• Each of these theories should be examined and discussed in terms of their importance
in understanding why banks are regulated. The key reason is the systemic risk
argument.
43
3. (a) Discuss the advantages of the prudential regulation of banks and discuss the
problems created by excessive regulation. (13 marks) 2015-3a-ZB
See subject guide, Chapter 5, pp.92–96.

Prudential regulation is justified based on:
i. Reducing systemic risk
ii. depositor protection
iii. reducing social costs of failure.
Excessive regulation creates:

i. moral hazard
ii. high costs
iii. barriers to competition.
Each of these arguments needs to be explained. Better answers would explain there is a
trade-off between these different arguments. However, to achieve the main outcome of
lower systemic risk, some moral hazard, costs etc. have to be borne.

Review Exercise 5
Arguments Against Regulation

• Regulation is (1) costly (2) have negative effects (3) with instability.
Regulation cost:
R________ administration costs employing staff to monitor banks
Adm________________ costs associated with the banks’ own compliance activities
C___________________ costs to comply with capital requirements
contribution to funds needed to compensate the clients of other banks which have failed
Need to avoid over-regulated (maintain minimum regulation) to prevent bank runs,

Excessive bank regulation may:
(i) reduce c___________ (i.e. regulation limits banks’ diversification by limiting bank portfolio choices or restricting branching)
(ii) (increase/ decrease) costs (reduces profitability) &
(iii) discourage financial in____________________
(iv) creates m____ h_____ (i.e. banks may take more risk as they will be bailed out if they face financial difficulties).
Depositors are less likely to monitor banks when regulator monitoring on their behalf. Deposit insurance
provides compensation if bank fail. so depositors deposit in banks paying the highest interest rates which are
likely to be the banks taking the most risk. i.e. regulation ended encourage risk taking. Banks will move from
excessively regulated to less regulated centre. European Union regulator encourages harmonised regulation 46
system across in different countries (i.e. ‘level playing field’).
Traditional Regulation Mechanisms - (1) Creation of A Central Bank

1) creation of a central bank 4) bank capital requirements
2) bank supervision (restrictions on entry, bank examination) 5) assessment of risk management
3) government safety net (deposit insurance 6) monitoring of liquidity
7) disclosure requirements
Functions of Central banks:
(i) M Control It is important for the government to control the money supply because
private issuance of payment means could easily generate fraud,
(to control money supply) counterfeiting & adverse selection problems. Monetary control helps to
stabilise prices.
(ii) P control Central bank is the ‘lender of last resort’ during financial crisis. The
lender of last resort function could go against free competition of banks.
(to minimize financial crises) Bank of England (founded in 1694, central bank of UK) laid the
foundation for other central banks. Federal Reserve Bank (FRS or The
Fed, central bank of US, founded 1913). It consists of 12 regional
Federal Reserve Banks & a Board of Governors. The Fed is mainly to
pool the reserves of each of the reserve banks. European Central Bank
(ECB) (in Frankfurt, July 1998) is the central bank for its member50states,
forms the European System of Central Banks.

Review Exercise 5
Traditional Regulation Mechanisms

(2) Bank supervision: restrictions on entry & bank examination
Bank supervision (= pru_____________ supervision)

i) To oversee bank op_____________
ii) To reduce m__________ h________ & ad_________ s___________
(by restricting entry & examining bank).
• Use chartering & licensing of banks to restrict entry (in US & UK).
• US commercial bank must has a national or state charter,
granted by the Comptroller of the Currency or by a state authority.
• Potential bankers have to apply for a charter by submitting the
bank operational plan for the regulator to evaluate
(its management quality, estimated future earnings, initial capital).
53

(2) Bank supervision: restrictions on entry & bank examination
• A UK bank must offer a broad range of services (e.g. deposit accounts, overdraft & loan
facilities). A licensed bank must have well c_________(min £5m of paid-up capital & reserves),
adequate liquidity, internal control & good management.
• EU Second Banking Coordination Directive allows banks to set up branches in other EU
countries if authorization are granted by their home regulator.
• Regulators use C___________ rating system (1-best, 5-worst) to examine that banks operate prudentially
(i.e. prudential supervision)
CAMELS = C__________ adequacy,
A__________ quality ,
M__________ quality,
E__________’ performance,
L___________,
S___________ to market risk.
56
• Regulators can alter a bank’s behaviour (or close the bank) if the CAMELS rating is low.

Review Exercise 5
2008-3e-ZAB
3(e) What is the CAMEL system? (5 marks)
• refer to p.72 of the subject guide.

• The Examiners would expect candidates first to clarify that the CAMEL system is an
internationally recognised framework used by bank examiners to evaluate banks (1
mark).
• A good answer should then explain how the CAMEL system works − banks are
scored on a scale of 1 (the best) to 5 (the worst) assessing five areas (1 mark):
capital adequacy, asset quality, management quality, earnings’ performance, and
liquidity (2 marks). The Examiners equally awarded marks to candidates referring to
the CAMELS system.
• Finally excellent answers should refer to the consequences for banks if the CAMEL
rating is sufficiently low − regulators can take formal actions to alter bank’s
behaviour (or even close the bank) (1 mark).
61
Traditional Regulation Mechanisms - (3) Government safety net

Governments safety net for depositors:
L________ Functions of central bank: provide liquidity to bank (in exchange for financial assets) in times of
financial distress. This increase the liquidity of the distressed bank but not its assets value. Central
of bank only provides liquidity to solvent banks. But it is difficult to differentiate solvent & insolvent banks.
L________ Central banks injected massive liquidity into their banking systems in 2007-2009 banking crisis/liquidity
crisis.Lender of last resort function increases moral hazard as problem banks expect central bank to
r_________ provide liquidity if they have financial difficulties. So banks have less incentive to manage liquidity effectively.
Solution: Central bank provide liquidity at rates higher than market rates in noncrisis periods
Dep______ Deposit insurance schemes (adopted by US & most developed countries) can protect depositors in case of
bank runs & bank panics. Depositors have less incentive to join bank run if they know their deposit is protected by
in________ an insurance scheme. Bank pays a deposit insurance premium to deposit insurance company FDIC (i.e. Federal
Deposit Insurance Corporation, USA). The Fed established FDIC in 1934 due to the Great Depression bank panics.
Deposit insurance was effective in stablising the banks as the bank failure rate declined from 28.16% (in 1933) to
0.37% (in 1934)
Deposit insurance: compulsory (for Feb members) or voluntary (for non-members).
Deposit insurance limits: US$250,000 (USA), £50,000 (UK), 100,000 Euros (Jan 2011).
Deposit Insurance coverage (different % of deposits)
100%- after 2007-09 financial crisis [100% of the first £2,000 & 90% of the next £33,000 (UK, Oct 2008)
D________ by the gov to troubled institutions 63
funding (see next slides)

Review Exercise 5

(3) Government safety net – (c) Direct funding
FDIC uses 2 methods to handle a failed bank:
1) FDIC pays off deposits up to the $250,000 insurance limit. FDIC pays the failed
P__________ bank’s creditors the proceeds of the liquidated assets proportionately. Deposit
account holders with more than $250,000 deposits get back more than 90% (but
method
within a few years).
2) FDIC finds a merger partner to takeover all the deposits of the failed bank (not
P_________ just those under $250,000) so that no depositor loses any money.In the too-big-
to-fail doctrine: the big insolvent banks would get a large infusion of capital from
& assumption
the FDIC, which would then find a merger partner to take over the insolvent
method banks & their deposits. Originally the policy was limited to the 11 largest US
banks, but now extended to big banks in general.
66

(3) Government safety net – (c) direct funding
• 100% deposit insurance creates m_________ h______ problem. Depositors have no incentives
to monitor a bank’s activities. Depositors do not withdraw deposits even if the bank is too risk (as
they know that they will not suffer losses if the bank fails). resulted banks undertake more risk.
• T____-b___- to- f_______ policy increases the moral hazard problem for big banks.
Solutions to the moral hazard problem due to 100% deposit insurance:

L_____c___ use for resolving bank failures under the FDICIA, 1991. Riskier banks pay higher
approach insurance premiums to the FDIC. Banks reduce their risks under the risk-based
deposit insurance premiums system
co-in______ to reduce moral hazard (UK, prior Oct2008) i.e. deposit insured is less than 100% (UK it
was 100% of the first £2,000 & 90% of the next £33,000). Depositors have greater
approach incentive to monitor (because of the threat of losing some of the deposits), but the
percentage lost has to be kept to a (low) level that provides the incentive not to join a run.
Note: Banks pay a flat-rate premium to their deposits.
69

Review Exercise 5
3(b) Discuss the moral hazard problems caused by the provision of ‘safety net’
arrangements for banks and examine solutions. (12 marks) 2015-3b-ZA
• See subject guide, Chapter 4, pp.98–99.
• This part requires a specific discussion of the moral hazard problems caused by the safety net
arrangements for banking created by the central bank/regulator. The safety net refers to:
• i. Lender of last resort – provision of liquidity to individual banks or the system of banks in
times of shortage.
• ii. Deposit insurance – to provide compensation to depositors in the event of the failure of
bank.
• iii. Direct funding (bailing out) of troubled banks – this came more to the fore in the aftermath of
the 2007–08 crisis as governments/central banks provided capital injections to insolvent/near
insolvent banks.
• Each of these safety net arrangements needs explaining with particular emphasis on the moral
hazard created. The solutions to the problem are related to the particular nature of the safety net
arrangement (e.g. deposit insurance, co-insurance, lender of last resort, penal rates of interest
etc.). Better answers may relate the too big to fail problem with the third aspect of the safety net
arrangements.
4(a) Explain why banks are vulnerable to liquidity problems. Explain how a shortage of
liquidity in the banking system as a whole can be mitigated. (8 marks) 20104a
• refer to pp.85–86 of the subject guide.

• Banking is subject to waves of confidence. When economies move into severe
recession and bad debts at banks increase depositors may lose confidence in a bank
and may panic and start/join a run.
• The structure of a bank’s balance sheet is such that a bank is not able to pay back a
large number of depositors at any point in time. This can further exacerbate the problem.
• A shortage of liquidity in the banking system as a whole can be mitigated by an injection
of liquidity from the central bank acting as lender of last resort. Better answers would
explain that central bank injections of liquidity were an important solution during the
recent financial crisis.
74

Review Exercise 5
4(b) Discuss the reasons for the lender of last resort facility provided by central banks
and discuss the problems with the provision of this facility. (7 marks) 2014-4b-ZB
See subject guide, Chapter 5, section headed ‘Government safety net’, subheading ‘lender
of last resort’.
This is the provision of liquidity support to banks in times of financial distress. Usually
involves swapping illiquid assets for liquid assets supplied by the central bank.
Reasons – liquidity risk is an important source of instability for banks/banking systems. At
times the banking system as a whole may run short of liquidity – this needs to be supplied
externally (as in the 2008 crisis).
In addition, individual banks may, at times, not be able to access liquidity through normal
market mechanisms. As long as the bank is still solvent it can then obtain funding from the
central bank.
Problems – creates moral hazard – countered by charging a ‘penal rate’ of interest on this
kind of support. Also, regulation can force banks to better manage their liquidity.
76
3. (a) What are the mechanisms of deposit insurance adopted in the USA and in the
UK? (4 marks) 2008-3a-ZAB
• refer to pp.72−73 of the subject guide.

• This question focuses on several aspects of banking regulation. In part (a) candidates
are expected to discuss deposit insurance schemes adopted in the USA and in the
UK.
• An outstanding answer should begin with a discussion on the rationale of deposit
insurance. To avoid runs on banks and bank panics, governments have established
deposit insurance schemes to provide protection for depositors. Under these
schemes the bank pays a premium to a deposit insurance company, such as the
Federal Deposit Insurance Corporation (FDIC) in the USA, and in exchange its
depositors have their deposit insured up to a fixed limit in case the bank fails (1
mark).
79

Review Exercise 5

• To avoid runs on banks and bank panics, governments have established deposit
insurance schemes to provide protection for depositors. Under these schemes the bank
pays a premium to a deposit insurance company, such as the Federal Deposit
Insurance Corporation (FDIC) in the USA, and in exchange its depositors have their
deposit insured up to a fixed limit in case the bank fails.
• analysis of the modalities in which deposit insurance is adopted in the USA and in the
UK:
– Insurance may be compulsory (all the members of the Federal Reserve System in
the USA) or simply voluntary (non-members if they meet the FDIC admission criteria)
– Insurance’s limit may differ widely (from $100,000 in the USA to £18,000 in the UK)
– Insurance may cover different percentage of deposits (100 per cent of deposits up
to a value of $100,000 at a bank in the USA, 90 per cent of deposits to a customer
up to a maximum of £18,000 in the UK)
80
3(a) What are the mechanisms of deposit insurance adopted in the USA and in the UK? (4
marks) 20083a

• To avoid runs on banks and bank panics, governments have established deposit
insurance schemes to provide protection for depositors. Under these schemes the bank
pays a premium to a deposit insurance company, such as the Federal Deposit
Insurance Corporation (FDIC) in the USA, and in exchange its depositors have their
deposit insured up to a fixed limit in case the bank fails.
• analysis of the modalities in which deposit insurance is adopted in the USA and in the
UK:
– Insurance may be compulsory (all the members of the Federal Reserve System in
the USA) or simply voluntary (non-members if they meet the FDIC admission criteria)
– Insurance’s limit may differ widely (from $100,000 in the USA to £18,000 in the UK)
– Insurance may cover different percentage of deposits (100 per cent of deposits up
to a value of $100,000 at a bank in the USA, 90 per cent of deposits to a customer
up to a maximum of £18,000 in the UK)
81

Review Exercise 5
4(b) Explain the role of deposit insurance in the regulation of a banking system and
discuss the solutions to the moral hazard problem created by deposit insurance. (11 marks)
20104b
• refer to pp.90–91 of the subject guide, and to pp.512– 15 (sixth edition) of Mishkin and
Eakins Financial markets and institutions.
• Deposit insurance can be used to increase depositors’ confidence in banks and hence
reduce the risk of a run developing on a bank. the recent financial crisis has
demonstrated the importance of deposit insurance in providing an underpinning of
confidence (when set at the correct level).
• Moral hazard created by deposit insurance includes:
– i. depositors having an incentive to place their deposit in high risk banks (paying the highest return)
as they are protected if the bank fails – example of Icelandic banks in the UK
– ii. bank managers having incentive to take more risk because if the worst happens then depositors’
funds are protected.
• Solutions to moral hazard include:
– for (i) co-insurance (although this has been abandoned in some countries such as the UK)
– for (ii) relate premiums for insurance to risk (as in US).
84
3(c) Examine how deposit insurance creates moral hazard problems in banking and
discuss solutions to the moral hazard created by deposit insurance. (12
• refer to pp.90–91 of the subject guide, and to pp.525–27 (sixth edition) of Mishkin and Eakins
Financial markets and institutions. 2010-3c-ZA
• Deposit insurance provides compensation to depositors in the event of a bank failure. Deposit
insurance can be used to increase depositors’ confidence in banks and hence reduce the risk of
a run developing on a bank. A very good answer would explain how the recent financial crisis has
demonstrated the importance of deposit insurance in providing an underpinning of confidence
(when set at the correct level).
Moral hazard created by deposit insurance includes:
i. depositors having an incentive to place their deposit in high-risk banks (paying the highest return)
as they are protected if the bank fails – example of Icelandic banks in the UK
ii. bank managers having incentive to take more risk because if the worst happens then depositors
funds are protected.
Solutions to moral hazard are
• for (i) co-insurance (although this has been abandoned in some countries, such as the UK)
• for (ii) relate premiums for insurance to risk (as in US). Better answers would reflect on why co-
insurance was abandoned by a number of countries during the financial crisis.
88

Review Exercise 5
• Candidates should then move to the analysis of the modalities in which deposit
insurance is adopted in the USA and in the UK: 2010-3c-ZA
– Insurance may be compulsory (all the members of the Federal Reserve System
in the USA) or simply voluntary (non-members if they meet the FDIC admission
criteria) (1 mark).
– Insurance’s limit may differ widely (from $100,000 in the USA to £18,000 in the
UK) (1 mark).
– Insurance may cover different percentage of deposits (100 per cent of deposits
up to a value of $100,000 at a bank in the USA, 90 per cent of deposits to a
customer up to a maximum of £18,000 in the UK) (1 mark).
89
3(b) Discuss the role of a deposit insurance scheme within a system of bank
regulation. (10 marks) 2006-3b-ZA
• short and clear explanation of the key features of deposit insurance such as: bank pays
premium to deposit insurance scheme; depositors are compensated in event of bank
failure; it should reduce the incentive of depositors to join a run so reducing the
systemic risk. Marks were awarded for this clear definition.
• discuss how deposit insurance introduces moral hazard which has to be managed.
– Co-insurance to reduce moral hazard relating to depositors.
– Premiums related to risk to reduce moral hazard relating to bankers.
• Hence successful reduction in systemic risk requires a careful implementation of
deposit insurance to mitigate inherent moral hazard.
• Relevant example(s) of schemes were rewarded with a mark.
92

Review Exercise 5
20083b
3 (b) What are the methods used to handle a failed bank in the USA? (6 marks)

• Payoff method: the FDIC pays off deposits up to the $100,000 insurance limit. After the
bank’s liquidation, then FDIC lines up with other creditors of the bank and receives its
share of the proceeds from the liquidated assets. Typically, account holders with
deposits in excess of the $100,000 limit get back more than 90 per cent (but the
process can take several years).
• Purchase and assumption method: the FDIC finds a merger partner who takes over all
the deposits of the failed bank (not just those under $100,000) so that no depositors
lose any money. This method has been used to implement the FDIC’s policy called ‘too
big to fail’: the big insolvent banks would get a large infusion of capital from the FDIC,
who then would find a merger partner to take over the insolvent banks and their
deposits. Originally the policy was limited to the 11 largest US banks, but has now been
extended to big banks in general.
94
3(b) What are the methods used to handle a failed bank in the USA? (6 marks)
• refer to p.73 of the subject guide. ZA-2008-3b
• The Examiners would expect excellent answers to discuss the two primary methods to handle
a US failed bank by making the following points:
– Payoff method: the FDIC pays off deposits up to the $100,000 insurance limit. After the
bank’s liquidation, then FDIC lines up with other creditors of the bank and receives its
share of the proceeds from the liquidated assets. Typically, account holders with deposits
in excess of the $100,000 limit get back more than 90 per cent (but the process can take
several years). (Up to 3 marks were awarded for making these points).
– Purchase and assumption method: the FDIC finds a merger partner who takes over all the
deposits of the failed bank (not just those under $100,000) so that no depositors lose any
money. This method has been used to implement the FDIC’s policy called ‘too big to fail’:
the big insolvent banks would get a large infusion of capital from the FDIC, who then would
find a merger partner to take over the insolvent banks and their deposits. Originally the
policy was limited to the 11 largest US banks, but has now been extended to big banks in
general. (Up to 3 marks were awarded for making these points).
96

Review Exercise 5
3(c) Identify the possible solutions to the moral hazard problem arising from a system of
100% insurance of deposits. (6 marks) 20083c

• ‘Least cost’ approach, as adopted in the USA in 1991 by introducing the Federal
Deposit Insurance Corporation Improvement Act (FDICIA) (1 mark). Riskier banks are
required to pay higher insurance premiums to the FDIC. If there is a system of risk-
based deposit insurance premiums then banks will have an incentive to reduce these
risks.
• ‘Co-insurance’ approach, as adopted in the UK. The amount of deposit insured under
the scheme would be less than 100 per cent (in the UK 90 per cent up to a maximum of
£18,000). Depositors have greater incentives to monitor (because of the threat of losing
some of the deposits), but the percentage lost has to be kept to a (low) level that gives
the incentive not to join a run. Note that banks pay a flat rate premium linked to their
amount of deposits.
98
3(c) Identify the possible solutions to the moral hazard problem arising from a system of
100 per cent insurance of deposits. (6 marks) 2008-3c-ZAB

• The Examiners would expect candidates to make a link with point (a), where the 100 per cent deposit
insurance scheme was introduced. Specifically, candidates are now required to discuss the solutions to
the moral hazard problem associated to such a scheme.
• An outstanding answer would be structured as an essay-style answer which covered the following points
on the two possible solutions to the moral hazard problem:
– ‘Least cost’ approach, as adopted in the USA in 1991 by introducing the Federal Deposit Insurance
Corporation Improvement Act (FDICIA) (1 mark). Riskier banks are required to pay higher insurance
premiums to the FDIC. If there is a system of risk-based deposit insurance premiums then banks will
have an incentive to reduce these risks. (Up to 2 marks for the description of this solution).
– ‘Co-insurance’ approach, as adopted in the UK (1 mark). The amount of deposit insured under the
scheme would be less than 100 per cent (in the UK 90 per cent up to a maximum of £18,000).
Depositors have greater incentives to monitor (because of the threat of losing some of the deposits),
but the percentage lost has to be kept to a (low) level that gives the incentive not to join a run. Note
that banks pay a flat rate premium linked to their amount of deposits. (Up to 2 marks for the
description of this solution).
100

Review Exercise 5
Too-big-to-fail problem
• T___-b____- to- f____(= too-important-to-fail) was a major problem in 2007–09
financial crisis as many large banks almost collapse. Too-big-to-fail banks (or large
systemically important banks) are banks that are important within financial markets,
their failure would have a catastrophic effect on those markets.
• Solution: Government inject capital to the banks under T______ A____ R____ Program (TARP)
Eg1.US government injected $45billion each to C_____group & Bank of A__________
in exchange for the equity stake to the government.
• Eg2.UK government injected capital to L________ Group (£20.3 billion) &
R_________B_____ of S_________ (RBS) (£45.5 billion) in exchange for 41% & 84%
equity stakes respectively.
• Some institutions are too big to be allowed to fail (causes a moral hazard).
• Before the crisis, large scale meant diversification & sophistication
as a result large banks having lower capital requirements.
• Glass-Steagall Act view: large diversified institutions were beneficial due to economies
of scale & diversification.
• Since the crisis this view has been challenged & solutions have been sought for the too-big- to-fail problem
102
Solutions for Too-big-to-fail problem

Solutions for too-big-to-fail
i. to reduce the probability of failure of these institutions while leaving the size & range of activities
unchanged
ii. to reduce the size of these institutions or to make them less interconnected or
to separate activities within the institution
iii. to increase the range of resolution options, set out in advance resolution & recovery plans (i.e. ‘living wills’).
Solutions for too-big-to-fail problem

i) larger banks need to hold more c________ & l_________ than smaller banks (a
reverse of the policy pre-crisis). This has been the approach adopted in
B__________ 3 discussed below.
ii) ‘N__________ banking’ (i.e. banks take in insured retail deposits & provide retail
payments systems, only hold government bonds as assets) (Kay, 2009). ‘new’ Glass-
Steagall Act (prohibits retail banks in trading proprietary asset). i.e. retail banks
cannot trade assets (e.g. CDOs) with market risk.
iii) Large banks produce ‘living wills’ to conduct an orderly-wind up of the bank if bank
face financial difficulties.
105
Regulators combine various solutions to reduce too-big-to-fail problem.

Review Exercise 5
20083d
3(d) What is the solution to the moral hazard problem arising from the
“too big to fail” policy? (4 marks)
• the solution has been a substantial limitation of the use of the ‘too big to fail’ policy
under the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The FDIC
must now close failed banks using the ‘least cost’ approach, thus it is more likely that
uninsured depositors will suffer losses.
• This limitation has been associated with a prompt corrective action provision. Banks are
now classified into five groups based on their capital and the FDIC has to take specific
actions if a bank falls out of the ‘well capitalised group’.
108
3(d) What is the solution to the moral hazard problem arising from the
‘too big to fail’ policy? (4 marks) 2008-3d-ZAB

• The examiners would expect candidates to make a link with point (b), where the ‘too
big to fail’ policy was introduced. Specifically, candidates are now required to discuss
the solution to the moral hazard problem associated with such a policy.
• An outstanding answer would state that the solution has been a substantial limitation
of the use of the ‘too big to fail’ policy under the Federal Deposit Insurance
Corporation Improvement Act (FDICIA). The FDIC must now close failed banks using
the ‘least cost’ approach, thus it is more likely that uninsured depositors will suffer
losses. (Up to 2 marks were awarded for making these points).
• This limitation has been associated with a prompt corrective action provision. Banks
are now classified into five groups based on their capital and the FDIC has to take
specific actions if a bank falls out of the ‘well capitalised group’. (Up to 2 marks were
awarded for making these points).
110

Review Exercise 5
4(b) Examine the ‘too big to fail problem’ in banking and discuss possible solutions to this
problem. (13 marks)
• See subject guide, pp.100–01. ZA-2012-4b

• Too-big-to-fail banks, or large systemically important banks as they are often
referred to, are banks that are considered to be so important within financial markets
that their failure would have a catastrophic effect on those markets.
Solutions include:
i. actions to reduce the probability of failure of these institutions while leaving the size
and range of activities unchanged
ii. actions to reduce the size of these institutions or to make them less interconnected or
to separate activities within the institution
iii. actions to increase the range of resolution options, in particular to set out in advance
resolution and recovery plans (often called ‘living wills’).
113
4(b) Explain the `too big to fail problem' in relation to banking. Explain why this
has become a problem in banking and discuss solutions to this problem. (13 marks)
• See Chapter 5 of the subject guide, the section on `Too big to fail problem'. ZA2013-4b
• Too-big-to-fail banks, or large systemically important banks, are banks that are considered to be so important
within financial markets that their failure would have a catastrophic effect on those markets.
• Before the crisis, though, there was a widely held view that large scale meant diversification and sophistication
and that this justified large banks having lower capital requirements. The repeal of the Glass-Steagall Act was
also partly based on the view that large diversified institutions were beneficial due to economies of scale and
diversification.
• The solution used for large distressed systemically important banks during the financial crisis was to use
government funds to provide capital injections to the banks.
• Since the crisis, this view has been challenged and solutions have been sought for the too- big-to-fail problem.
There are essentially three solutions:
• actions to reduce the probability of failure of these institutions while leaving the size and range of activities
unchanged actions to reduce the size of these institutions or to make them less interconnected or to separate
activities within the institution
• actions to increase the range of resolution options; in particular, to set out in advance resolution and recovery
plans (often called `living wills'). 115

Review Exercise 5
4. Discuss the causes, consequences & possible solutions to the

‘too big to fail’ problem in banking. (25 marks) 2014-4-ZA
See subject guide, Chapter 5, section headed ‘Too big to fail’.
Causes include:
i. Banks were allowed to grow based on the notion that larger (more diversified) banks are safer. Larger
banks often had lower capital requirements under the Basel capital adequacy regime.
ii. The repeal of the Glass-Steagall Act in the US prompted the merger of commercial and investment
banks in the early 1990s.
Consequences include:
i. Less competition – incumbents have a cost advantage over new entrants.
ii. Moral hazard – banks may take more risk knowing that regulators may not allow them to fail.
iii. Cost for governments/regulators of bailouts – reference to 2008 crisis.
Solutions include:
i. Regulate larger banks more strictly (for example, higher capital requirements).
ii. Reduce the size of these institutions or make them less connected – e.g ring-fencing in the UK or new
Glass-Steagall type Act (Volker rule) in the US.
iii. Increase the range of resolution options – living wills.
Better answers will examine the likely effectiveness of the main solutions
117
and whether a combination of solutions is required.
Traditional Regulation Mechanisms- 4) Bank capital requirements

Bank regulations reduce bank’s incentive to take risks
by restricting a__________ holding & increasing bank c__________ requirements:
① Restrict the holding of r_________ assets (i.e. ordinary shares/ common stocks)
② Limit the l__________ amount (especially for individual borrowers)
③ reduce loan portfolio risk by d__________________
④ maintain sufficient bank c______________________.
• Bank’s capital is important to minimize insolvency risk of a bank
(i.e. banks prospective ability to meet its liabilities in the long run).
Bank’s capital (=issued s____________ capital & accumulated r_______________)

• is the margin for covered creditors when bank’s assets were liquidated.
• The capital absorbs any l________ incurred by the bank on assets, and
to protects depositors & other creditors.
119

Review Exercise 5
3. (a) Explain the importance of capital in preventing bank failures. (7 marks)
• See p.101 ff. of the subject guide. ZA-20111a

• Capital needs defining first.
• The importance of capital is that it provides a bank with a buffer to absorb
unexpected losses.
• An example to illustrate this (such as the one provided in the subject guide) would
get more marks.
125
Traditional Regulation Mechanisms- (4) Bank capital requirements

L__________ capital ratio
= capital / bank’s total assets = g_______ ratio (in UK) = deposits + external liabilities
capital + reserves
• 1st measure of bank’s capital requirement (under FDIC Improvement Act in US)
• lower gearing ratio lower risk of losing capital lower insolvency risk
• UK applies consensus approach where no specific measurement ratio,
it depends on the nature of the bank’s business & assets.
Classified bank into 5 groups according to their capital

1) W_____ capitalised bank leverage capital ratio > 5%
2) A___________ capitalised bank Leverage capital ratio> 4%
3) u_______capitalised bank fail to meet capital requirements
4) s__________ly undercapitalised bank
127
5) c__________ly undercapitalised bank

Review Exercise 5

Risk asset ratio (under Basel 1)
= capital to risk-weighted assets ratio = Capital / Risk-w___________ assets
• 2nd measure of a bank’s financial health, measures bank’s credit risk exposure
• bank’s different assets have different risk.Asset with higher risk greater weight
• Effective from 1993 under Basel (1 / 2 / 3) (i.e. Basel Capital Adequacy Agreement, 1988)
• World widely used. (min ____% for total capital, min ____% for Tier 1 capital)
.
Bank capital Items
T____capital issued share capital, accumulated reserves
T___ capital medium & long-term subordinated debt (debt that ranked below all other debt if bank default),
general provisions & current year unpublished profits.
Risk weight: Risk-weighted asset = asset x risk rate
0% cash, cash equivalents & government securities in OECD countries
20% interbank loans in OECD countries
50% mortgages
Problem of Risk–asset ratio 100% commercial loans
i) assume risks are independent (so allow addition of the risk-weighted assets)
• But portfolio theory says risks are interdependent, therefore the overall (diversified) risk is lower than the sum of individual130
risk.
ii) all commercial loans are equally risky (i.e. all with 100% risk weight).
20073a
Q: How can bank regulation reduce the bank’s incentive to take risks? (5 marks)
• refer to page 74 of the subject guide.
• bank regulations can reduce the bank’s incentive to take risks by introducing
restrictions on asset holding and bank capital requirements.
• the mechanisms used by banks to achieve this objective:
1. restrictions on holding risky assets (i.e. ordinary shares (UK)= common stocks (US)
2. limitations on the amount of loans, in particular the categories of the individual borrowers
3. reduction of the risk of the loan portfolio by diversification
4. maintenance of a sufficient level of bank capital
133

Review Exercise 5
3. (a) How can bank regulation reduce the bank’s incentive to take risks? (5m)
• refer to page 74 of the subject guide. 2007-3a-ZAB
• An outstanding answer to this question would state that bank regulations can
reduce the bank’s incentive to take risks by introducing restrictions on asset holding
and bank capital requirements (1 mark). In particular, the answer would then need
to indicate the mechanisms used by banks to achieve this objective:
① restrictions on holding risky assets (i.e. ordinary shares, known in the USA as
common stocks) (1 mark)
② limitations on the amount of loans, in particular the categories of the individual
borrowers (1 mark)
③ reduction of the risk of the loan portfolio by diversification (1 mark)
④ maintenance of a sufficient level of bank capital (1 mark).
135
3. (a) Explain the importance of capital in preventing bank failures. (7 marks)
• See p.101 ff. of the subject guide. ZA-20111a

• Capital needs defining first.
• The importance of capital is that it provides a bank with a buffer to absorb
unexpected losses.
• An example to illustrate this (such as the one provided in the subject guide) would
get more marks.
138

Review Exercise 5
5(c) Identify typical aspects of a banks capital requirement as imposed by regulators. (5

marks) 2008-5c-ZA

• The Examiners would expect candidates to begin with the motivation behind the bank
capital requirements imposed by bank regulations – to reduce the bank’s incentive to
take risks (1 mark).
• Candidates should then list the four mechanisms most widely used:
– restriction on holding risky assets (1 mark)
– limitation on the amount of loans, in particular the categories or the individual
borrowers (1 mark)
– reduction of the risk of the loan portfolio by diversification (1 mark)
– maintenance of a sufficient level of bank capital (1 mark).
141
4. (a) Define what a bank’s capital is and explain why bank capital is important in
protecting depositors from loss. (8 marks) 2010-4a-ZA
• refer to p.92 of the subject guide, and to pp.433–34 (sixth edition) of Mishkin and
Eakins Financial markets and institutions.
• Bank capital is essentially shareholders’ funds or assets less deposit claims. It
provides a buffer to absorb losses made by the bank and thus protects depositor
claims from a reduction in value. A good answer would examine the differences
between the various definitions of capital including tier 1, core tier 1, tier 2 etc.
• An example to illustrate the buffer role played by capital would be rewarded with
additional marks.
144

Review Exercise 5
5(a) Explain what capital is and discuss the reasons why regulators place emphasis on
banks maintaining adequate capital. ( 12marks) ZA-2006-5a
• definition of capital (or assets less deposit liabilities). It can also be defined as
shareholders funds (share capital and accumulated reserves) plus long-term debt
(subordinated loans).
• Students are then expected to explain that capital protects a bank against
insolvency, and to give a definition of insolvency as the prospective inability of a
bank to meet all of its liabilities. Hence if the value of assets reduced, capital will
absorb loss by reducing in value. Students should also explain that the
consequence is that shareholders bear risk of loss and depositors funds are
unaffected. The greater the capital held the more protection of depositors funds –
regulators identify capital adequacy in relation to credit risk (risk-assets ratio),
market risk and under Basel 2, operational risk.
147
Assets (£) Liabilities (£)

Cash 20 Deposits 75
Government bills 10 Capital 25
Commercial loans 70
Total 100 Total 100
i) Gearing ratio = 3 ( = 75/25)

Gearing = deposit + ext liabilities = 75 = 3
capital + reserve 25
ii) Risk-weighted assets are: Cash (20*0% ) ￡0

Government bills (10*0% ) ￡0
Loans (70*100%) ￡70
Total (risk-weighted assets) ￡70
Risk–asset ratio = capital = 25 = 35.7%
rik-weighted asset 70 150

Review Exercise 5
• The gearing ratio is the amount of deposits and external liabilities divided
by the bank’s total capital and reserves. 20073b
• Gearing ratio = 3 (=75/25).
• i) Risk-weighted assets are:
Cash (20*0%) ￡0
Government bills (10*0%) ￡0
Loans (70*100%) ￡70
Total ￡70
• ii) Risk–asset ratio = 25/70 = 35.7%
151
ZA-2007-3b
3 (b) Consider bank ABC that has the following balance sheet:
i. What is the gearing ratio of Bank ABC?

ii. What is the risk-asset ratio of Bank ABC?
(7 marks)
153

Review Exercise 5
The gearing ratio is the amount of deposits and external liabilities divided by the bank’s
total capital and reserves. ZA-2007-3b
Gearing ratio = 4.3 (=65/15).
i. Risk-weighted assets are:
• Cash (20*0%) ￡0
• Government bills (10*0%) ￡0
• Loans (50*100%) ￡50
Total ￡50
ii. Risk–asset ratio = 15/50 = 30%

1 mark awarded for correct definitions; 2 marks for correct input data; 1
mark for correct answer on risk-weighted assets; 1 mark for correct
answer on risk–asset ratio.
155
Q: Explain the risk-assets ratio under Basel 1 and discuss the main problems that have
been identified with it. How will it change under Basel2 ? (13 marks) 20073c
• refer to pages 75–76 of the subject guide.

• risk–assets ratio is the ratio of capital to risk-adjusted assets
• explain the risk–assets ratio under Basel 1.
• Capital is divided into tier 1 (issued share capital and disclosed accumulated reserves) and tier 2 (medium- and long-
term subordinated debt + general provisions and unpublished profits)
• The value of each category of asset is risk-adjusted in a crude way according to its exposure to credit risk. Risk
weights of 0, 20%, 50% and 100% are used. Off balance sheet items are also converted to credit equivalents and
then risk-weighted. The minimum ratio required by Basel 1 is 8%.
• Individually negotiated with regulator.
Main problems associated with the risk–assets ratio under Basel 1:
– 100% risk weight applied to all commercial non-bank loans. This implies that it does not reward diversification
– relative risk weights may not reflect relative risks – can also lead to misallocation of resources
– assumption of independence of risks
• under ‘The New Basel Capital Accord’ (so-called Basel 2, effective from the end of 2006), although no change is envisaged for the
definition of capital, and the minimum capital coefficient of 8% is also to remain unchanged, several changes have been introduced
with regard to the credit risk assessment. In particular, the present risk–asset ratio will be modified by separating loans into different
classes according to their risk measured by credit ratings from rating agencies. This overcomes the problem with the current risk–
asset ratio, which treats all loans as equally risky.
158

Review Exercise 5
• Students should then discuss the main problems associated with the risk–assets ratio under
Basel 1: ZA-2007-3c
– 100% risk weight applied to all commercial non-bank loans. This implies that it does not
reward diversification (1 mark)
– relative risk weights may not reflect relative risks – can also lead to misallocation of
resources (1 mark)
– assumption of independence of risks (1 mark).
• Students should finally explain that under ‘The New Basel Capital Accord’ (so-called Basel
2, effective from the end of 2006), although no change is envisaged for the definition of
capital, and the minimum capital coefficient of 8% is also to remain unchanged, several
changes have been introduced with regard to the credit risk assessment. In particular, the
present risk–asset ratio will be modified by separating loans into different classes according
to their risk measured by credit ratings from rating agencies. This overcomes the problem
with the current risk–asset ratio, which treats all loans as equally risky (2 marks).
162
5(d) Explain the risk-assets ratio under Basel 1 and discuss the main problems that have
been identified with it. How will it change under Basel 2? (13 marks) 20085d
• Risk-assets ratio is the ratio of capital to risk adjusted assets
• explain the risk-assets ratio under Basel 1.
– Capital is divided into tier 1 (issued share capital and disclosed accumulated reserves) and tier 2 (medium- and
long-term subordinated debt + general provisions and unpublished profits)
– The value of each category of asset is risk adjusted in a crude way according to its exposure to credit risk. Risk
weights of 0, 20%, 50% and 100% are used. Off balance sheet items are also converted to credit equivalents
and then risk weighted
– The minimum ratio required by Basil 1 is 8%
– Individually negotiated with regulator
• the main problems associated to the risk–assets ratio under Basel 1:
– 100% risk weight is applied to all commercial non-bank loans. This implies that it does not reward diversification
– Relative risk weights may not reflect relative risks and can also lead to misallocation of resources
– Assumption of independence of risks
• under ‘The New Basel Capital Accord’ (so-called Basel 2, effective from the end of 2006), although no change is
envisaged for the definition of capital, and the minimum capital co-efficient of 8 per cent is also to remain unchanged,
several changes have been introduced as regards the credit risk assessment. In particular, the present risk–asset
ratio will be modified by separating loans into different classes according to their risk measured by credit ratings from
rating agencies. This overcomes the problem with the current risk–asset ratio, which treats all loans as equally 164risky.

Review Exercise 5
5(d) Explain the risk-assets ratio under Basel 1 and discuss the main problems that
have been identified with it. How will it change under Basel 2? (13 marks) 2008-5d-ZAB
• refer to pp.75–76 of the subject guide.
• Candidates should begin by showing that they understand that riskassets ratio is the ration of
capital to risk adjusted assets (1 mark).
• Candidates are then expected to explain the risk-assets ratio under Basel 1. The Examiners
would be expecting points to be made such as:
– Capital is divided into tier 1 (issued share capital and disclosed accumulated reserves)
and tier 2 (medium- and long-term subordinated debt + general provisions and
unpublished profits) (2 marks are awarded for this).
– The value of each category of asset is risk adjusted in a crude way according to its
exposure to credit risk. Risk weights of 0, 20%, 50% and 100% are used. Off balance
sheet items are also converted to credit equivalents and then risk weighted (3 marks).
– An additional 2 marks are awarded if examples are given. The minimum ratio required by
Basil 1 is 8% (1 mark).
– Individually negotiated with regulator (1 mark).
167
Candidates should then discuss the main problems associated to the risk–assets ratio
under Basel 1: 2008-5d-ZAB
– 100% risk weight is applied to all commercial non-bank loans. This implies that it
does not reward diversification (1 mark was awarded for this).
– Relative risk weights may not reflect relative risks and can also lead to
misallocation of resources (1 mark was awarded for this).
– Assumption of independence of risks (1 mark was awarded for this).
• Candidates should finally explain that under ‘The New Basel Capital Accord’ (so-
called Basel 2, effective from the end of 2006), although no change is envisaged for
the definition of capital, and the minimum capital co-efficient of 8 per cent is also to
remain unchanged, several changes have been introduced as regards the credit risk
assessment. In particular, the present risk–asset ratio will be modified by separating
loans into different classes according to their risk measured by credit ratings from
rating agencies. This overcomes the problem with the current risk–asset ratio, which
treats all loans as equally risky. (2 marks were awarded for this).
168

Review Exercise 5
3(b) Explain how the risk assets’ ratio under Basel 1 was constructed and discuss
the problems with this construction. (10 marks)
ZA-20111a
• See p.103 of the subject guide.

The risk assets ratio is constructed as follows:
• Risk Assets ratio = Capital / Risk adjusted value of assets.
• Answers need to explain the two components of the ratio.
The main problems with the Basel 1 implementation are:
i. no reward for banks that diversify (i.e. weights are additive)
ii. arbitrary definition of risk weights
iii. all commercial loans have the same risk weight of 100%. Better
• answers will discuss these problems in terms of how important they are and how
they impacted on banking.
171
4(b) Explain the risk assets ratio introduced under the Basel 1 capital adequacy regime
and outline the main problems with this Basel 1 ratio. (9 marks)
• refer to pp.93–94 of the subject guide, and to pp.516–17 (sixth edition) of Mishkin and Eakins
Financial markets and institutions.
• A starting point for answering this question is to define the risk assets ratio (RAR). The RAR =
Capital / Sum of risk weighted assets. 2010-4b-ZA
• Capital is made up of tier 1 and tier 2 capital. These need to be defined.
• Risk weighted assets are the asset value multiplied by a weight reflecting relative credit risk. So,
cash would have zero weight, government bonds 20%, mortgages 50% and commercial loans
100%.
• Better answers would emphasise that the risk being assessed here is credit risk and this risk
appears both on and off the balance sheet.
• The minimum RAR is 8%. The main problems with the RAR under Basel 1 are:
1. assumes risks are independent therefore no benefit from diversification
2. all commercial loans are given 100% risk weight
3. relative risk weights may not accurately reflect relative weights and my distort asset allocation.
Better answers would illustrate each of these problems with an example. 174

Review Exercise 5
5(b) Explain the risk-assets ratio under Basel 1 and discuss the main problems that have
been identified with it. ( 13marks) 2006-5b-ZA
• showing that they understand that risk assets ratio is the ration of capital to risk adjusted assets.
• Students are then expected to explain the risk-assets ratio under Basel 1. The Examiners would be
expecting points to be made such as:
• Capital is divided into tier 1 (issued share capital and disclosed accumulated reserves) and tier 2
(medium- and long term subordinated debt and general provisions and unpublished profits). The
value of each category of asset is risk adjusted in a crude way according to its exposure to credit
risk. Risk weights of 0, 20 per cent, 50 per cent and 100 per cent are used. Off balance sheet items
also converted to credit equivalents and then risk weighted. Additional marks are awarded if
examples are given. The minimum ratio required by Basil 1 is 8 per cent. Individually negotiated with
regulator.
• discuss the main problems associated to the risk assets ratio under Basel 1:
– 100 per cent risk weight applied to all commercial non-bank loans. This implies that it does not
reward diversification.
– Relative risk weights may not reflect relative risks – can also lead to misallocation of resources.
– Assumption of independence of risks.
177
3(c) Explain the changes to the construction of the risk assets’ ratio under Basel 2 & and discuss to
what extent the changes address the problems with the Basel 1 construction.(8 marks)
ZA-20111a
• See p.103 of the subject guide.

• The main change introduced by Basel 2 is to allow a more precise measurement of
the risk weight assigned to commercial loans.
• Two approaches to measurement introduced: standardised approach using credit
ratings and banks’ internal models.
• The change only addresses the last problem outlined in part (b) of this question.
• Each of these approaches needs to be discussed in terms of how they improve on
Basel 1.
180

Review Exercise 5
(4) Bank capital requirements

Traditional Regulation Mechanisms -
Market risk amendment (under revised Basel 1)

• Revised Basel 1 (1998) aimed to harmonise the treatment of market risk.
• Use building block approach to incorporate market risk into risk-based capital
• set minimum market risk capital requirement for open positions in debt, equity &
derivatives held in the bank’s trading books (trading = to resale for short-term profit).
• Bank’s long-term investments are subject to credit risk capital requirements.
Overall minimum capital requirement

= c_______ risk capital requirement (for loans & long-term investments)
+ m_______ risk capital requirement (for open positions of loans & long-term investments)
• Market risk requirements provide a internal market risk measure, namely ‘___________________’ (VAR).
VAR estimate the maximum bank loss on a particular portfolio over a given holding period with statistical
confidence. In financial crisis 2007–09, banks had massively increased their market risk exposure prior
crisis. Securities with market risk exposure significantly reduce the capital held. Regulator increase the
capital requirements for market risk. Market risk problem became apparent after implementing Basel 1.
Thus created Basel 2 (i.e. the new accord under the Basel Committee on Banking Supervision). 182

M____________ Capital (under Basel 2, 200__)
Definition of capital & minimum capital coefficient (8%) remained unchanged.
2 main changes of the credit risk assessment
i) use standardized approach to modify the risk asset ratio by classifying commercial loans
based on their risk measured by credit ratings agencies. (This overcome the problem of
current risk asset ratio, which treats all the commercial loans equally risky).
ii) large international banks can use their own internal credit rating approach to determine the
riskiness of each loan. Both new approaches are to reduce the capital requirements.
O____________ risk was added
• Minimum capital = bank’s risk-weighted assets + capital charges for market risk & operational risk:
Risk asset ratio (min 8%) = Total Capital
Risk-weighted assets +(capital charges for market risk + Operational risk ) x 12.5
•ThreeUse 12.5 factor to convert
pillars of Basel 2: the capital charges to an 8% minimum. Basel 2 Accord introduced the 3 pillars of regulation.
Min c____ requirements

S______________ review an assessment by supervisors of the risk assessment processes used by banks
184
M___________ discipline bank disclose more information disclosure

Review Exercise 5

Financial crisis & Basel 3 (S________ 2012)
• Before Basel 2 had been fully implemented around the world,2007-2009 financial crisis occurred. It is
unfair to say that Basel 2 created the crisis as many countries had not implemented Basel 2 prior 2007
crisis.The crisis showed that banks capital is insufficient to the risks they faced under the Basel capital
adequacy framework (Basel 1 or 2). This inadequacy of capital was in terms credit risk & market risk
exposure. Basel (1& 2) capital adequacy framework is procyclical in its operation (i.e. it exacerbated the
strength of the business cycle). Under the Basel capital adequacy framework, capital requirements fall
during the economic upswing where lending growth is strong & credit losses are low. This accentuate the
upswing with well-capitalised banks able to lending aggressively. In recessions, bank capital requirements
increase as credit losses accumulate & banks facing capital constraints may cutback lending & worsen
the recession. Increased the amplitude of the business cycle.
• These requirements (except for 8) will be phased between 201__ -201__ to allow banks to
increase their capital without harming economic recovery from the financial crisis.
• Common equity will go up from 2% under Basel 2 to _____% (4.5% + 2.5%).
• In normal times banks will operate on a 7% ratio. Banks can reduce the capital conservation
buffer towards zero & minimum common equity ratio towards 4.5% when financial stress.
under Basel 3, regulators emphase greater on common equity to protect banks from
financial stress. The procyclicality problem is addressed by (4) & (5). 188

Basel 3 adjusted the capital adequacy
1)C_______________ e_____________ Minimum common equity to risk weighted assets ratio = 4.5%.
(ordinary shares + retained earnings) Note: no formal definition of common equity under Basel 2 (referred to as
form a greater part of Tier 1 capital. core tier 1 capital). Many regulators imposed 2% as the minimum common
equity to risk weighted assets ratio
2) Tier ____ equity = common equity + more strictly defined capital instruments – preferred stock
risk weighted assets
3) Total capital >____% T____________ capital = Tier 1 + Tier 2 capital
risk weighted assets (no change compared to Basel 2)
4) Capital conservation buffer Banks need to build capital during ‘good times’ for bad times (i.e.
(2.5% of risk weighted assets) & is made up of procyclicality problem) Restricting banks from paying dividends as capital
common equity. approaches the minimum requirements to enforce buffer.
5) National regulators impose an when credit growth excessively & a build-up of system-wide risk Can release
additional 2.5% capital buffer this capital buffer during the downswing to enable banks to continue lending
(= countercyclical capital b________).
6) To increase c_________ r_____________ i.e. too-big-to-fail problem
for large systemically important banks
7) use non-risk based leverage ratio (as a This will guard against banks increasing lending excessively where this is
‘backstop’). Tier 1 capital to total assets (3%). not picked up by the risk-based measures. 191
8) Higher capital requirements for market risk implemented in 2011

Review Exercise 5
3(b) Discuss the main changes to the assessment of capital adequacy of banks
proposed under Basel 3. (13 marks)
See subject guide, pp.104–06. 20123b
The main changes introduced by Basel 3 are:
1. Common equity (defined as ordinary or common shares plus retained earnings) should form a
greater part of Tier 1 capital. There will be a minimum common equity to risk weighted assets
ratio of 4.5%.
2. Tier 1 equity (made up of common equity plus other more strictly defined capital instruments –
mainly preferred stock) to risk weighted assets must be greater than 6% (compared to 4%
under Basel 2).
3. Total capital (Tier 1 plus Tier 2 capital) to risk weighted assets must be greater than 8% (no
change compared to Basel 2).
4. A capital conservation buffer equal to 2.5% of risk weighted assets and made up of common
equity. This buffer will allow banks to build up capital during ‘good times’ which can then be
drawn on in times of financial stress.
5. In addition, national regulators will be able to impose an additional 2.5% capital buffer when
credit growth is judged to be excessive and there is a build-up of system-wide risk (this is
known as a countercyclical capital buffer).
6. National regulators will also have further discretion to increase capital requirements for large
systemically important banks (to address the too-big-to-fail problem).
• Better answers would discuss these changes, in particular, explaining why they were 195
introduced.
4(c) Discuss the reasons for the proposed changes in capital regulation under Basel 3.
(12 marks) 2014-4c-ZB
See subject guide, Ch 5, section headed ‘The financial crisis and Basel 3’.
The main changes are:
i. Greater emphasis on core capital (quality of capital).
ii. Increase in capital.
iii. Counter-cyclicality in capital requirements through buffer built up in ‘good times’.
iv. Use of leverage ratio as a ‘backstop’ to risk assets ratio.
v. Greater monitoring of liquidity and more prescription of liquidity requirements.
Better answers will discuss the reasons for the introduction of these changes (related to
lessons learnt from the 2008 crisis).
197

Review Exercise 5
4(c) Outline the Basel 2 capital adequacy regime and 2010-4c-ZA

discuss to what extent it addresses the problems with the Basel 1 regime. (8m)
• refer to p.94 of the subject guide, and to p.517 (sixth edition) of Mishkin and Eakins
Financial markets and institutions.
• Under Basel 2 banks can choose between the standardised approach and the internal
models approach to measure risk weights for use in calculation of the RAR.
• Under the standardised approach the risk weights are obtained from externally provided
credit ratings.
• Under the internal models approach the risk weights come from the bank’s own internal
models.
• Better answers would explain the essential differences between the two permitted
approaches.
• A good answer would explain that this new approach only overcomes problem (2) in (b)
above.
• In addition a new capital requirement is introduced in relation to operational risk.
• Very good answers would explain that the recent financial crisis has led to a rethink of
capital regulation of banks and Basel 2 will be refined again. 200
4(b) Discuss the differences between micro-prudential regulation and macro-prudential

regulation and explain why macro-prudential regulation has been given greater emphasis
since 2008. (13 marks) ZB2013-4b
• See the subject guide, Chapter 5, section on `Macro-prudential policy'.
• Micro-prudential regulation - this is concerned with preventing the failure of individual
banks through capital adequacy, supervision, etc. It aims to prevent systemic failure by
preventing individual bank failure leading to contagion effects.
• Macro-prudential regulation, in contrast, aims to identify and reduce the build up of
systemic risk e.g. common exposures to price bubbles, interconnectedness, etc.
• Macro-prudential regulation has been given more emphasis since the 2008 crisis as the
previous micro-approach failed to prevent the crisis (i.e. it failed to prevent the build up
of systemic risk).
205

Review Exercise 5
5(c) Discuss the monitoring of liquidity in banking, with particular reference to the UK. (5 marks)
• refer to p.77 of the subject guide 20085c
List of mechanisms through which liquidity can be provided:

1. holding cash or assets which are easily liquefied holding an appropriately mismatching
of portfolio cash flows from maturing assets
2. maintaining an appropriately diversified deposit base.
Methods used for monitoring liquidity in the UK

• In the UK, the regulator does not apply any specific liquidity ratio to all banks. Instead
the Bank of England uses liquidity gap analysis to ensure that liquidity is within
reasonable limits. Outstanding answers should explain that this implies the preparation
of a maturity ladder, showing the accumulated mismatch of short-term asset and
liabilities over a set of time periods up to one year.
208
Traditional Regulation Mechanisms -(6) Monitoring of liquidity

Liquidity = inability of a bank to meet deposit short-term withdrawals even though it is viable in the long run.
Ways to increase liquidity
a) holding c_______ or a________ which are easily liquefied,
b) mismatching of portfolio cash flows from maturing assets,
c) maintaining an appropriately diversified d___________ base
d) having access to wholesale markets.
• Not much attention on the liquidity risk assessment prior the financial crisis.
• Many banks source liquidity heavily from w_______________ funding & s______________.
• With increased bank solvency issues & the quality of securitisation products these sources of
liquidity began to close down as banks found they could no longer securitise assets or
borrow easily from other banks through wholesale markets. The early stages of the crisis
showed up as l___________ problems at banks. Required central banks’ liquidity support to
sustain the financial system. Even so some banks still failed, so force m_______ is required.
• Now regulators aim to strengthen l__________________ of banks. Banks should hold more
high quality (marketability) liquid assets to generate liquidity even during periods of
extreme financial stress. Government bond markets operated normal during 2007-09 financial
crisis, so regulators require banks to hold more high quality g______________ b______.
210

Review Exercise 5
Traditional Regulation Mechanisms- (7) D____________ requirements

• Bank regulators require certain standard accounting principles & the information
disclosure in assessing the bank’s portfolio & bank’s risk exposure.
• Information disclosure aims to solve the f_____-rider problem, Market discipline plays
an important role in limiting a bank’s risk exposure. Bank should disclosure information
related to non-p___________ assets, loan-loss r_______, der_________ activities.
More disclosure means greater tra_____________. US bank regulators are becoming
more ‘user-oriented’ in financial disclosure. i.e. the ‘SEC effect’. It states that investor
need full information through disclosure for investment decisions making.
• Banking must adopt disclosure requirements similar to the SEC regulations or publish
reasons for the difference. The Fed & FDIC have established Securities Disclosure
Units(e.g.mini-SECs) within their own agencies. A bank more than 500 shareholders is
subject to SEC disclosure standards.
213
Alternatives to traditional regulation: Disclosure-based regulation of banking

Since 1996, New Zealand undertakes alternative approach (derived from f_____ banking
approach) to regulate banks’ information disclosure & market discipline:
i) to provide depositors & investors with reliable & timely information for investment decisions,
ii) to comply consumer protection law by securities issuers & financial services provider
New Zealand: i) no deposit in___________ scheme & ii) no depositor pro__________

3 pillars bank supervision approach in New Zealand:
1st- reinforce the banks to maintain the systems & capacity, to identify, measure, monitor &
control their risks & maintain prudent operations. is the most effective means to promote
S___________ discipline
systemic soundness. Given that a bank management team are best placed to
understand & responsible for the banks’ risks. Aims to align closely the bank and public
incentives of promoting a sound financial system
2nd- Reinforce the prudent management of banks. Market rewards well-run banks with lower
M___________ discipline pricing for funding, greater access to funding, greater market share & higher share price
Market penalizes poorly run banks. Ultimate market discipline lies on creditors (i.e. retail
& wholesale depositors) to have bank run & force its closure.
3rd- Manage bank’s prudent risk with limited regulatory & supervisory mechanisms.
216
R___________ discipline Minimum regulatory to avoid unintended distortions to banking behaviour.

Review Exercise 5

Disclosure mechanisms (1st- Self discipline):
a) promoting high quality, regular & timely f__________ d_____________ by banks,
to sharpen the incentives for the prudent management of risks
b) promoting accountability for a bank’s directors,
by requiring bank directors to sign attestations in their bank’s public disclosure statement on
matters relating to the adequacy of their bank’s risk management systems
c) avoiding explicit or implicit government support for banks, & sharpening the incentives
for bank directors & senior management to take responsibility for their banks.
Effective market discipline (2nd pillar)
i) Competitive & contestable banking system (unlimited number of banks registration in New Zealand)
ii) Depositors have strong incentives to monitor & exert bank’s discipline (without deposit
insurance)
• Market is well informed of bank’s financial performance & condition,banks need to disclose quarterly
statements & credit rating
• Low supervisory - central bank (i.e. Reserve Bank of New Zealand) does not responsible for prudent
219
risk management.
4. (a) Discuss the role of market discipline in regulating banks. (6 marks)

See subject guide, Chapter 5, section headed ‘Disclosure requirements’. 2014-4a-ZB
Market discipline provides an extra level of discipline on a bank. The scrutiny and actions by
the market may encourage banks to moderate their risk taking. The market refers to both
depositors and shareholders.
If depositors do not like the level of risk taken by the bank (which may impact on the value of
their deposit) they can switch their deposit to another bank. If enough depositors decide to do
this it will adversely affect the funding of the bank causing liquidity problems. The potential for
this to occur may lead the bank to moderate their risk taking.
A similar reasoning applies to discipline by the shareholders – if enough shareholders do not
like the risk taking by the bank they can sell their shares thus driving down the value of the
bank.
Market discipline can be used to different degrees in regulating banking.
Discussion should focus primarily on:
i. Free banking approach to regulation – in this approach, market discipline acts as the primary
regulatory force. Application of this in the New Zealand regulatory system.
ii. Pillar 3 under Basel 2. Under the Basel regime (from Basel 2 on) market discipline provides
an extra source of discipline on banks – in addition to regulation. 224

Review Exercise 5

Intervention of Central bank
a) registering banks (only for entities with good standing & sound risk management)
b) imposing pru________________
prudential requirements (to minimize bank failure) with
minimum c__________________
capital ratios to risk w_____________
weighted asset
c) imposing corporate governance requirements on composition of a bank’s board of
directors of local banks.
disclose
d) requiring banks to d____________ quarterly financial statements & information
(audited yearly & reviewed half yearly)
e) Regularly m______________
monitoring banks’ financial disclosure & prudential condition.
f) meeting with banks’ senior management annually to discuss banks’ strategic direction &
risk management; meeting with important banks boards of directors & auditors regularly
g) responding to financial dis__________
disclosure (e.g. as the lender of last resort to a solvent
but illiquid bank, or giving directions to a problem bank.)
225

• Reserve Bank of NZ is responsible for the registration & supervision of banks:
- to promote a sound & efficient financial system &
- to avoid significant damage to the financial system
Reserve Bank of New Zealand is different from other central bank
i) (with/ without) depositor protection (rather focus on systemic stability)
without
ii) Banks are not subject to li________.
licensing (only with the right to use the word ‘bank’ in a
name, title or advertisements that is subject to registration). Any entity can conduct
banking business (e.g. deposit-taking) without bank registration or licensed in any
other way.
Registered banks are the only financial institutions in New Zealand that are subject to
a comprehensive licensing & supervision framework.
Critics of New Zealand approach
• banks are reluctant to admit problems if information is disclosed publicly
• depositors may not understand the information disclosed
• Directors bear unlimited liability may discourage the best people
228
from taking banking positions and weakening the bank management

Review Exercise 5
4(b) Discuss the importance of disclosure in relation to bank regulation. (10 marks)
• See pp.108–10 of the subject guide. 20111a

• Free banking – the New Zealand (NZ) approach to regulation places more emphasis on
disclosure thus allowing the market to regulate. Answers need to explain the notion of
markets regulating (i.e. depositors choosing where to place their deposit). If they think a
bank is too high a risk (based on information disclosed) they can choose not to place their
deposit in that bank but place it in a lower-risk bank instead. This will force high-risk
banks to limit risk taking so that they can attract sufficient deposit funding.
• You need to discuss the detail of the NZ approach including disclosure reports, etc.
• Better answers will discuss the greater emphasis given to disclosure in the Basel 2
regime – the third pillar: market discipline. Under Basel 2 banks are forced to disclose
more information to the market – emphasis here is more on shareholders and long-term
capital providers providing the discipline, compared to the NZ model where depositors are
expected to play a greater role.
233
International Banking Regulation

• Bank regulation problems derive from the international nature of banking as banks can
shift their banking business from one country to another.
• Regulators can supervise domestic banks but have difficulties in examining
(i) foreign operations of domestic banks
(ii) foreign banks with domestic branches
• For international banking, it is not clear which national regulator should have primary
responsibility for supervising the bank. A bank may obtain license in a weakly regulated
country but operated in other countries. to better investigate the difficulties of regulating
international banking, highlighted by the Bank of C_____
Credit & & C_______ International (BCCI)
Commercial
scandal in 1991.
• Bank for International Settlements (in Basel Committee) issued a new set of minimum standards in 1992
for the supervision of international banking after the Bank of Credit & Commerce International (BCCI)
scandal 1991. Bank operating in many countries will be supervised by a single home-country regulator,
which can ‘capably perform consolidated supervision’, with enhanced powers to acquire information.
• Regulator believes that the home country regulation of a bank is ineffective, it can restrict the operations
of the foreign bank. Cooperation among regulators in different countries & standardisation of regulatory
requirements represent the new trend in banking regulation.
• e,.g. EU Second Banking directive & complementary directives aimed at providing harmonisation234 of
solvency regulation across the EU (Basel 1,Basel 2 & Basel 3).

Review Exercise 5
4. (a) With reference to examples discuss the relationship between bank regulation
and financial crises. (15 marks) 20111a
• Not directly covered in the subject guide but better students will be able to
• relate the material on regulation in Chapter 5 to financial crises such as the recent
banking crisis.
The kinds of issues that can be discussed include:

i. insufficient capital – problems with the Basel capital adequacy regime including
insufficient weight given to mortgage lending in RAR.
ii. insufficient attention paid to liquidity risk
iii. insufficient capital set against market risk
iv. too big to fail problem had been allowed to develop
v. inadequate scrutiny of the build up of systemic risk.
239

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Review Exercise 5

Review Exercise 5-Regulations of Banks

Principles of Banking and Finance Ex5-pg1

Principles of Banking and Finance Ex5-pg2

34 Discuss the main changes to the assessment of capital adequacy of banks2012-3b-ZB

• Free banks issue distinct p m (i.e. bankHK notes) (1935–64)

Free banking problems: c____________, w__________ banking, f____________ banking,

Principles of Banking and Finance Ex5-pg3

Free Banking Problems

Advantages of free banking system

Principles of Banking and Finance Ex5-pg4

• See subject guide, Chapter 4, pp.90–96.

Importance of Bank Regulations

Argument for bank regulation:

Argument for banking regulation:

Principles of Banking and Finance Ex5-pg5

Arguments for Bank Regulation -(1) Fragility of Banks

Banks are fragile because:

Argument for Bank Regulation- (2) Systemic Risk

Principles of Banking and Finance Ex5-pg6

Arguments for Bank Regulation -(3) Protection of depositors

Arguments for Bank Regulation - (3) Protection of depositors

Bank failures are serious to the economy because:

Principles of Banking and Finance Ex5-pg7

• refer to pages 67–69 of the subject guide.

Principles of Banking and Finance Ex5-pg8

Main reasons for regulating banks are: 20123a

Main arguments against include:

See subject guide, pp.92–96.

Arguments against include:

Principles of Banking and Finance Ex5-pg9

See subject guide, Chapter 5, pp.92–96.

Excessive regulation creates:

Principles of Banking and Finance Ex5-pg10

Arguments Against Regulation

Need to avoid over-regulated (maintain minimum regulation) to prevent bank runs,

Traditional Regulation Mechanisms - (1) Creation of A Central Bank

Principles of Banking and Finance Ex5-pg11

Traditional Regulation Mechanisms

Bank supervision (= pru_____________ supervision)

Traditional Regulation Mechanisms

Principles of Banking and Finance Ex5-pg12

• refer to p.72 of the subject guide.

Traditional Regulation Mechanisms - (3) Government safety net

Principles of Banking and Finance Ex5-pg13

Traditional Regulation Mechanisms

Traditional Regulation Mechanisms

Solutions to the moral hazard problem due to 100% deposit insurance:

Principles of Banking and Finance Ex5-pg14

• refer to pp.85–86 of the subject guide.

Principles of Banking and Finance Ex5-pg15

• refer to pp.72−73 of the subject guide.

Principles of Banking and Finance Ex5-pg16

• refer to pp.72−73 of the subject guide.

• refer to pp.72−73 of the subject guide.

Principles of Banking and Finance Ex5-pg17

Principles of Banking and Finance Ex5-pg18

Principles of Banking and Finance Ex5-pg19

• refer to p.73 of the subject guide.

Principles of Banking and Finance Ex5-pg20

• refer to p.73 of the subject guide.

• refer to p.73 of the subject guide.

Principles of Banking and Finance Ex5-pg21

Free banking problems: c, w banking, f__ banking,

Bank’s capital (=issued s capital & accumulated r___)

New Zealand: i) no deposit in_ scheme & ii) no depositor pro