20220910170707HCTAN008C5 Topic - 5 Regulation

Topic 5 -Regulations of Bank
Topic 5
Regulations of Banks
Outline +Exam focus
___________ banking Disclosure-based Regulation ___________ banking

[=unregulated banking] [New Zealand approach] Arguments for vs against
7 traditional
(7) disclosure requirements regulation mechanisms:
Topic 5
⑥ monitoring of liquidity
Regulation ① creation of a central bank
[micro vs macro
of Banks
prudential regulation]
② bank supervision
⑤ assessment of risk management
④ Bank ________ requirements ** ③ government __________________ ***

(i) lender of last resort,
Basel 3 (ii) deposit insurance,
3 pillars (iii) direct funding
1) Min capital requirement 2 moral hazard problems/ solution:
2) Supervisory control (i)100% deposit insurance and 2 T5-pg1
3) Mkt discipline (to disclose info) (ii) too-big-to fail
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Outline for Topic 5

1. Free Banking and its problems:
a) counterfeiting,
b) wildcat banking,
c) fraudulent banking,
d) over-issue of bank notes and
e) over-expansion by banks
2. Argument for bank regulation:

a) fragility of banks
b) systemic risk
c) protection of depositors
Outline for Topic 5

3. Traditional Regulation Mechanisms:
1) creation of a central bank
2) bank supervision (restrictions on entry, bank examination-CAMELS)
3) government safety net
a) Central bank as a ‘lender of last resort’
b) deposit insurance
c) direct funding by the government to troubled institutions [too-big-to-fail]
4) bank capital requirements
- Leverage capital ratio -Risk asset ratio
- Market risk amendment -Minimum Capital
- Financial crisis & Basel 3
5) assessment of risk management [Macro-prudential policy (under Basel 3)]
6) monitoring of liquidity
7) disclosure requirements T5-pg2
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Outline for Topic 5

4. Alternatives to traditional regulation:
(Disclosure-based regulation of banking)
3 pillars bank supervision approach in New Zealand:
① Self discipline
② Market discipline
③ Regulatory discipline
5. International Banking Regulation
Learning outcomes
• understand the importance of banks regulation

• explain the main cases of non-regulated banking systems in history & their
economic rationale
• discuss the main arguments for & against bank regulation
• explain how banks are regulated through traditional regulation mechanisms
• discuss the problems of the traditional regulation mechanisms
• discuss the response of the Basel Committee on Banking Supervision to the
global financial crisis of 2007–09
• illustrate alternative regulation mechanisms
• discuss the implications of the recent trend in harmonizing global bank
regulation
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Introduction
• Banking regulation exists in many countries.
• Non-regulated banking systems (i.e. free banking) in some countries .
• Banking system is more heavily regulated than other sector of the economy.
• There are several forms of banking regulation, through various regulation
mechanisms.
• A recent trend towards greater harmonisation of bank regulation in the world.
• Financial crisis 2007–09 revealed banking regulation deficiencies.
Part A:
Unregulated [Free] vs Regulated banking
(advantages & disadvantages)
Part B: 7 Traditional Regulation Mechanisms
① creation of a central bank
③ government safety net
1-lender of last resort, 2-deposit insurance, 3-direct funding
2 moral hazard problems:
(i)100% deposit insurance and (ii) too-big-to fail
④ bank capital requirements
⑥ monitoring of liquidity [micro vs macro prudential regulation]
(7) disclosure requirements
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Part C: New Zealand [Disclosure-based] Approach Of Bank Regulation
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Key concept
Free banking [= _____________ banking], no central bank

Problems: counterfeiting, wildcat banking, fraudulent banking
over-issue of $, over-expansion
Bank failure  need bank regulation
Arguments for [=agree] Arguments against [=disagree]
bank regulation bank regulation
1) Fragility of bank avoid overregulation, else may:
[# withdrawal] i) competition
ii) financial innovation
2) ________________________ risk iii) cost
[bank problem spread iv) moral hazard problems
quickly nationwide] a) 100% deposit insurance
3) Protection of _______________ b) _____________________________
Free Banking
= unregulated financial system.
• financial system with:
no central bank/ no financial regulator/ no government intervention.
• operate freely, subject to market forces &
the rules of ‘normal’ commercial and contract law.
• Example: financial laissez-faire.
Free banking era:
• USA (1838-1863) Scotland (1716–1845)
• Canada (1820–1935) Hong Kong (1935–64)
• Switzerland (1830s & 1840 - 1881)
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Free Banking
A free banking system
• consists of banks whose deposits are largely repayable on demand
• no central bank, no supervision, no restriction on the activities of banks, and
no state insurance scheme for deposits.
• Free banks issue distinct private monies (i.e. bank notes) which are
perpetual, non-interest bearing debt claims that redeemable on demand.
• Credit default risk exists on bank notes.
Arguments against private money issuance

a) banks can over-issue their currency, making the conversion impossible
(i.e. wildcat banking).
a) 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) 11
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Free Banking
• unstable because market failures, monopolies & information symmetry.
Free banking problems:

a) counterfeiting,
b) wildcat banking,
c) fraudulent banking,
d) over-issue of bank notes and
e) over-expansion by banks.
Traditional view
• Free banks are prone to failures & lead to systemic banking instability.
• So need banking regulation.
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• Example of free banking failures: Indiana, Wisconsin & Minnesota. T5-pg6
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Free Banking
• 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) Self-correcting mechanism non-exists under a monopolised government
money supply.
so free banking is more stable than central banking.
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Free Banking
• Depositors are aware that if bank failed they would lose their deposits.
• Depositors require greater reassurance that their deposits are safe.
Bank regulation mechanisms
i. disclose information (e.g. audited accounts)
ii. prudent lending policies
iii. adequate capital
From next slide
• 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) 14
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Concept Check Activity:

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.
• consists of banks whose deposits are largely repayable on demand
• no central bank, no supervision, no restriction on the activities of banks, and
• no state deposit insurance scheme.
• Free banks issue distinct private money (i.e. bank notes)
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. wildcat
banking).
b) Transaction costs increase when thousands of distinct bank notes circulate
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in a given geographical area (e.g. 3 thousand in USA & Canada in their
15 periods of free banking)
Exam Focus
PYQ-QA5 – Regulations of Banks
1 Critically examine the view that unregulated banking is better for banking2013-4a-ZA
stability than regulated banking. (12 marks)
2 Explain free (unregulated) banking and discuss the advantages and2015-3a-ZA
disadvantages in relation to the stability of the banking system. (13m)
3 Discuss the advantages and disadvantages of unregulated banking.(12 m) 2018-4a-ZA
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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.
Approaching the question
• 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.
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Importance of Bank Regulations

Argument for bank regulation:
a) to protect depositors,
b) to assure the safety & soundness of banks,
c) to avoid (or limit) the effects of bank failures,
d) to maintain monetary stability,
e) to protect the payment system and
f) to encourage efficiency & competition in the financial system & economy.
Pros & Cons of bank regulation:

① fragility of banks
② systemic risk
③ protection of depositors
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Arguments for Bank Regulation

(1) Fragility of Banks
• Bank panics 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 ‘lender of last resort’ in times of financial crises, i.e.
Central banks are the ultimate supplier of liquidity to bank(s) threatened by a
liquidity crisis.
• Central banks have led lifeboat rescues,
healthy banks take over the deposits of the troubled banks.
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(1) Fragility of Banks
Banks are fragile because:
1) bank provide liquidity insurance 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 structure of banks:
with liquid liabilities (deposits) & illiquid assets (loans) 20
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Argument for Bank Regulation

(2) Systemic Risk
• Central bank & bank regulation always try to prevent systemic risk.
Systemic Risk
= risk that the a failure bank spreads to other solvent banks
when depositors are unable to distinguish between good & bad banks.
• One bank run (can be justified if the bank has been imprudent)
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. 21
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(2) Systemic Risk
Classical bank run
= 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) retail deposits &
(ii) wholesale deposits (through 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 inter-bank lending drains away & lenders demand higher collateral.
• Banks are highly interconnected & banking system problem spread quickly.
• Banks are important financial intermediaries & in underpinning economy,
the consequences of banking systemic failure is catastrophic.
• So, banks need to be regulated. 22
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(3) Protection of depositors
• Banks need to be regulated (i) to protect the public depositors &
(ii) to ensure the payment system are safe.
• Need prudential regulations as depositors lack of expertise & knowledge
to assess the bank’s quality.
• There are different bank regulations for retail & wholesale depositors
(due to their have different perceived expertise).
• More regulation on retail banking
as retail depositors are less knowledgeable than wholesale depositors.
• Retail banks are subject to fairly rigorous control, whereas
wholesale banks are subject to a much lighter prudential control.
• 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 23
allowed retail banks to engage in investment banking activities.
23

• Difficult to regulate the universal banks (with retail & investment banking) in
Europe as its retail banking is intertwined with investment banking.
• Investment banking is inherently riskier than retail banking.
• Regulators are reluctant to fail retail banks due to the failure consequences.
• Many universal banks have serious financial difficulties due to the
speculative activities of their investment banking operations.
• Universal banks are rescued with state funds to protect depositors’ funds in
their retail operations and to prevent systemic risk.
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Consequences of bank failures (if no bank regulation)
1) Very costly to the failing bank’s depositors, stockholders, borrowers &
other banks (with interbank lending accounts).
2) bank’s important role in the payment system
Bank failures are serious to the economy because:

i) Bank’s creditors (depositors) are also their customers.
• Non-financial firm’s creditors are bank; whereas
banks’ creditors are householders (unable to monitor banks activities)
ii) Depositors have insufficient information & expertise
to differentiate between safe & risky banks.
• So, it is important to regulate banks to protect depositors 25
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• 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).
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Arguments Against Regulation

• Regulation is (1) costly, (2) have negative effects & (3) with instability.
4 types of regulation costs

a) Regulator administrative costs (i.e. employing staff to monitor banks)
b) Administrative costs associated with the banks’ own compliance activities
(i.e. staff to produce return required by the regulator)
c) Capital cost to comply with capital requirements
d) the contribution to funds needed to compensate the clients of other banks
which have failed.
Avoid over-regulated (maintain minimum regulation) to prevent bank runs
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Arguments Against Regulation

Excessive bank regulation may
(i) reduce competition (i.e. regulation limits banks’ diversification
by limiting bank portfolio choices or restricting branching)
(ii) raises costs (reduces profitability) &
(iii) discourage financial innovation
(iv) creates moral hazard (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 system 28
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across in different countries (i.e. ‘level playing field’).
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Concept Check Activity

Arguments for and Against Bank Regulations
Argument for banking regulation:
a) F________________ of banks
b) S________________ risk
c) protection of d_____________
Arguments Against banking regulation:

Regulation is (1) c____________
(2) have negative effects [discourage competition and innovation]
(3) Create moral hazard problems:
a) 100% deposit insurance
b) Too-big-to-fail
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Exam Focus
1 Critically examine the view that unregulated banking is better for banking stability2013-4a-ZA
than regulated banking. (12 marks)
2 Explain free (unregulated) banking and discuss the 2015-3a-ZA
advantages and disadvantages in relation to the stability of the banking system. (13m)
3 Discuss the advantages and disadvantages of unregulated banking.(12 m) 2018-4a-ZA
5 Discuss the reasons for and against the prudential regulation of banks. (15m) 2006-3a-ZA
6 Discuss the arguments for and against the regulation of banks. 2012-3a-ZB
7 Discuss the arguments for and against bank regulation. (13 marks) 2017-3a-ZA
8 Discuss the arguments for and against regulating banks. (12 marks) 2012-4a-ZA
9 Discuss the arguments for bank regulation. (13 marks) 2007-5a-ZB
10 Discuss the reasons for the regulation of banks. (12 marks) 2018-4a-ZB
11 Discuss the main reasons for regulating the banking system. (10 marks)-online 2021-2a-ZA
12 Discuss the main reasons for regulating banks and 2016-4a-ZA
examine the safety net arrangements put in place in most banking systems. (15 marks)
13 Critically examine the reasons used to explain why banks are subject to 2013-4a-ZB
prudential regulation. (12 marks)
14 Discuss the advantages of the prudential regulation of banks and discuss the2015-3a-ZB
problems created by excessive regulation(13m
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3(a) Discuss the arguments for and against bank regulation. (13 marks)
2017-3a-ZA
• See subject guide, Chapter 5, pages 92{6
The key arguments in favour include:
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.
2. Systemic risk -the contagion effect exacerbated by asymmetric information.
3. Depositor protection.
The main arguments against are:
1. Cost. 2. Complexity- creates opportunities for arbitrage which can lead to unintended
consequences.
3. Moral hazard.
4. Increases barriers to entry { less competition.
• Better answers would identify that systemic risk is the most important reason to
justify prudential regulation of banks. So regulators are willing to accept the costs
cited above in order to get the main benefit of reduced systemic risk.
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Part A:
Unregulated [Free] vs Regulated banking
(advantages & disadvantages)


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Traditional Regulation Mechanisms Key concept

1) Creation of central bank monetary control ($ supply)
prudential control( financial crises)
2) Bank supervision [prudential supervision] CAMELS rating
C= capital A= asset (loan) qualityM= mgt L= liquidity
E= earnings S= sensitivity to mkt risk
**3) Government _________________________ ****

(3a) lender of last resort [= central bank]
*(3b) ______________________(e.g.FDIC) US- 100% deposit[max $250k]
UK -90% deposit [max £50k/ £80k]
*(3c) direct funding
CB handle failed banks by (i) payoff
(ii) purchase & assumption method
[too-big-to-fail]
*4) Bank capital requirement-____________________ 1, 2, 3

i) leverage ratio (gearing) (ii) risk-asset ratio
5) Assessment of risk management [________ vs _________ prudential policy]

6) Monitoring of liquidity [hold more gov bond]
7) Disclosure requirement [eg. non-performing loan,derivative activities]
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Traditional Regulation Mechanisms

② bank supervision (restrictions on entry, bank examination)
③ government safety net (deposit insurance)
⑦ disclosure requirements.
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(1) Creation of A Central Bank
Central banks: (i) monetary control & (ii) prudential control
(i) Monetary Control (i.e. control money supply)

• It is important for the government to control the money supply
because private issuance of payment means could easily generate
fraud, counterfeiting & adverse selection problems.
• Monetary control helps to stabilise prices.
35
35

(1) Creation Of A Central Bank
(ii) Prudential control (to minimize financial crises)
• Central bank is the ‘lender of last resort’ during financial crisis.
• The lender of last resort function could go against free competition of banks.
• 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 member states, forms the European System of Central Banks.
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(2) Bank supervision: restrictions on entry & bank examination
Bank supervision (= prudential supervision)
i) To oversee bank operations
ii) To reduce moral hazard & adverse selection
(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).
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• A UK bank must offer a broad range of services
(e.g. deposit accounts, overdraft & loan facilities).
• A licensed bank must have
well capitalised (minimum £5 million 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
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• Regulators use CAMEL system to examine that banks operate prudentially
(i.e. prudential supervision)
CAMELS rating: scoring scale 1 (best) to 5 (worst)
a) Capital adequacy
b) Asset quality
c) Management quality
d) Earnings’ performance
e) Liquidity
f) Sensitivity to market risk.
• Regulators can alter a bank’s behaviour (or close the bank)
if the CAMELS rating is low.
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3(e) What is the CAMEL system? (5 marks) 20083e
• refer to p.72 of the subject guide.

• CAMEL system is an internationally recognised framework used by bank
examiners to evaluate banks.
• banks are scored on a scale of 1 (the best) to 5 (the worst) assessing five
areas : capital adequacy, asset quality, management quality, earnings’
performance, and liquidity.
• If the CAMEL rating is sufficiently low − regulators can take formal actions to
alter bank’s behaviour (or even close the bank)
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Part A: Unregulated [Free] vs Regulated banking (advantages & disadvantages)


(lender of last resort, deposit insurance, direct funding)
41
41

(3) Government safety net
Governments safety net for depositors:
a) Central bank as a ‘lender of last resort’
b) deposit insurance
c) direct funding by the government to troubled institutions.
42
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42

(3) Government safety net-
(a) Lender of last resort

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 bank only provides liquidity to solvent banks.
• But it is difficult to differentiate solvent & insolvent banks.
• Central banks injected massive liquidity into their banking systems
in 2007-2009 banking crisis/liquidity crisis.
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43

(3) Government safety net –
(a) Lender of last resort
• Lender of last resort function increases moral hazard as problem banks
expect central bank to 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
• See Freixas et al. (1999) for discussion of the lender of last resort role.
• Discuss the moral hazard consequences of central bank liquidity support to banks
during & after the global financial crisis of 2007–09.
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Concept Check Activity

Traditional Regulation Mechanisms - (3) Government safety net
Governments safety net for depositors:
L_______ of 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
L_______ bank only provides liquidity to solvent banks. But it is difficult to differentiate solvent & insolvent banks.
r________ 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
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 an
in_______ 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 (see other slides)

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funding
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Exam Focus
15 Discuss the moral hazard problems caused by the provision of 2015-3b-ZAB
‘safety net’ arrangements for banks and examine solutions. 12m
16 Discuss the main reasons for regulating banks and examine the 2016-4a-ZA
safety net arrangements put in place in most banking systems. (15 marks)
17 Explain the key features of the safety net in the regulatory system for banks. 2017-3b-ZB
Discuss the problems caused by this safety net and the solutions to these problems. (10 marks)
18 Explain the ‘safety net’ mechanisms in protecting against systemic risk in banking. (6m 2019-4c-ZB
19 Discuss the reasons for the lender of last resort facility provided by central banks and2014-4b-ZB
discuss the problems with the provision of this facility. (7 marks)
20 What are the mechanisms of deposit insurance adopted in the and in the ? (4 2008-3a-ZAB
21 Discuss the role of a deposit insurance scheme within a system of bank regulation. (102006-3b-ZA
mark
22 Explain the role of deposit insurance in the regulation of a banking system and discuss the2010-4b-ZB
solutions to the moral hazard problem created by deposit insurance. (11 marks)
23 Identify the possible solutions to the moral hazard problem arising from a system of 2008-3c-ZAB
100% insurance of deposits. (6 marks)
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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.
47
2014-4b-ZB
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. (7m)
Ch5, 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. 48
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48

(b) Deposit insurance

• Deposit insurance schemes 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 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)
49
49

(3) Government safety net
b) Deposit insurance
Deposit insurance was adopted by US & most developed countries.
Deposit insurance:
a) compulsory (for all the Feb members) or
b) voluntary (for non-members if they meet the FDIC admission criteria).
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) 50
T5-pg25
50

(3) Government safety net – Deposit Insurance
• 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.
Solutions to the moral hazard problem due to 100% deposit insurance:
L_____c__ use for resolving bank failures under the FDICIA, 1991. Riskier banks
_ approach pay higher insurance premiums to the FDIC. Banks reduce their risks
under the risk-based deposit insurance premiums system
co- 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).
in______ Depositors have greater incentive to monitor (because of the threat of losing
approach 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. 51
51
Exam Focus
20 What are the mechanisms of deposit insurance adopted in the and in the ? (4 2008-3a-ZAB
21 Discuss the role of a deposit insurance scheme within a system of bank regulation. (102006-3b-ZA
mark
22 Explain the role of deposit insurance in the regulation of a banking system and discuss the2010-4b-ZB
solutions to the moral hazard problem created by deposit insurance. (11 marks)
23 Identify the possible solutions to the moral hazard problem arising from a system of 2008-3c-ZAB
100% insurance of deposits. (6 marks)
52
T5-pg26
52
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.
53
• 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). Before 2008
– Insurance may cover different percentage of deposits
(100% of deposits up to a value of $100,000 at a bank in the USA,
90% of deposits to a customer up to a maximum of £18,000 in the UK)
(1 mark).
T5-pg27
54

(c) Direct funding
FDIC uses 2 methods to handle a failed bank:
1) Payoff method
• FDIC pays off deposits up to the $250,000 insurance limit.
• FDIC pays the failed 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 within a few years).
2) Purchase & assumption method
• FDIC finds a merger partner to takeover all the deposits of the failed bank
(not 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 the FDIC, which would then find a merger partner to
take over the insolvent banks & their deposits.
• Originally the policy was limited to the 11 largest US banks, 55
but now extended to big banks in general.
55

(3) Government safety net – (c) direct funding
• 100% deposit insurance creates moral hazard 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.
• Too-big-to-fail policy increases the moral hazard problem for big banks.
56
T5-pg28
56

(3) Government safety net – (c) direct funding
Solutions to the moral hazard problem due to 100% deposit insurance:
(1) use least cost approach for resolving bank failures under the 20083c-ZAB
• Federal Deposit Insurance Corporation Improvement Act (FDICIA, 1991).
Riskier banks pay higher insurance premiums to the FDIC.
• Banks reduce their risks under the risk-based deposit insurance premiums
system
(2) Use co-insurance approach 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 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.
57
• Note: Banks pay a flat-rate premium to their deposits.
57

(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
P________ the failed bank’s creditors the proceeds of the liquidated assets
proportionately. Deposit account holders with more than $250,000
__ method
deposits get back more than 90% (but within a few years).
2) FDIC finds a merger partner to takeover all the deposits of the failed
P________ bank (not 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 the FDIC, which would then find a merger
assumption partner to take over the insolvent banks & their deposits. Originally the
method policy was limited to the 11 largest US banks, but now extended to big
banks in general.
58
T5-pg29
58
3(c) Identify the possible solutions to the moral hazard problem arising from a
system of 100% insurance of deposits. (6 marks) 2008-3c-ZAB
• refer to p.73 of the subject guide.

• 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).
59
Too-big-to-fail problem
• Too-big-to-fail (= 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 Troubled Asset Relief Program (TARP).
Examples
• US government injected $45billion each to Citigroup & Bank of America in
exchange for the equity stake to the government.
• UK government injected capital to Lloyds Group (£20.3 billion) & Royal Bank
of Scotland (RBS) (£45.5 billion) in exchange for 41% & 84% equity stakes
respectively.
60
T5-pg30
60
• 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.
61
61
3 Solutions for too-big-to-fail
1) to reduce the probability of failure of these institutions
while leaving the size & range of activities unchanged
2) to reduce the size of these institutions or
to make them less interconnected or
to separate activities within the institution
3) to increase the range of resolution options,
set out in advance resolution & recovery plans (i.e. ‘living wills’).
62
T5-pg31
62
Solutions for too-big-to-fail problem
1) larger banks need to hold more capital & liquidity than smaller banks
(a reverse of the policy pre-crisis).
This has been the approach adopted in Basel 3 discussed below.
2) ‘Narrow 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.
3) Large banks produce ‘living wills’ to conduct an orderly-wind up of the
bank if bank face financial difficulties.
• Regulators combine various solutions to reduce too-big-to-fail 63

problem.
63
• Too-big-to-fail (= too-________-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 Citigroup &
Bank of America in exchange for the equity stake to the government.
• Eg2.UK government injected capital to Llyolds Bank Group (£20.3 billion) &
Royal Bank of Scotland (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.
64
• Since the crisis this view has been challenged & solutions have been sought for the too-big- to-fail T5-pg32
problem
64
Concept Check_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..
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. 65
Regulators combine various solutions to reduce too-big-to-fail problem.
65
Exam Focus
24 What are the methods used to handle a failed bank in the USA? (6 marks) 20083bZAB
25 What is the solution to the moral hazard problem arising from the “too big to2008-3d-ZAB
fail” policy? (4 marks)
26 Examine the ‘too big to fail problem’ in banking and discuss possible2012-4b-ZA
solutions to this problem. (13 marks)
27 Explain the `too big to fail problem' in relation to banking. Explain why this2013-4b-ZA
has become a problem in banking &discuss solutions to this problem. (13m)
28 Discuss the causes, consequences & possible solutions to the2014-4-ZA
‘too big to fail’ problem in banking. (25 marks)
29 4(a) Discuss the causes, consequences and solutions of the ‘too big to fail’2016-4a-ZB
problem in banking. (15 marks)
30 Explain the causes, consequences and solutions for the problem of banks2018-4b-ZA
being ‘too big to fail’. (13 marks)
66
T5-pg33
66
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. (13m)
• See Chapter 5 of the subject guide, the section on `Too big to fail problem'.
Approaching the question 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 3 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
67
and recovery plans (often called `living wills').
67
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 68
T5-pg34
and whether a combination of solutions is required.
68
Reminder Extra info

Topic 4: [solutions]
(1)moral hazard problems arise in Equity mkt
(2) moral hazard problems arise in Debt mkt
Topic 5:
(1)moral hazard problems arise in 100% deposit insurance
(2) moral hazard problems arise in too-big-too-fail
69
Part A:Unregulated [Free] vs Regulated banking (advantages & disadvantages)



70
T5-pg35
70

(4) Bank capital requirements
Bank regulations reduce bank’s incentive to take risks
by restricting asset holding & increasing bank capital requirements:
① Restrict the holding of risky assets (i.e. ordinary shares/ common stocks)
② Limit the loan amount (especially for individual borrowers)
③ reduce loan portfolio risk by diversification Asset = Liabilities + Equity capital
Capital = Asset - Liability
④ maintain sufficient bank capital.
• 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 capital =shareholders’ funds or assets - deposit claims
Bank’s capital (=issued share capital & accumulated reserves)
• is the margin for covered creditors when bank’s assets were liquidated.
• The capital absorbs any losses incurred by the bank on assets, and
71
to protects depositors & other creditors.
71
Asset = Liab + Equity

Liquid asset 15
Gov bill 20 capital 10
Loan [asset] 65 deposit [liab] 90__
Total Assets 100___ total 100
Scenario 1 = small loss = $5

Liquid asset 15
Gov bill 20 capital 10 ?
Loan [asset] 65 ? deposit [liab] 90____
?
Total Assets 100___? total 100__?
Scenario 2 = big loss = $20

Liquid asset 15
Gov bill 20 capital 10 ?
Loan [asset] 65 ? deposit [liab] 90___ ? T5-pg36
Total Assets 100 ? total 100 ?
72
Example
Example: Balance sheet of bank
Assets ($) Liabilities ($)
Liquid assets 15
Government bills 20 Capital 10
Loans 65 Deposits 90
Total 100 Total 100
• If many bank’s customers unexpectedly default,

loans’ value in the balance sheet is reduced by $5.
• Consequence: for the bank’s shareholders
• Capital value is _________ by $5 as well.
• Co-operation the shareholders bear the bank risk, while
depositors are protected from asset losses by the bank’s capital. 73
73
Traditional Regulation Mechanisms- 4) Bank capital requirements

Bank regulations reduce bank’s incentive to take risks
by restricting assets holding & increasing bank capital requirements:
① Restrict the holding of risky assets (i.e. ordinary shares/ common stocks)
② Limit the loan amount (especially for individual borrowers)
③ reduce loan portfolio risk by diversification
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
Bank to protects
Itemsdepositors & other creditors.
capital issued share capital, accumulated reserves
T____capit 74
al T5-pg37
T___
74
medium & long-term subordinated debt (debt that ranked below all other debt if
Exam Focus
31 How can bank regulation reduce the bank’s incentive to take risks? 2007-3a-ZAB
32 Identify typical aspects of a banks capital requirement as imposed by2008-5c-ZA
regulators.(5 m)
33 Define what a bank’s capital is and explain why bank capital is important in2010-4a-ZA
protecting depositors from loss. (8 marks)
34 Explain the importance of capital in preventing bank failures. (7 m) 2011-3a-ZA
35 1(b) Explain the importance of capital in protecting a bank from becoming2019-1b-ZA
insolvent. (7 marks) [2019-1b-ZA]
75
75
3. (a) Distinguish between liquidity and solvency in relation to a bank. Explain

how a bank could become insolvent and explain the role of capital and liquidity
in preventing insolvency. (10 marks) 2016-3a-ZA
• See Ch5, sections headed `Bank capital requirements' and `Monitoring of liquidity”
• Liquidity refers to having sufficient access to cash or cash equivalents that enable it to meet
• its ongoing cash commitments (deposit repayments, new loans, staff salaries etc.).
• Solvency refers to the prospective ability of a bank to meet its debts as they fall due.
• Liquidity is a short-term concept and solvency is a long-term concept.
• A bank can become insolvent (assets < deposit liabilities) as a result of reductions in the
• value of assets (for example large loan defaults or write-downs of the value of market traded
• assets), or losses from activities.
• Capital refers to total assets deposit liabilities (essentially = equity in the bank). Capital
• can absorb losses from asset write-downs and therefore keep the bank solvent. The
regulator places emphasis on banks holding sufficient capital to cover expected and
unexpected losses.
• Liquidity will also increase confidence among depositors { a run less likely. A run could lead
• the bank into liquidating assets to meet liquidity needs which, if done quickly, could lead to
• insolvency. Hence both adequate capital and liquidity play an important role in maintaining
the solvency of a bank T5-pg38
76
1(b) Explain the difference between illiquidity and insolvency in

relation to banking. (7 marks) 2019-Q1a-ZB
(b) Illiquidity is a state where the bank is short of liquidity. This typically arises
when deposit withdrawals are higher than expected and insufficient liquid
assets are available.
• Insolvency is a state where assets are valued at less than deposit liabilities.
This typically arises when asset values fall due to loan defaults etc.
• Better answers will explain the relationship between the two states and how
insolvency is a more serious problem.
77

Leverage capital ratio
= capital / bank’s total assets
• 1st measure of bank’s capital requirement.
• Federal Deposit Insurance Corporation Improvement Act (FDICIA in US),

Classified bank into 5 groups according to their capital.
① ‘Well capitalised’ bank (leverage capital ratio > 5%)
② ‘Adequately capitalised’ bank (ratio > 4%)
③ ‘undercapitalised’ banks (i.e. fail to meet capital requirements).
④ ‘significantly undercapitalised’
⑤ ‘critically undercapitalised’
78
T5-pg39
78
(4) Bank Capital requirement Key concept
(a) Leverage ratio (US) = Total capital

Total asset
Gearing ratio (UK) = Deposit + external liabilities

capital + reserves
___________ ratio = Total capital_________

risk-weighted asset
(0%, 20%, 50%, 100%)
risk rate x asset
[2007, 7 marks)
Measure min capital required

______ Tier 1 capital [eg common equity]
Tier 1 capital [eg. reserves]
+ Tier 2 capital [eg. subordinated debt]
______ capital
79
Leverage capital ratio

= gearing ratio (in UK)
• deposits + external liabilities
capital + reserves
• 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.
80
T5-pg40
80
From previous example

Example
Example: Balance sheet of bank
Assets ($) Liabilities ($)
Liquid assets 15
Government bills 20 Capital 10
Loans 65 Deposits 90
Total 100 Total 100
Gearing = deposit + ext liabilities =

capital + reserve
• If many bank’s customers unexpectedly default,

loans’ value in the balance sheet is reduced by $5.
• Consequence: for the bank’s shareholders
• Capital value is reduced by $5 as well.
• Co-operation the shareholders bear the bank risk, while
depositors are protected from asset losses by the bank’s capital. 81
81

Risk asset ratio (under Basel 1)
• 2nd measure of a bank’s financial health.
• measures bank’s credit risk exposure
= capital to risk-weighted assets ratio
• Risk asset ratio = Capital
Risk-weighted assets
i.e. bank’s different assets have different risk.
• Asset with higher risk  greater weight
• Effective from 1993 under Basel 1
(i.e. accepted in the Basel Capital Adequacy Agreement of 1988)
• World widely used 82
T5-pg41
82

Bank’s capital
① Tier 1 capital - issued share capital, accumulated reserves.
② Tier 2 capital – medium & long-term subordinated debt
(debt that ranked below all other debt if bank default),
general provisions & current year unpublished profits.
Risk-weighted asset = asset x risk rate Example- see next few slides
Risk weight:
0% (cash, cash equivalents & government securities in OECD countries)
20% (interbank loans in OECD countries)
50% (mortgages)
100% (commercial loans)
• Higher risk weight means higher credit risk exposure.
• Off-balance sheet items are converted into credit risk equivalents &
83
assigned an appropriate risk weight.
83
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)
Gearing = deposit + ext liabilities =
capital + reserve
ii) Risk-weighted assets Cash (20* 0% ) ￡0

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

risk-weighted asset
T5-pg42
84
General Description Of Assets In Each Of The 4 Risk

Categories Extra notes
85
Regional National Bank (RNB), Extra notes
Risk-based Capital (Millions Of Dollars): Category 1 & 2
T5-pg43
86
Extra notes
Regional National Bank (RNB),
87
Extra notes
Regional National Bank (RNB),
T5-pg44
88


• 8% (minimum) for total capital Tier 1 capital (min 4%)
Tier 2 capital
• 4% (minimum) for Tier 1 capital Total capital (min 8%)
Problem of Risk–asset ratio

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 individual risk.
ii) all commercial loans are equally risky (i.e. all with 100% risk weight).
89
89
Tier 1 capital [=primary capital] Extra info

+ Tier 2 capital [= secondary capital]
= Total capital
Total Capital____________________
Tier 1 + Tier 2
Core Tier 1
e.g common stock e.g. subordinated debt
reserves
Basel A B C D E F
Tier 1 capital min 4% 4 5 6 8 4 3
+ Tier 2 capital x__ 4 4 2 0 5 6
= Total capital min 8% 8 9 8 8 9 9 T5-pg45
90
Risk-based capital standards Extra notes
…two measures of qualifying bank capital

Tier 1 (Core) Capital
• Equals the sum of:
– Common equity
– Non-cumulative perpetual preferred stock
– Minority interest in consolidated subsidiaries, less intangible assets such
as goodwill
Tier 2 (Supplementary) Capital

• Equals the sum of:
– Cumulative perpetual preferred stock
– Long-term preferred stock
– Limited amounts of term-subordinated debt
– Limited amount of the allowance for loan loss reserves (up to 1.25
percent of risk-weighted assets)
91
Exam Focus
36 Explain the risk-assets ratio under 1 and 2006-5b-ZA
discuss the main problems that have been identified with it. ( 13marks)
37 Explain the risk-assets ratio under 1 and 20073c-ZAB
discuss the main problems that have been identified with it.
How will it change under Basel2 ? (13 marks)
38 Explain the risk-assets ratio under Basel 1 & 2008-5d-ZAB
discuss the main problems that have been identified with it.
How will it change under 2? (13 marks)
39 Explain the risk assets ratio introduced under the 1 capital adequacy regime and outline2010-4b-ZA
the main problems with this 1 ratio. (9 marks)
40 Explain how the risk assets’ ratio under 1 was constructed and 2011-3b-ZA
discuss the problems with this construction. (10 marks)
41 Explain the changes to the construction of the risk assets’ ratio under 2 & and 2011-3c-ZA
discuss to what extent the changes address the problems with the 1 construction.(8 m
42 Explain the risk-assets ratio underlying the Basel capital adequacy framework. (8 m 2019-4a-ZAB
43 Critically discuss the use of the risk assets ratio used to assess the capital adequacy2021-2a-ZB
of banks in the Basel regulatory framework. (10 marks) online
92
T5-pg46
92
3(c) Explain the risk-assets ratio under Basel 1 and discuss the
main problems that have been identified with it.
2007-3c-ZAB
How will it change under Basel 2? (13 marks)
• refer to pages 75–76 of the subject guide.
• Students should begin by showing that they understand that risk–assets ratio
is the ratio of capital to risk-adjusted assets (1 mark).
• Students would then be 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 &unpublished profits)
(2 marks were 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 were awarded if
examples were given. The minimum ratio required by Basel 1 is 8% (1
mark). Individually negotiated with regulator (1 mark).
93
• Students should then discuss the ZA-2007-3c
main problems associated with the risk–assets ratio under Basel 1:

1) 100% risk weight applied to all commercial non-bank loans. This
implies that it does not reward diversification (1 mark)
2) relative risk weights may not reflect relative risks – can also lead to
misallocation of resources (1 mark)
3) 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).
T5-pg47
94

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.
credit risk capital requirement (for loans & long-term investments)

+ market risk capital requirement (for open positions of loans & long-term investments)
=Overall min capital requirement
95
95

Market risk amendment (under revised Basel 1)
• Market risk requirements provide a internal market risk measure, namely
‘value-at-risk’ (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). 96
T5-pg48
96
Basel 1 Basel 2 Basel 3* Key concept

[1993] [end of 2006] GFC
USA-1 Jan 2008-> 2009
Min 8% 8% >8%
Credit risk credit risk credit risk
______ risk mkt risk
___________ risk operational risk
_____________ risk
capital conservation _________

= counter cyclical cap buffer
min buffer required
min 2% [core Tier1] 4.5% + 2.5% = 7.0%
min 4% [Tier 1] 6 % + 2.5% = 8.5%
x [Tier 2] x x x
min 8% 8% + 2.5% = 10.5%
3 _______________ of Basel Agreement

1) Min capital requirement (1) (1) + liquidity requirement
2) Supervisory control (to assess risk mgt)(2) (2) + firm-wide risk mgt
+ cap planning
3) Mkt discipline (to disclose info) (3) (3) + enhanced risk disclosure
97

Minimum Capital (under Basel 2, 2006)
• 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.
98
T5-pg49
• Operation risk was added
98

Minimum Capital (under Basel 2, 2006)
• Minimum capital is a percentage of the risk-weighted assets of the bank plus
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
• Use 12.5 factor to convert the capital charges to an 8% minimum.
• Basel 2 Accord introduced the 3 pillars of regulation.
Three pillars of Basel 2:
① minimum capital requirements
② supervisory review – an assessment by supervisors of the risk assessment
processes used by banks
③ market discipline – bank disclose more information disclosure.
99
99
Extra notes
T5-pg50
100
Extra notes
http://www.google.com.sg/imgres?q=basel+1+and+basel+2&um=1&hl=zh-CN&tbm=isch&tbnid=eidKaBhg5XzMUM:&imgrefurl=http://www.dayonbay.org/coco-bonds-growing-
popularity/&docid=wOT9yMUNjNR19M&imgurl=http://www.dayonbay.org/wp-
101
content/uploads/2011/01/capital.png&w=648&h=244&ei=912HUIvXBcOxrAeR1oGQDg&zoom=1&iact=rc&dur=466&sig=111819202431382620505&page=2&tbnh=101&tbnw=22
8&start=10&ndsp=13&ved=1t:429,r:18,s:0,i:123&tx=78&ty=42&biw=979&bih=464
101

Financial crisis & Basel 3
• 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.
102
T5-pg51
102

Financial crisis & Basel 3
• 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. 103
103

Financial crisis & Basel 3 (Sept 2012)
Basel 3 adjusted the capital adequacy
1) Common equity (ordinary shares + retained earnings)
form a greater part of Tier 1 capital.
Minimum common equity to risk weighted assets ratio = 4.5%.

Note: no formal definition of common equity under Basel 2
(referred to as core tier 1 capital).
Many regulators imposed 2% as the
minimum common equity to risk weighted assets ratio
2) Tier 1 equity
= common equity + more strictly defined capital instruments – preferred stock
104
T5-pg52
risk weighted assets
104

Financial crisis & Basel 3 (Sept 2012)

3) Total capital > 8%
(total capital = Tier 1 + Tier 2 capital) (no change compared to Basel 2)
4) Capital conservation buffer (2.5% of risk weighted assets) & is
made up of common equity.
Banks need to build capital during ‘good times’ for bad times
(i.e. procyclicality problem)
• Restricting banks from paying dividends as capital approaches
105
the minimum requirements to enforce buffer.
105

5) National regulators impose an additional 2.5% capital buffer
when credit growth excessively & a build-up of system-wide risk
(= countercyclical capital buffer).
Can release this capital buffer during the downswing to enable banks to
continue lending.
6) To increase capital requirements for large systemically important banks
(i.e. too-big-to-fail problem).
7) use non-risk based leverage ratio (as a ‘backstop’).
Tier 1 capital to total assets (3%).
This will guard against banks increasing lending excessively
where this is not picked up by the risk-based measures.
106
T5-pg53
8) Higher capital requirements for market risk (implemented in 2011).
106

Financial crisis & Basel 3 [video: BBC news-Basel 3 and Bank Reform]
• These requirements (except for 8) will be phased between 2013 -2019
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 7% (= 4.5% + 2.5%).
• In normal times banks will operate on a 7% ratio.
• Banks can reduce the capital conservation buffer towards 0 &
minimum common equity ratio towards 4.5% when financial distress.
• under Basel 3, regulators emphase greater on common equity
to protect banks from financial distress.
• The procyclicality problem is addressed by points (4) & (5). 107
107
Traditional Regulation Mechanisms- (4) Bank capital requirements

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
form a greater part of Tier 1 capital. to as 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
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 procyclicality problem) Restricting banks from paying dividends as
of common equity. capital approaches the minimum requirements to enforce buffer.
5) National regulators impose an when credit growth excessively & a build-up of system-wide risk
additional 2.5% capital buffer Can release this capital buffer during the downswing to enable
(= countercyclical capital b________). banks to continue lending
6) To increase c_________ i.e. too-big-to-fail problem

r_____________
for large systemically important banks
108
7) use non-risk based leverage ratio (as a This will guard against banks increasing lending excessively where T5-pg54
‘backstop’). Tier 1 capital to total assets this is not picked up by the risk-based measures.
108
Exam Focus
44 Outline the 2 capital adequacy regime and 2010-4c-ZA
discuss to what extent it addresses the problems with the 1 regime. (8m)
45 Discuss the main changes to the assessment of capital adequacy of banks proposed2012-3b-ZB
under 3. (13 marks)
46 Discuss the reasons for the proposed changes in capital regulation under Basel 3(122014-4c-ZB
47 Discuss the main changes to capital regulation introduced by Basel 3.(15m 2017-3a-ZB
48 Discuss how Basel 3 improves on Basel 1 and 2 in terms of improving the ability of2018-4b-ZB
banks to withstand shocks. (13 marks)
49 Discuss the problem of pro-cyclicality in capital regulation and explain how Basel 32019-4b-ZAB
aims to mitigate this. (11 marks) [2019-4b-ZA]
50 Discuss to what extent Basel 3 helps to make the banking system2021-2b-ZA
more resilient to future financial crises. (15 marks) online
51 Discuss the changes to the Basel framework for regulating banks introduced by Basel 2021-2b-ZB
3 and discuss the extent to which they make a banking crisis less likely.. (15 marks) online
109
109
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. 2012-3b
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 T5-pg55
introduced.
110
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 & 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).
111
111
4(b) Discuss the problem of pro-cyclicality in capital regulation and explain

how Basel 3 aims to mitigate this. (11 marks) 2019-4b-ZAB
• For (b), see subject guide, Chapter 5, pages 104-5.

• (b) Pro-cyclicality is a situation where capital regulation promotes (increases
the amplitude) of the economic cycle. In boom times, risk is seen to be lower
hence capital requirements are lower leading to greater credit expansion
hence pushing economic activity higher. The opposite occurs in a recession
with lending now pushed lower due to the need to have more capital to
support new lending. Basel 3 addresses this by introducing an additional
capital buffer in operation in boom times which slows down the growth of
lending. This buffer can then be released in a recession allowing more
lending. The aim is to reduce the amplitude of economic cycles.
• Better answers will explain how the capital buffer works in practice.
T5-pg56
112
Part A:
Unregulated [Free] vs Regulated banking (advantages & disadvantages)

[micro vs macro prudential regulation]
Part C: New Zealand [Disclosure-based] Approach Of Bank Regulation 113
113
Exam Focus
58 Discuss the differences between micro-prudential regulation and macro-prudential2013-4b-ZB
regulation and explain why macro-prudential regulation has been given greater
emphasis since 2008. (13 marks)
59 Distinguish between micro- and macro-prudential regulation & give examples of how2016-4b-ZAB
macro-prudential regulation might work in practice (10 marks)
60 Explain the differences between micro and macro prudential regulation of banks. (6m2019-4c-ZA
114
T5-pg57
114

(5) Assessment of risk management
• New trend in bank supervision.
• Traditionally, only assess the quality of bank’s assets at a specific time and
their compliance with capital requirements.
But this is now inadequate due to financial innovation.
• Derivatives trading implies that a healthy bank can become insolvent
very rapidly because of trading losses.
• E.g. collapse of Barings in Feb 1995 following losses in derivates trading.
• (Read Mishkin & Eakins (2009), p.439 to understand better Barings’ problem.)
• This problem was addressed in Basel 2 by
(i) new capital requirements for operational risk and
(ii) pillar 2 which allows supervisors to assess the risk assessment processes
& models used by banks.
• US regulator now emphasis more evaluating the risk management system.
• Give a separate risk management rating into the CAMELS system. 115
115

Macro-prudential policy (under Basel 3)
• Traditionally, regulator use micro-prudential regulation approach
to examine the capital & liquidity adequacy of individual banks.
• It aims to prevent systemic failure of the banking system
(the primary aim of regulation) by preventing the failure of individual banks.
• 2007-09 financial crisis showed that this approach failed to identify &
prevent the build-up of systemic risk in the banking sector
through exposure to asset price bubbles & high degrees of inter-
connectedness through derivatives & wholesale funding of liquidity.
• Now regulators use macro-prudential regulation approach which aims
(i) to identify the build-up of systemic risk in bank due to external factors &
(ii) to develop tools for intervening to reduce such systemic risk.
116
T5-pg58
116

Macro-prudential policy (under Basel 3)
• Regulator impose capital controls with the
capital conservation buffer & the discretionary capital buffer
when credit growth excessively in the banking system as a whole.
• This need to be augmented with other monitoring & intervention techniques
by regulators.
• This is discussed further in a Bank of England discussion paper on the role of
macroprudential policy (2009).
117
117
4(b) Distinguish between micro- and macro-prudential regulation and give

examples of how macro-prudential regulation might work in practice. (10 marks)
2016-4b-ZAB
• See subject guide, Chapter 5, section headed `Macro-prudential policy'.
• Micro-prudential regulation refers to ensuring the soundness of an individual
institution, for example by ensuring they maintain sufficient capital and good management of
liquidity. It used to be believed that by ensuring that an individual bank did not fail, the
contagion effects of bank failure are reduced and so there is less risk of systemic failure.
• Macro-prudential regulation is aimed at preventing failure of the system by identifying
and reducing risks at the system level. In this approach, risks are seen to be partly
endogenous. The greater interconnections between banks through the interbank market or
securitisation create greater risk of systemic failure. Regulators place greater emphasis on
macro-prudential regulation as the lessons of the banking crisis of 2007/08 have shown
that the systemic risk that emerged was due more to macro-prudential type risks than
to imprudent behaviour of individual institutions. Both types of regulation matter but there
is now a greater awareness of the contribution to systemic risk from interconnections
between banks and macro-risks. This has led in the UK to the formation of the Financial
Policy Committee with a specific remit to assess and recommend policy actions to address
macro-prudential risk.
• Examples of implementation include introducing limits on mortgage lending to prevent a
T5-pg59
• housing market bubble, or the counter-cyclical capital buffer introduced through Basel 3.
118
Part A:

⑤ assessment of risk management [micro vs macro prudential regulation]
119
119
Exam Focus
52 Discuss the monitoring of liquidity in banking, with particular reference to the UK. (5 m2008-5c-ZB
53 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
54 Distinguish between liquidity and solvency in relation to a bank. Explain how a bank2016-3a-ZA
could become insolvent and explain the role of capital and liquidity in preventing
insolvency. (10 marks)
55 Distinguish between liquidity and solvency in relation to a bank. Explain how a bank2016-3a-ZB
could become illiquid and how attempts to rectify this situation by the bank could lead
it to become insolvent. (10 marks)
56 Distinguish between liquidity and solvency in relation to a bank. Explain how a bank2018-1a-ZB
could become insolvent and explain the role of capital and liquidity in preventing
insolvency. (12 marks)-
57 Explain the difference between illiquidity and insolvency in relation to banking. (7m 2019-1b-ZB
120
T5-pg60
120

(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 cash or assets which are easily liquefied,
b) mismatching of portfolio cash flows from maturing assets,
c) maintaining an appropriately diversified deposit base
d) having access to wholesale markets.
121
121

(6) Monitoring of liquidity
• Not much attention on the liquidity risk assessment prior the financial crisis.
• Many banks source liquidity heavily from wholesale funding & securitisation.
• 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 liquidity problems at banks.
• Required central banks’ liquidity support to sustain the financial system.
• Even so some banks still failed, so force mergers is required.
• Now regulators aim to strengthen liquidity 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,
122
so regulators require banks to hold more high quality government bonds. T5-pg61
122
5(c) Discuss the monitoring of liquidity in banking, with particular reference to the
UK. (5 marks) 20085c
• refer to p.77 of the subject guide

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. 123
123
Part A:

⑤ assessment of risk management [micro vs macro prudential regulation]

Part C: New Zealand [Disclosure-based] Approach Of Bank Regulation 124
T5-pg62
124

(7) Disclosure 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 free-rider problem,
• Market discipline plays an important role in limiting a bank’s risk exposure.
• See the 3rd pillar of the Basel capital adequacy framework.
125
125

(7) Disclosure requirements
• Bank should disclosure information related to
non-performing assets, loan-loss reserves, derivatives activities
• More disclosure means greater transparency.
• 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.
126
T5-pg63
126
Concept Check Activity: Disclosure-based regulation of banking

Since 1996, New Zealand undertakes alternative approach (derived from free 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__________

1st- reinforce the banks to maintain the systems & capacity, to identify, measure, monitor &
S___________ discipline control their risks & maintain prudent operations. is the most effective means to promote
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
R___________ discipline mechanisms. Minimum regulatory to avoid unintended distortions to banking
127
behaviour.
127
4(b) Discuss the importance of disclosure in relation to bank regulation.(10m)

• See pp.108–10 of the subject guide. 20114b
• 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 3rd 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.
T5-pg64
128
Exam Focus
64 With reference to examples discuss the relationship between 2011-4a-ZB
bank regulation and financial crises. (15 marks)
65 Discuss the lessons of the 2007/8 global financial crisis for bank2013-1-ZA
regulators.(25m
66 Explain the main causes of the 2008 global financial crisis and briefly2019-2-ZB
explain how Basel 3 addresses these causes. (25 marks)
129
129
1. Discuss the lessons of the 2007/8 global financial crisis for bankregulators.
(25 marks) ZA2013-1
• The global financial crisis of 2007/8 exposed many weaknesses in the structure of
banks and the effectiveness of the system of bank regulation. As the crisis broke,
banks were found to be short of liquidity and short of capital. Liquidity shortages
emerged because banks had come to rely upon securitisation and liability
management to manage their liquidity.
• As a consequence banks had run down their stocks of liquidity on the balance
sheet over time. In addition, banks had exposed themselves to excessive amounts of
risk; both market and credit. The capital allocated to cover this risk, determined by the
Basel capital accord, was inadequate. The new Basel 3 Accord addresses the issues of
liquidity | with more monitoring and greater holdings of stocks of liquidity required |
and capital | with more capital of better quality required. As Basel 3 is the main
development post-crisis this needs to be discussed in some detail.
Other lessons learnt include:
• The need to focus more on systemic risk. Prior to the crisis the emphasis in bank
regulation had been to ensure the safety of individual banks and hence the system.
Post-crisis the emphasis has moved to macro-prudential regulation where factors that
might impact on systemic risk are monitored and managed. Banks had become 130too
big to fail | need to address such problems. T5-pg65
130
Lesson Learnt from GFC Extra info

 Need Re-regulation [= new regulation= Basel 3]
PYQ 2012,2014,2017
Regulation mechanism no.
Basel 3
4) Increase min capital [eg. 2.5% buffer capital 1st pillar
[bank need to have more capital min cap req
during good time for bad time]
5) From micro to macro prudential regulation 2nd pillar

[individual] [nationwide] supervisory review
failed to prevent systemic risk [to assess risk mgt]
[contagion effect]
due to banks  highly interconnected
so need macro prudential regulation
6) liquidity  to strengthen liquidity 1st pillar

[hold more gov bond =high quality liquid asset]
7) disclosure of information [ transparency] 3rd pillar

e.g. Derivatives activities[=off b/s], loan losses mkt discipline
[to disclose info]
131
Part A:
Part C: New Zealand [Disclosure-based] Approach

132
T5-pg66
Of Bank Regulation
132
Outline +Exam focus
___________ banking Disclosure-based Regulation ___________ banking

[=unregulated banking] [New Zealand approach] Arguments for vs against
7 traditional
(7) disclosure requirements regulation mechanisms:
Topic 5
Regulation ① creation of a central bank
[micro vs macro
of Banks
prudential regulation]
④ Bank ________ requirements ** ③ government __________________ ***

(i) lender of last resort,
Basel 3 (ii) deposit insurance,
3 pillars (iii) direct funding
1) Min capital requirement 2 moral hazard problems/ solution:
2) Supervisory control (i)100% deposit insurance and 133
3) Mkt discipline (to disclose info) (ii) too-big-to fail
133
Alternative Key concept

Free banking _______________-based Regulation Traditional
[unregulated] [New Zealand, 1996] regulated banking
No central bank Central bank central bank
No supervision ________ supervision Supervision
No deposit insurance _____ deposit insurance deposit insurance
3 pillars 3 pillars [Basel]

1) Self discipline 1) Min capital requirement
2) Mkt discipline 2) Supervisory review
3) Regulatory discipline 3) mkt discipline
Depositor Depositor
Incentive to monitor bank Min incentive to monitor bank
based on the disclosed _____
T5-pg67
134
Alternatives to Traditional Regulation:

Disclosure-based regulation of banking
• Since 1996, New Zealand undertakes alternative approach (derived from
free banking approach) to regulate banks’ information disclosure &
market discipline:
i) to provide depositors & investors with reliable & timely information for
investment decisions, and
ii) to comply consumer protection law by securities issuers & financial services
provider
New Zealand
i) no deposit insurance scheme
ii) no depositor protection
135
135
Alternatives to traditional regulation:

① Self discipline
② Market discipline
③ Regulatory discipline
1st pillar-‘Self discipline’

• 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 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
136
T5-pg68
136

Disclosure mechanisms:
a) promoting high quality, regular & timely financial disclosure 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.
137
137

2nd pillar- ‘Market discipline’

• Reinforce the prudent management of banks.
• Market rewards well-run banks with
a) lower pricing for funding
b) greater access to funding
c) greater market share
d) 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.
138
T5-pg69
138

Effective market discipline

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 risk management.
139
139
Exam Focus
58 Discuss the importance of disclosure in relation to bank regulation.10m 2011-4b-ZB
59 Discuss the role of market discipline in the regulation of banks.(6m) 2010-4c-ZB
60 Discuss the role of market discipline in regulating banks. (6 marks) 2014-4a-ZB
140
T5-pg70
140
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 & 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 141
discipline provides an extra source of discipline on banks – in addition to regulation.
141

3rd pillar-‘Regulatory discipline’

• Manage bank’s prudent risk with limited regulatory & supervisory mechanisms.
• Minimum regulatory to avoid unintended distortions to banking behaviour.
142
T5-pg71
142

Intervention of Central bank
a) registering banks
(only for entities with good standing & sound risk management)
b) imposing prudential requirements (to minimize bank failure)
with minimum capital ratios to risk weighted asset
c) imposing corporate governance requirements
on composition of a bank’s board of directors of local banks.
d) requiring banks to disclose quarterly financial statements & information
(audited yearly & reviewed half yearly)
e) Regularly 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 distress
(e.g. as the lender of last resort to a solvent but illiquid bank, or 143
giving directions to a problem bank.)
143

• 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) no depositor protection (rather focus on systemic stability)
ii) Banks are not subject to 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 that144
are
subject to a comprehensive licensing & supervision framework. T5-pg72
144

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
from taking banking positions and weakening the bank management
145
145
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.
• Note: read Mishkin & Eakins (2009) p.523
• to better investigate the difficulties of regulating international banking,
highlighted by the Bank of Credit & Commerce International (BCCI) scandal
in 1991.
146
T5-pg73
146
International Banking Regulation

• 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 harmonisation of solvency regulation across the EU
(Basel 1,Basel 2 & Basel 3).
147
147
Revision Exercise
Topic 5- Regulations of Banks
1. Critically examine the view that free (unregulated banking) is better for
banking stability than regulated banking. [=advantages/ disadvantages]
(12,13 marks)
2. Discuss the arguments/reasons for and against the regulation of banks
[/discuss the problems created by excessive regulation]
(12,12,12,13,13,15,15]
3. What is the CAMEL system? (5 marks)
148
T5-pg74
148
4. Explain the key features of the safety net (= lender of last resort, deposit
insurance, direct funding) in the regulatory system for banks. Discuss the
problems caused by this safety net and the solutions to these problems.
(10,12,15 marks)
5. 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)
6. Explain the role/ mechanism of 100% deposit insurance in the regulation
of a banking system & discuss its moral hazard problems and solutions.
(4,6, 10,11,11 marks)
7. Explain the `too big to fail” in relation to banking. Explain why this has
become a problem in banking & discuss solutions to this problem. (4,
13,13m) /Discuss the causes, consequences and solutions of the ‘too
big to fail’ problem in banking. (15,25 marks)
8. What are the methods (= direct funding= payoff method + purchase
assumption method) used to handle a failed bank in the USA? (6 marks)
149
149
9. Define what a bank’s capital is and explain why bank capital is important in
protecting depositors from loss/ in preventing bank failure (7, 8 marks)
10. Distinguish between liquidity and solvency in relation to a bank. Explain
the role of capital and liquidity in preventing insolvency. [Explain how a
bank could become illiquid and how attempts to rectify this situation by the
bank could lead it to become insolvent]. (10,10 marks)
11. Explain the risk-assets ratio under Basel 1 & discuss the main problems
that have been identified with it. How will it change under 2? (8,9, 10,
13,13,13 marks)
12. Discuss the main changes and the reasons for the changes to capital
regulation introduced by Basel 3.(12,13, 15m)
13. Discuss the differences between micro-prudential regulation and macro-
prudential regulation and explain why macro-prudential regulation has been
given greater emphasis since 2008. [+give examples of how macro-
prudential regulation might work in practice ] (10, 13 marks)
14. Discuss the role of market discipline [/ importance of disclosure] in the
regulation of banks.(6,6, 10m) 150
T5-pg75
150
Summary for Topic 5

• This topic explain why banks are singled out for heavier regulation than other
sectors of the economy is also to explain why banks should be regulated at
all (free banking against banking regulation). There are three main reasons
for banking regulation:
– the fragility of banks, due to their role in providing liquidity insurance to
depositors and in screening and monitoring borrowers
– the existence of systemic risk, due to a run on solvent banks owing to the
asymmetric information problem
– the need to protect depositors because of their lack of the necessary
expertise and knowledge to assess the quality of the bank.
151
151
Summary for Topic 5

• Having established that there is a case for banking regulation, this topic
investigated the traditional regulation mechanisms used in most countries:
– creation of a central bank
– bank supervision (restriction on entry and bank examination to oversee
who operates banks and how they are operated)
– government safety net (mainly through deposit insurance to avoid bank
panics)
– bank capital requirements (restrictions on measures such as leverage
capital ratio and risk–asset ratio to reduce the bank’s incentives to take
risks)
– assessment of risk management, monitoring of liquidity and disclosure
requirements.
152
T5-pg76
152
Summary for Topic 5

• An alternative mechanism (implemented in New Zealand) is based on
disclosure requirements only and uses the market discipline to police the
behaviour of banks.
• The financial crisis of 2007–09 revealed many important deficiencies in
traditional bank regulation mechanisms including capital requirements for
credit and market risk and assessment of liquidity. These have been partly
addressed by Basel 3 capital requirement changes and related developments
in the areas of liquidity assessment.
• The final issue examined is the trend towards greater harmonisation of
banking regulation across the world.
153
153
Sample examination questions

1.
a. Why do banks need regulations?
b. How can deposit insurance provide stability in the banking system?
2.
a. What are the forms of regulations designed to reduce moral hazard problems
created by deposit insurance? Do they completely eliminate the moral hazard
problem?
b. What are the costs and the benefits of the ‘ too-big-to-fail’ policy? What are
the recent regulatory restrictions to the use of this policy?
154
T5-pg77
154
Sample examination questions

3.
a. Which bank regulation concerns bank capital requirements? Discuss the
system of capital regulation under Basel 1 and the main innovations
introduced by Basel 2.
b. What forms does bank supervision take, and how does it help in promoting a
safe and sound banking system?
c. How can disclosure requirements be used in banking regulation? Compare
and contrast the experience of the USA and New Zealand.
4.
a. Discuss to what extent the new Basel 3 capital requirements solve the
problems revealed by the financial crisis of 2007–09.
b. Discuss how effective the changes introduced in Basel 3 will be in preventing
155
systemic risk in banking.
155
References
• M. Buckle (2011) Principle of Banking and Finance Subject Guide, Chapter 5.
Essential reading
• Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapter 20.
• Dow, S. ‘Why the banking system should be regulated’, Economic Journal
106(436) 1996, pp.698–707.
• Dowd, K. ‘The Case for Financial Laissez-Faire’, Economic Journal 96(106)
1996, pp.679–87.
Further reading
• Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004)] Chapter 17.
• Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The
MIT Press, 2008) Chapter 9.
• Heffernan, S. Modern Banking. (Chichester: John Wiley and Sons, 2005)
Chapters 4 and 5.
• Sinkey, J.F. Commercial Bank Financial Management in the Financial-
Services Industry. (Upper Saddle River, NJ: Pearson Education, 2002) 156 T5-pg78
Chapter 16.
156

20220910170707HCTAN008C5 Topic - 5 Regulation

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Topic 5 -Regulations of Bank

Outline +Exam focus

___________ banking Disclosure-based Regulation ___________ banking

⑤ assessment of risk management

④ Bank ________ requirements ** ③ government __________________ ***

Outline for Topic 5

2. Argument for bank regulation:

Outline for Topic 5

Outline for Topic 5

• understand the importance of banks regulation

Free banking [= _____________ banking], no central bank

3) Protection of _______________ b) _____________________________

Arguments against private money issuance

Free banking problems:

• Regulatory failure to prevent the 2007-2009 banking crisis has raised

Advantages of free banking system

• The higher the bank capital,

Concept Check Activity:

Importance of Bank Regulations

Pros & Cons of bank regulation:

Arguments for Bank Regulation

Arguments for Bank Regulation

2) A source of mitigation of fragility

Argument for Bank Regulation

Arguments for Bank Regulation

Arguments for Bank Regulation

Arguments for Bank Regulation

Arguments for Bank Regulation

Bank failures are serious to the economy because:

Arguments for Bank Regulation

Arguments Against Regulation

4 types of regulation costs

Avoid over-regulated (maintain minimum regulation) to prevent bank runs

Arguments Against Regulation

Concept Check Activity

Arguments Against banking regulation:

Part B: 7 Traditional Regulation Mechanisms

Part C: New Zealand [Disclosure-based] Approach Of Bank Regulation

Traditional Regulation Mechanisms Key concept

**3) Government _________________________ ****

*4) Bank capital requirement-____________________ 1, 2, 3

5) Assessment of risk management [________ vs _________ prudential policy]

Traditional Regulation Mechanisms

Traditional Regulation Mechanisms

(i) Monetary Control (i.e. control money supply)

Traditional Regulation Mechanisms

Traditional Regulation Mechanisms

Traditional Regulation Mechanisms

Traditional Regulation Mechanisms

3(e) What is the CAMEL system? (5 marks) 20083e

• refer to p.72 of the subject guide.

Part A: Unregulated [Free] vs Regulated banking (advantages & disadvantages)

③ government safety net

Traditional Regulation Mechanisms

Traditional Regulation Mechanisms

(a) Lender of last resort

Traditional Regulation Mechanisms

Concept Check Activity

D________ by the gov to troubled institutions (see other slides)

Problems – creates moral hazard – countered by charging a ‘penal rate’ of

Traditional Regulation Mechanisms

(b) Deposit insurance

_ banking Disclosure-based Regulation _ banking

④ Bank requirements ③ government __________ *

3) Protection of _ b) _______________

3) Government _________________________ **

5) Assessment of risk management [ vs _ prudential policy]

• 100% deposit insurance creates m___ h problem. Depositors have no

___ ratio = Total capital_