Systematically important financial institutions

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Background

In this chapter the reader will be introduce to the background of this paper. Description will be made of the Basel Accords and the financial crisis of 2007- today. Also potential obstacles to regulation will be intro-duced.

The Basel Accord

Basel I

The first framework to measure banks’ capital adequacy was assigned by BIS in 1988 and was called Basel I. The main objectives of Basel I was to make the soundness and stability of the international banking system stronger and to make competition equal among inter-national banks. This accord focused on banking in terms of lending. The focus in the regu-lation was on credit risk (Eun & Resnick, 2008).

Minimum capital adequacy

The minimum capital adequacy for risk-weighted assets under Basel I was set at 8 per cent. Capital was divided into two classes Tier 1 and Tier 2 capital. Tier 1 capital was referred to as core capital. Included in Tier 1 was for example common stockholders’ equity and non-cumulative perpetual preferred stocks. Requirements for Tier 1 capital was set to be the capitals risk weight times 4 per cent of risk-weighted averages. The supplementary capital, Tier 2, was for example reserves and long-term and convertible preferred stock. Tier 2 cap-itals were restricted to be maximum a 100 per cent of Tier 1 capital. Together they outlined the total capital, which was required to be a minimum of 8 per cent of weighted risk assets, times the risk weight. From the capital certain deductions were allowed to be made, good-will could for example be deducted under certain criteria from Tier 1 capital (Balthazar, 2006; Casu et al. 2006; Eun & Resnick, 2008).
Eun and Resnick (2008) explains that the risk-weighted assets were divided into four cate-gories in which the assets respective weight was set. Assets weighted at zero per cent were assets labelled as no risk, for example US government bonds. Short-term claims were seen as low risk and were weighted at 20 per cent. House mortgages were seen more risky and weighted at 50 per cent. The last category was for the riskiest assets with a respective risk-weight of 100 per cent.

Risk-asset ratio

To calculate the required minimum capital an approach called risk-asset ratio was used. Casu et al. (2006) explains this approach in a good way. First the assets should be classified according to risk-weights. Second off-balance sheet assets should be converted to their on-balance values. Third the money value of the assets should be multiplied with their weight and finally the risk-weighted assets should be multiplied with the minimum capital per centage. Figure 2 is illustrating this approach with an example.

Critique of Basel I

Balthazar (2006) give critique of Basel I. Seven specific points is laid out as the weaknesses of Basel I. The possibility for banks to keep the risk level almost unchanged while at the same time lower the capital requirements is one. This could be done through securitization using a special purpose vehicle (SPV). Basically this means that the bank sell loans to SPVs and the SPV usually get a subordinated loan from the bank. The SPV issues securities on the loans to get funding to buy the loans. This means that the loans are collected by the SPVs and packaged to form securities. The securities are then sold by the SPVs. Since it is the loans issued by the bank underlying the securities then the risk level remains at 100 per cent, if this was the risk-weight assigned to these loan from the beginning. But the SPVs has lower risk weight which requires the bank to have a lower capital buffer backing up the loans.
Example from Saunders (2010) explains how banks arbitrage from securitization. In Figure 3 a bank has 100 M€ BBB rated loans. The bank constructs a SPV (see figure) out of the loans with two tranches. The first tranche is structured to protect against defaults and re-ceives a higher credit assessment rating. The second tranche is low quality. The first tranche is sold to outside investors and the bank or its subsidiaries buy the second tranche.
Because under Basel I these risks were weighted with same weight, having 20 M€ of credit bonds results in a 1.6 M€ capital requirement (see Table 1). That is 6.4 M€ less than with 100 M€ of loans which had almost the same risk as the bonds. The bank arbitraged 6.4 M€ this way, meaning that the capital requirement was 6.4 M€ less.
Other critique by Balthazar (2006) is that Basel I only focused on credit risk. Banks are ex-posed to more risk than that. Basel I had almost the same requirements for all type of ac-tivities of the bank. Meaning that different risk levels etc. were ignored. The lack of recog-nition of diversification is also pointed out as a critique.
Eun and Resnick (2008) also give critique to Basel I regarding the lack of recognition of other risks. They focus especially on the omission of market risk in the framework, which made banks fail even though they followed the minimum capital requirement set out by Basel I.

Regulated and united banking industry

Although Basel I got a lot of critique, the framework paved way for a regulated and united banking industry that worked under same regulations. The goal of equal competition be-tween international banks was closer to be fulfilled (Balthazar, 2006). Casu et al. (2006) also highlight this step forward in regulation that Basel I was. But also describe the critiques that Balthazar (2006) explained.
An amendment to Basel I was published in 1996. This gave some improvements, but it was not enough. For example, market risk was introduced in the amendment (Casu et al. 2006). Because of the critique of Basel I, the Basel Committee started to reconsider the frame-work and in 1999 the first proposal to a new framework, Basel II, was published (Baltha-zar, 2006).

Basel II

Basel II has a design of three pillars, see figure 3.

Pillar 1- Minimum capital requirement

The Basel Committee on Banking Supervision (BCBS) explained in year 2004 that the first pillar is concerned with the calculation of minimum capital requirements. It is divided into different risk areas: credit risk, operational risk and market risk. The credit risk is divided into three approaches that can be used to find this risk. As with Basel I, the minimum capi-tal requirement is 8 per cent. What has been changed in Basel II is that this requirement now includes adjustment for different risks and, as mentioned, different approaches to cal-culate the credit risk.
The total risk weighted capital is multiplied with 8 per cent as in Basel I. The difference is that the total risk weighted capital is calculated in a different way. The sum of the risk-weighted assets from credit risk is summed up together with 12.5 per cent of the capital re-quirements for operational risk and market risk (BCBS, 2004).
According to the Basel Committee on Banking Supervision (2004) banks can use three ap-proaches to find the credit risk; the standardized approach, the internal ratings-based (IRB) approach or a securitization framework. The standardized approach is based on the Basel I way of calculating the credit risk. Assets are given risk-weights, which will be the ground for capital requirement. The weights given are those decided in the framework. The se-cond approach is the IRB approach and gives the bank a right to use its own internal sys-tem to classify the risk-weights given exposure to risk. Banks may use the IRB approach if the bank has received supervisory approval. The securitization framework is the last way of deciding the credit risk for the minimum capital requirement. This means that banks have to decide if a transaction should be under the securitization framework when deciding the regulatory capital. If it is, then it should be backed by capital; the banks have to hold capital that backs up all of their securitization (BCBS, 2004).
Operational risk is defined as risk that may result from internal or external operations con-ducted through bank activities. Different methods can be used to calculate this risk as well (BCBS, 2004). Eun and Resnick (2008) gives example of operational risk, which could be fraud or computer failure resulting in loss of data.
Trading book activities is the last step in pillar 1. It is here the market risk is found. The definition of market risk that was included in the amendment of Basel I in 1996 is here re-defined (BCBS, 2004). Marking to market value is what decides the market risk. This is the value of the assets to the market and this value should be up to date. If this value is not available or in some other way cannot be used, the marking to model value should be used (Eun & Resnick, 2008).

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Pillar 2- Supervisory review process

Basel Committee on Banking Supervision (2004) explains that this pillar is for regulators to be able to see that a bank is properly capitalized regarding their risk exposure and to make banks come up with their own internal methods to review processes. This means that pillar 2 should make sure that pillar 1 is fulfilled. Balthazar (2008) explains that this pillar gives the regulators right to take action against a bank that do not fulfill the capital requirements.

Pillar 3- Market discipline

This pillar wants to incorporate market discipline into banks; making banks publish infor-mation about their risk assessment and the way they will use Basel II. The information will make it easier for market participants to judge banks’ soundness (Balthazar, 2006; Casu et al., 2006).

Critique of Basel II

Tarullo (2008) explains that the biggest news in Basel II compared to Basel I was the IRB approach that let bank use there own method for setting capital requirements. It is also this method that has got a lot of the critique directed towards Basel II. He explains that this model was developed with the benefit that banks could shape their requirements after the specific risks that they were exposed to. A good thought but it is also here the critique lies. Credit risk models were in the time of Basel II implementation a relative new phenomena and had not been used that much.
Tarullo (2008) explains that it was risky to let banks develop their own credit risk models because knowledge of credit risk models was not that widespread yet. He raises the ques-tion of reliability of the banks own models. Five points are laid out concerning the reliabil-ity. First, is the question of the model’s assumptions. If these are not good the model can-not be good either. It is hard to test these models because good test data did not exist when Basel II was developed. Third, correlations among variables may not be correctly captured in the models. The forth point is an important one. Banking failures and crises are events that are likely to be found in the tails of models, which are important to capture in a good way. The last point comes from the fact that not all risks come from the outside. Risks may as well come from inside the bank and this might not be reflected in models.

The financial crisis of 2007-today

During the financial crisis of 2007-today Basel II was seen as having some flaws, the IRB approach was one, and it was time for the Basel Committee to gather again and to attend to those flaws. This work led to the framework called Basel III (BIS, 2010). To understand the changes made in Basel III compared to Basel II, background of what occurred during the crisis need to be clarified.

Causes and effects

According to Chang (2010) the crisis started with overvaluation of the housing market in the United States in 2006. Consumers on the housing market received loans easily and there was a belief on the market of increasing house prices. Lenders gave out loans easier to consumers because the rising market of certain financial instruments. These were for ex-ample mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). These instruments transferred the risk associated with the loans to the investors, which made lenders more willing to set up loans.
Fabozzi (2009) explains that MBSs is debt obligations that are issued backed by cash flow coming from a pool of mortgage loans. This pool of mortgage loans is residential mortgag-es that have been packed together. The principal or interest that investors receive comes from interest payments and principals that are made by the borrowers of the mortgage loans; this is what is meant with that the securities are backed by mortgages. Securitization is the name of the process of creating MBSs. CDOs is securities that are backed by a pool that is diversified and includes different type of debt obligations. MBSs are for example a debt obligation that might be a part of a CDO.
The market for these securities, or financial instruments, grew and investors from all over the world started to invest in the housing markets of United States (Chang, 2010). But in 2006 interest rates rose and house prices started to decline. Which led to the collapse of this market and came to affect not only the United States.
The creation of investment instruments that should meet specific type of risk exposure is called financial innovation. MBSs and CDOs were part of the financial innovation before the crisis. As mentioned these helped in increasing the credit flow, but they are also some-times mentioned as ways of bypassing regulation (Chang, 2010). But what happened in 2006 was that house prices declined and the housing market collapsed (Acharya, Philippon, Richardson & Roubini, 2009). When this happened it turned out that the new financial in-novations instruments were hard to price. And they had larger risk connected to them than expected (Chang, 2010). The instruments were so complex that banking regulators had left the risk pricing to be made by the banks themselves.

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Shadow banking system

Main investors in these instruments were hedge funds and investment banks. These are part of an industry called the shadow banking system. The shadow banking system is not under the same regulations as the banking industry. The shadow banking system collapsed during the crisis due to high leverage or debt ratio and has been seen as one of the causes of the crisis (Chang, 2010). Investment banks in U.S. like Bear Stearns, Merrill Lynch, Goldman Sachs and Morgan Stanley were all highly leveraged and received some kind of help through bailout programs provided by the government. Lehman Brothers was another big investment bank but got liquidated in the crisis and hence did not receive any help from the government in the form of a bailout (Chang, 2010). The BCBS also put high leverage in the banking industry as one of the triggers for the financial crisis. Or they state that high leverage was the reason that the crisis became so large (BCBS, 2010).
Fannie Mae and Freddie Mac were two corporations providing MBSs to the market. These corporations existed to help consumers to easier receive loans from financial institutions. But when the housing bubble burst these were placed in conservatorship by intervention of the government (Chang, 2010).

Crisis in Europe and Asia

As already mentioned, the investment in MBSs and CDOs were not just made by investors in US, the instruments have been sold in Europe and other places around the globe as well. Chang (2010) describes that it developed to a liquidity crisis in the credit markets. Many countries got affected. In the United Kingdom (UK), Bank of England had to step in to help banks. In 2008 the major banks of Iceland collapsed, partly due to the bank run that had started to occur in the UK. It even led to the Icelandic government taking over the control of banks. Ireland and its overleveraged banks came into a recession in 2008 after have been hit by the crisis. Hungary, Russia, Spain, Ukraine and Dubai were other victims of the financial crisis. Some of these countries even needed to get emergency loans from the International Monetary Fund (IMF) or the European Central Bank (ECB). Greece is another country that got hit hard and is still under the process of being saved through loans from the ECB (Chang, 2010).

Potential obstacles to regulation

Too big to fail

Governments and central banks throughout the globe have cleaned up after banks in this financial and economic crisis. A question raised from this is the moral hazard that bailing out may lead to. It may send a signal to banks that it is alright to take big risks and loose money because the government will save the bank if things go bad. This leads to the ques-tion of banks being too big to fail (TBTF) or too important to fail (TITF). This is an im-portant question when evaluating banking regulation, because it may have large effects on the effectiveness of the regulation.
Moosa (2010) explains that TBTF is a saying that government cannot let big firms fail be-cause of that they are big. It comes from the thought underlying systematic risk, which is the risk of bad consequences on the whole market if a firm fails. The banking industry is a industry that is very interconnected; the failure of one bank may lead to bad consequences on the whole industry. That is why TBTF is a concept that affects this industry a lot. There are different meanings when talking about TBTF but when it comes to banks and especial-ly in light of the crisis it means that a bank is too big to be allowed to fail.
Firms that are big have advantages compared to smaller firms. This comes in form of greater market power and greater ability to diversify. Diversification means spreading out of risks. And not at least for banks it may come as a benefit of being bailed out in case of failure. Bailing out by the government means that the government steps in and takes over the management of the bank. This protects the depositors of the bank (Moosa, 2010).
Moosa (2010) says that it is a big problem with bailing out of financial institutions. When an institution gets bailed out taxpayers’ money is used. This money could have instead gone to health care or school etc. And it leads to future generations being affected. Also a prob-lem with TBTF is that it creates a moral hazard. As already mentioned, if a bank is bailed out when it fails this may give the signal to other banks in the industry that are in the same size that they also are TBTF. This may induce them to take larger risks than before because they now believe that they are being protected.
It is the size of the banks that is in focus in TBTF. Moosa (2010) suggest a solution to the problem; regulate the size of banks. Meaning that banks should not be allowed to get so big that they are classified as being too big to fail. This is an important note to keep in mind when analysing Basel III

Table of Contents
1 Introduction
1.1 Problem
1.2 Purpose
1.3 Limitations
1.4 Method
2 Theoretical Framework
2.1 The banking industry
2.2 Regulation of banks
3 Background
3.1 The Basel Accord
3.2 The financial crisis of 2007-today
3.3 Potential obstacles to regulation
4 Basel III
4.1 Description of the Basel III framework
4.2 Previous research
5 Interviews with banks and supervisors
5.1 Presentation of banks and supervisors
5.2 Interviews
6 Analysis
6.1 Capital requirements
6.2 Liquidity standards
6.3 Systematically important financial institutions
6.4 Shadow banking system
6.5 Financial innovation
6.6 Leverage ratio
7 Conclusions: Can Basel III protect against new banking failures?
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