Nazar

Hussain
MB2E-17-
16-38
Chapter 7
International
Banking
Regulation
and the Basel
Accords
Introduction

– Global financial crisis

– Financial Service Authority(FSA)
– US treasury Secretary Tim Geithne
Why Banks are Important?

– Lending
– Taking Deposit
– Difference between the degree of liquidity
of their Asset and Liabilities
– Banks are at the center of the payment
system
Kinds of Risk Facing

– Financial Risk
– Credit Risk
– Market Risk
– Non Financial Risk
– Operational Risk
– Other kind of Risks
Other Types of Risks

– Liquidity Risk
– Compliance Risk
– Processing Risk
– System Risk
– Human Resource Risk

(cont.)
Other Types of Risks
– Crime Risk
– Disaster Risk
– Fiduciary Risk
– Business Risk

(cont.)
Other Types of Risks

– Country Risk
– Political Risk
– Sovereign Risk
– Purchasing Power Risk

(cont.)
Operational Risk
– General Description of Operational Risk
and Operational Loss events
– Direct Operational Losses
– Indirect Operational Losses
– Opportunity Losses
– Assurance Cost
Operational Risk in the
Foreign Exchange Market

– Introduction of Euro
– Consolidation of Foreign Exchange Dealer
– Consolidation of Foreign Exchange
Processing in Global or Regional
Processing Center
– Outsourcing of Back Office Functions
Regulatory Functions and
Forms of Regulation

– Regulatory Functions
– Macro prudential Supervision
– Micro prudential Supervision
– Conduct of Business Regulation
Regulatory Functions and
Forms of Regulation

– Forms of Banking Regulation

– Deposit Insurance Regulation
– Operation Regulation
– Regulation of the Accounting Process
– Global Banking Regulation
H.M.Omer
Arshad
MB-2E-17-21
Capital and related
concepts
– Capital
– Economic capital
– Regulatory capital
– Capital adequacy

(cont.)
 Capital and related
concepts (cont.)
– The capital ratio and the risk-adjusted capital ratio
are calculated as follows:
K
k
A

K
k 
A
n

w A i i
A  i 1
n

w
i 1
i

(cont.)
 Capital and related
concepts (cont.)

– The risk-adjusted rate of return on capital is

calculated as:


RAROC 
K

(cont.)
 Capital and related
concepts (cont.)

– Regulatory capital arbitrage is a process

whereby banks exploit differences between
a portfolio’s true economic risk and
regulatory risk by, for example, shifting the
portfolio’s composition towards high-yield,
low-quality (or high-risk) assets
 The Basel Committee

– The BCBS was established in 1974 following

the collapse of Bankhaus Herstatt
– The BCBS does not have any supranational
authority with respect to banking supervision,
and this is why its recommendations and
standards do not have legal force
Functions of the Basel
Committee

– Defining the role of regulators in cross-

jurisdictional situations
– Ensuring that international banks do not
escape comprehensive supervision by the
domestic regulatory authority
– Promoting uniform capital requirements so
that banks from different countries may
compete with each other on a ‘level playing
field’
 The Basel I Accord
– In 1988, the BCBS established the Basel I Accord
for measuring capital adequacy for banks
– The objective of Basel I were:
(i) to establish a more ‘level playing field’ for
international competition among banks
(ii) to reduce the probability that such
competition would lead to bidding down of
capital ratios to excessively low levels
Requirements of Basel I
– Banks are required to hold as capital an
amount of no less than 8% of their risk-
weighted assets
– The capital ratio, k, can be calculated as:

K
k  0.08
CR
Criticism of Basel I

– It has very limited sensitivity to risk

– Failure to differentiate between high-

quality and low-quality assets within a
particular asset classes

(cont.)
Criticism of Basel I (cont.)

– It completely ignores operational risk.

– The Accord gives very limited attention to

credit risk mitigation despite the availability
of risk management tools such as credit
derivatives

(cont.)
 The Basel II Accord

– In response to the criticism of the Basel I

Accord and to address changes in the
banking environment that the 1988 Accord
could not deal with effectively, the BCBS
decided to create a new capital accord, Basel
II
Requirements
– While retaining the key elements of the
Basel I Accord, including the general
requirement that banks ought to hold a
regulatory capital ratio of at least 8% of
their risk-weighted assets
The capital ratio under
Basel II
– Because Basel II accounts for operational
risk, the capital ratio formula becomes:
K
k  0.08
CR  MR  OR
The pillars of Basel II
– The Basel II Accord has three pillars:
(i)minimum regulatory capital
requirements
(ii) the supervisory review process
(iii) market discipline through
disclosure requirements
The first pillar: Minimum capital
requirements

– The first pillar deals with maintenance of

regulatory capital calculated for three
major components of risk that a bank
faces: credit risk, operational risk,
and market risk.
– Different approaches are used to measure
these risks

(cont.)
The second pillar: Supervisory
review

– This is a regulatory response to the first pillar,

giving regulators better 'tools' over those
previously available. It also provides a
framework for dealing with systemic
risk, concentration risk, strategic
risk, reputational risk, liquidity risk and legal
risk etc.
The third pillar: Market
discipline

– This pillar aims to complement the

minimum capital requirements and
supervisory review process by developing a
set of disclosure requirements which will
allow the market participants to gauge the
capital adequacy of an institution.
 Criticism of Basel II

– Basel II represents inappropriate or inadequate

financial supervision. While capital adequacy
requirements are designed to protect banks
from insolvency, the problems faced by banks
during the global financial crisis were illiquidity
and leverage

(cont.)
Criticism of Basel II (cont.)
– The resulting risk-sensitive capital
requirements enhance procyclicality of the
banking system.
– Banks tend to contract their lending activities
in downturns and expand it in booms.

(cont.)
Criticism of Basel II (cont.)

– Business and reputational risks, which are

not recognised by Basel II, may be more
significant than the direct operational losses
that the banking industry has been asked to
monitor

(cont.)