Transcript Document 7113993

Building a Sound Banking System
Notes prepared by John Caskey ([email protected])
May 2002
I. Risks in Banking
1.
2.
3.
4.
5.
6.
Credit risk
Interest rate risk
Exchange rate risk
Liquidity risk
Market risk
Operational risk
Risks may be off the balance sheet as well as on the balance sheet
Bank owners/managers should assess risk-reward tradeoffs and determine the
optimal amount of risk that the bank should bear and capital that it should hold
to absorb unfavorable shocks. Risk assessment and control mechanisms can be
crude or sophisticated.
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II. Methods of measuring and adjusting key risks
A. Credit risk
1. Measuring credit risk. A bank will typically review a time series of past ratios, such as:
 Nonperforming loans/total loans
 Charge-offs/total loans
From these data, the bank could determine an expected loss rate, for which it would set aside
loss provisions, and a reasonable upper bound for losses that might have to come out of capital.
Where appropriate data are available, a bank might also use:
 Credit bureau information to assess credit risk for small borrowers.
 Rating agencies (such as S & P) for large business borrowers.
Sophisticated banks increasingly use internal credit risk models that generate probability
distribution functions for various levels of loss. These models are analogous to VAR
methodologies, discussed below, that are used to analyze market risks. (See reading by Hirtle
et al)
2. Managing credit risk. Managed by underwriting standards, monitoring, and diversification.
Sophisticated banks might use credit derivatives.
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B. Interest rate risk (refinance and reinvestment risk). Arises from mismatch in repricing
periods.
1. A standard way to measure a bank's interest rate risk is to use "basic gap anal ysis":
For each period into the future, one calculates:
Repricing Gap (RGAP) = assets that reprice in this period – liabilities that reprice
For a reasonable shock to interest rates, one calculates for each period:
Change in net interest income = i * (RGAP)
To assess the cumulative effect on net interest income, one sums the projected changes in net
interest income over a relevant time period.
A limitation with this approach is that it ignores capital gains and losses created instantly by
changes in interest rates. This approach assumes that all of the effect comes from future
income flows. In simple cases, it also assumes a static balance sheet. But long-term loans
might, for example, be prepaid when interest rates fall.
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2. To account for the effects of capital gains and losses, banks typically use Duration Gap
analysis. The duration of an asset or portfolio is its weighted-average time-to-maturity using
the present value of cash flows as weights. Since, for small changes in interest rates,
∂P/P = -D[∂i/(1+i)]
a bank can use duration measures for assets and liabilities to calculate the impact of small
interest rate changes on its net worth. See Saunders (2000) for more details on this. Note that
the above equation implies that there is a linear relationship between changes in interest rates
and the price of an asset. This approximation only works for small changes in interest rates.
For large changes, one needs to recognize that the actual relationship is nonlinear.
3. Interest rate risk can be managed by adjusting the structure of assets and liabilities to alter
the repricing gap. The risk can also be shifted to borrowers via floating interest rates. This
can, however, create credit risk. Sophisticated banks use derivatives (options, futures,
forward market, swaps, etc) to hedge interest rate risks. In over-the-counter markets, this
introduces counterparty risks since no exchange guarantees the fulfillment of the contract.
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C. Exchange rate risk
 Arises from mismatched currency denominations of assets and liabilities or the maturity of these FX dominated assets and liabilities. In countries where future ER is
highly uncertain, bank liabilities to foreigners are often denominated in FX.
 Banks can measure FX risk by analyzing changes in value of items on and off the
balance sheet to various hypothetical changes in exchange rates.
 Banks can reduce ER risk by denominating a similar share of assets and liabilities
in FX. This shifts ER risk on to borrowers. This may augment the bank's credit
risk. Sophisticated banks use derivatives (options, futures, forward market, swaps,
etc) to hedge exchange rate risks.
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D. Liquidity risk
Arises from mismatched maturity structure of assets and liabilities. Could force fire
sales of assets or inability to meet withdrawal requests.
1. Banks can measure the risk by forecasting the "liquidity gap" for each period.
Forecast liquidity gap = money out – money in
= new loans and securities purchases + deposit withdrawals
– loan repayments and maturing securities – new deposits
Contingent assets, such as loan commitments, and liabilities can complicate these
forecasts.
2. Banks use interbank loans and central bank loans to manage liquidity in the shortrun. Balance sheet structure manages it in the longer run.
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E. Market risk
 Risk that the market price of a publicly-traded asset will decline. Banks with large trading
portfolios face the greatest market risk. Market risk can be both on and off the balance sheet.
 Sophisticated banks use value-at-risk (VAR) models to measure market risk. The models
measure the possible future loss in a portfolio over the next day (daily earnings at risk, or
DEAR) which, with a certain probability (typically the 95 th or 99th percentile), will not be
exceeded under normal market conditions. VAR over n days = DEAR x SQRT(n).
 VAR models takes into account asset diversification and correlation. To do so, they estimate
each asset's standard deviation of price and the variance/covariance of asset prices in the
portfolio. An alternative is to calculate the variations in the value of the portfolio using prices
over the past, say, 500 days. One can then trace out a probability distribution function for the
value of the portfolio.
 VAR models give one aggregate measure of the market risk that the bank faces.
 To test for losses under abnormal market conditions, banks will run periodic (weekly is
common) stress tests. These tests revalue the trading portfolio under diverse extreme
conditions.
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III. Why do governments use regulation and supervision to limit risks
in the banking system?
A. There can be significant externalities associated with bank failures, so
banks may take on more risk than is optimal from a social point of view.
1. A bank failure can harm other banks
 Because it is difficult for outsiders to know the value of bank assets, a
bank failure can cause depositors to lose trust in other banks, even banks
in good condition. Depositors may run.
 Banks borrow from each other to deliver credit to the best projects and to
clear interbank payments on a net basis, so the failure of one bank can
cause losses to other banks.
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2. A run on one healthy bank may not create a problem because it may be able to
borrow from other banks. A run on many banks at the same time can result in:
 A disruption of bank credit as banks seek liquid assets to meet the demand for
withdrawals.
 A collapse in asset values from “firesales” of bank assets. This pushes banks
into insolvency.
 A suspension banks' ability to honor requests to withdraw or transfer deposits,
disrupting the payments system.
3. If there are widespread adverse shocks to banks, banks will not know quickly
whether other banks are solvent or not. The interbank loan market may stop
functioning. This disrupts the allocation of credit and slows the clearing of
interbank payments.
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4. Bank credit and the use of bank liabilities for payments are critical inputs for
most business and household transactions. Any widespread disruption will
cause spending and production to decline. GDP and employment fall.
5. Bank failures hurt loan customers if banks can acquire useful information
about the customers only by making a substantial investment. Loan clients
have long-term relationships with banks. Real resources are lost when a bank
closes.
B. Governments know that bank runs and failures can be costly to the economy,
and so in a crisis governments will have to insure bank liabilities to prevent
runs and the ensuing costs. Moreover, since households use banks for savings,
governments may face tremendous political pressures to insure bank liabilities.
This means that bank failures can be costly to the government. The government therefore has a fiscal interest in regulating banks to reduce the odds of
such failures.
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C.
Bank regulation is not intended to prevent banks from
failing. It is intended to reduce the externalities
associated with bank failures by arranging for orderly
closures. It is also intended to ensure that bank risktaking is optimal from a social point of view, not the
private viewpoint of the bank owners.
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IV. Government-Imposed Minimum Bank Capital Standards
 Capital directly protects depositors, or the insurance fund, in case of an unexpected
loan loss.
 Capital indirectly protects depositors because it reduces the owners' incentives to take
risks. The larger the capital, the less the incentive to take on risk. (An important
qualification: If managers seek to obtain a target ROE, increased capital could lead to
greater risk taking.)
 Another way to accomplish this is to make bank owners liable for some, or all, of a
bank’s loss. This then requires monitoring the owners’ net worth.
A. Simple approach
1. Regulators set a minimum capital asset ratio (or leverage ratio) and specified how
capital is to be measured. Standard is to cover credit risk.
L = core capital/average assets
Core capital = paid in capital + retained earnings
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Roughly speaking, a ratio of 5% or higher is considered “well-capitalized.” A ratio
under 4% is “inadequate.”
2. Book value of assets versus market values. Banks in the U.S. use book values, except
that securities in their trading account (which they do not plan to hold to maturity) are
valued at market values. Some European countries use market value for almost all bank
assets. Book value accounting does not capture capital changes caused by changes in
interest rates or exchange rates. This seems to argue for a market value accounting
standard. However, market value accounting is more difficult to implement.
3. Problems with the simple leverage ratio as a measure of capital adequacy
 If based on book values, a bank with a 2% capital/asset ratio could actually be
insolvent.
 Does not adjust for the level of risk in the balance sheet.
 Does not include off-balance sheet risks.
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B. The Basle Accord
The Basle Accord was initially put forth by the B.I.S. in 1988 and has been amended several times
since. It originated in a U.S./U.K. collaboration intended to harmonize minimum capital standards for
international banks in high-income countries. The concern was that, without international standards,
countries might try to build big banking industries with lax standards. Over 100 countries have now
adopted the BIS standards and they apply them to domestic as well as international banks. The BIS
recently announced a new set of standards that, if approved, are to take effect in 2006
The major innovation of the 1988 accord was that it adjusted required capital levels based on a crude
measure of the credit risk in a bank's portfolio.
1. Capital definitions
Tier I capital (core capital) = book value common equity (paid in capital and retained earnings) +
a limited amount of perpetual preferred stock + minority equity interests in consolidated
subsidiaries - goodwill.
(Goodwill is an accounting item that reflects the amount a bank pays above market value when it acquires other banks
or subsidiaries)
Tier II capital = general loan loss reserves (up to 1.25% of risk-adjusted assets) + convertible and
subordinated debt instruments with maturities over 10 years (up to specified limits).
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2. Calculation of risk-adjusted assets
Calculate capital/asset ratios using risk-adjusted measure of average assets.
Risk adjusted value of bank’s on-balance-sheet assets = Sum(wiai)
where w is the risk weight of the ith asset and a is the dollar book value of the ith asset.
Risk Weights for Various “Risk Buckets”
Category 1 (0% weight)
Category 2 (20% weight)
Category 3 (50% weight)
Category 4 (100% weight)
0, 10, 20, or 50% weight
Cash, CB reserves, and OECD government securities
OECD interbank deposits, cash in process of collection, and non-OECD bank deposits and government securities
Home mortgages
All other assets, principally loans to the private
sector
Claims on other public sector entities, such as
loans to municipalities. Weight is determined by
national bank regulators.
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3. Treatment of off-balance-sheet contingent and guarantee contracts
 First a credit-equivalent amount is calculated using a weighting system. For example:
100% weight
50% weight
20% weight
Direct credit enhancements (loan guarantees),
such as standby letters of credit
Unused credit lines with original maturity over
one year
Commercial L/Cs collateralized by underlying
shipment
 The risk adjusted asset value is calculated as follows:
Risk adjusted asset value = credit-equivalent value x risk weight
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4. Off-balance-sheet over-the-counter derivative contracts are also converted to credit-equivalent values to obtain a risk-adjusted asset value.
 Risk adjusted asset value = credit-equivalent value x risk weight
 Credit equivalent value = current exposure + potential exposure
 Current exposure = cost of replacing a derivative contract at today's
prices (can't be negative)
 Potential exposure = notional principal of contract x exposure conversion factor
 Exposure conversion factor depends on maturity of contract and assumed volatility of interest rates and exchange rates. Regulators set
minimum values.
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5. Treatment of market risks in the trading portfolio.
 Banks can choose between two ways to measure market risk.
 Use the BIS standardized framework. This puts bonds, FX, and equity into
numerous different categories and specifies capital requirements for each
category, recognizing some offsetting of risks.
 Subject to regulatory approval, banks can use an internal model to calculate
the value at risk (VAR).
 If the bank uses an internal VAR model, BIS standards require that the bank set
aside capital equal to the greater of:
 The previous day's 10-day VAR
 The average 10-day VAR over the previous 60 days multiplied times 3.
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6. BIS capital adequacy standards
Tier I > 4% adequately capitalized
Tier I > 6% well-capitalized
Tier I + Tier II > 8% adequately capitalized
Tier I + Tier II > 10% well-capitalized
B.I.S. standards also allow for Tier 3 capital, consisting of subordinated debt with maturity of
between 2 to 5 years. Tier 3 capital, which is capped at 250% of tier 1 capital, can only be used to
cover a bank's market risk.
7. How can a bank increase its capital/asset ratio?
 Sell equity - It is difficult to sell equity in a possibly insolvent bank since any new equity
contributions may go to cover the losses of the bank's creditors
 Retain earnings. This may not be possible if the bank has too many non-earning assets.
 Shrink the assets and liabilities of the bank
 Shift assets toward assets with little weight in the BIS risk-adjusted weighting formula.
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C. Current proposal for a new set of BIS capital standards
1. Problems with the Basle Accord standards
 They do not adjust for FX risk or interest rate risk (aside from those in derivative
contracts or in traded securities held in the trading portfolio), or asset
concentration risk.
 The credit risk categories are crude.
 Banks begin to exploit weaknesses in the rules, increasing the risk in balance
sheets. For example, banks securitize assets (such as low-risk commercial loans)
that have lower risk than rules would indicate. Leaves banks with higher-risk
assets on their books. Such moves are called regulatory arbitrage.
 The decision about capital adequacy is too mechanical. It does not ask banks or
their supervisors to think deeply about the various types of risk a bank faces and
whether capital is adequate for these risks.
 The Basle Accords may be too reliant on supervisory oversight to contain risks
rather than using market forces to penalize banks that take on too much risk.
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2. In 1999, the BIS proposed an outline for new capital adequacy standards. The
details are currently under development. They are to be finalized in 2003 and implemented beginning in 2006. The revised standards have three "pillars:
Pillar 1: The new standards attempt to measure balance sheet risks more accurately. Subject to supervisory approval, banks can choose one of two approaches:
 They can use a standardized approach with finer distinctions among credit risk
based on the ratings of approved third-parties. For example, loans to firms
with S&P AAA or AA- credit ratings would get 20% weight. Loans to firms
with B- rating would get 150% weight. The OECD/non-OECD distinction
will be dropped in favor or third-party credit ratings for governments. For
loans to banks, the risk weight would be one level above that of the home
country, or could be based on the credit rating of the bank itself.
 Banks can develop their own internal credit risk models and credit risk management systems.
The new standards do not change the overall 8% capital/asset ratio guideline, but
they add a measure of market risk and operational risk to the denominator.
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Pillar 2: The supervisory process is to adhere to four principles:
 Banks should relate their capital needs to their risk profile and must have a strategy
for maintaining adequate capital levels.
 Supervisors should review these arrangements and take action if they see
weaknesses.
 Banks should operate at above-minimum capital levels and supervisors should be
able to require above-minimum capital levels.
 Supervisors should intervene before capital falls below minimum levels.
Pillar 3: Enhance the role of market discipline by requiring banks to release a set of
uniform disclosures at regular intervals.
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V. Other Government Regulations to Address Bank Safety & Soundness
A. Entry restrictions and usury ceilings on deposit interest rates and floors on
loan interest rates to prevent "ruinous" competition.
 Enhances charter value which should make owners more cautious.
 Enhances power of political parties, agencies, or people giving out charters.
 Trade-off of stability (safety and soundness) versus competition (innovation
and efficiency).
B. Monitor prudent banking practices with respect to liquidity, interest rate risk,
and exchange rate risk.
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C. Accounting standards. Transparent accounting aids market discipline and
government supervision.
 Bad loans can easily be hidden by making new loans to enable the borrowers to
pay the interest or by reporting interest earnings even when the interest is not
being paid. This can make an unprofitable bank look profitable. Called
"evergreening."
 Regulators set rules for declaring nonperforming loans and setting aside loan
loss reserves. Restrictions on making new loans to cover interest payments on
old loans.
 Reports should be on a consolidated basis for banks with affiliates or for bank
holding companies. Point is to reveal weak affiliates and to cancel out interfirm dealings that strengthen one company at the expense of another.
D. Restrictions on portfolios
 Diversification across businesses and industries. Typically, exposure to any
one business is not to exceed 10% of capital.
 Restrictions on holding higher-risk securities.
 Restrictions on off-balance-sheet exposure (guarantees, letters of credit, etc).
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E. Approval of management and ownership
 Regulators prevent those with criminal records or other problems from
serving in top management or on board of directors. Charter approval is
contingent upon having a good management team.
 Regulators require “good” management practices. Clear organizational
chart and lines of authority. Prudent practices.
F. Requirements for arms-length business dealings
 Restrictions on insider lending. Loans to board members or top management must be reported. Restrictions on extent of such loans.
 Separate banking ownership from ownership of nonfinancial firms. Limitations on business dealings of affiliates. Countries differ widely on the degree to which they require banks to be separate from nonfinancial firms.
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G. CAMEL ratings. A short-hand method that regulators use to evaluate banks is to
issue a CAMEL rating. CAMEL is the acronym for:
 Capital adequacy
 Asset quality
 Management
 Earnings
 Liquidity
In the U.S., regulators rate banks from 1 to 5 on each of these measures; 1 is the best.
H. Discretion versus "prompt corrective action."
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VI. Issues in bank regulation in lower-income and transition economies
A. Many economists argue that BIS standards are not appropriate for most developing
countries since banks in DCs are exposed to much higher levels of risk.
 Most bank loan portfolios are poorly diversified geographically and across industries.
 Banks frequently face significant ER risks.
 Much larger macro shocks (GDP, ER, interest rates, etc) in these economies.
Implication: Banks need to meet higher capital standards and need to come up with
creative ways to diversify (syndicate loans internationally, open economy to branches
of foreign banks, etc.). Perhaps "market discipline" should be enhanced.
B. Connected and inside lending is a common problem. Regulations need to improve
in this area.
C. Enforcement of regulations is as much of a problem as the actual regulations. Enforcing regulations means taking on powerful people.
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VII. Nonbank Depository Institutions
A. Thrifts, savings banks, or other special depository institutions.
 These are regulated to channel credit to specific sectors, such as housing or agriculture. They
are generally given some regulatory advantage in obtaining liabilities with appropriate maturities.
 Some are privately owned, some are organized as not-for-profit cooperatives, and some are
government owned.
 Commonly function as savings institutions for the middle-class.
B. Credit unions. Not-for-profit cooperatives that were started in Germany in the 1850s. Spread
to many other countries. They are commonly restricted to taking retail deposits and making consumer loans or small scale business loans.
C. Most non-bank depositories are regulated similarly to banks but get less attention since they
are smaller and impose less systemic risk.
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