How can banks be Regulated?
The financial crises has raised the question of how banks should be regulated. There could either be:
- Statutory Regulation
- Self-Regulation
What are the benefits of Self-Regulation?
- Less red tape, so fewer regulation costs are passed onto customers
- Before government regulation banks held much more capital and self-regulation was effective
- Incentives, rather than rules encourage self-regulation
- Additional rules did not stop the banking crises in 2007
What are the Benefits of Statutory regulation?
- The economy depends on banks, so regulation must be stringent
- Banks only pay lip service to self-regulation
- There is no such thing as safe highly leveraged institution
- So far, self-regulation has been weak
- If firms are too big to fail they must be regulated from the outside
What is Corporate Governance?
Corporate Governance is the relationship between a firm’s directors, its shareholders and stakeholders
- Management, awareness, evaluation and mitigation of risk are all definitions of good governance
- Willingness to apply the spirit and letter of the law
- Good supervision and management enhances performance
- Accountability to shareholders and stakeholders is key
- Attracts new investment into companies
- Underpins capital market confidence in the firm
- Provides a framework for a firm to pursue its strategy in an ethical and effective way
Which independent UK regulator promotes high standards of Corporate Governance and how?
The Financial Reporting Council through the Combined Code – last updated in 2014 – but 2008 used here ***
What does the Combined Code 2008 consist of?
- Board Structure
- The Board – responsible for the company’s success
- Board Balance – mixture of directors and NEDs
- Chairman and CEO – should be separate
- Board Appointments – formal, rigorous selection procedure
- Board Performance
- Re-election – at regular intervals, subject to good performance
- Remuneration Procedure – independent, formal and transparent
- Remuneration – sufficient to attract, retain and motivate
- Performance Evaluation – rigorous annual evaluation
- Control
- Financial Reporting – a balanced and understandable assessment
- Internal Controls – robust to safeguard assets
- Audit Committee and Auditors – maintaining internal control procedures
- Shareholder Relations
- Relations with Shareholders – dialogue based on mutual objectives
- Constructive Use of the AGM – to encourage participation
- Shareholder Voting – shareholders should use votes carefully
What was the Walker Review and what were its specific recommendations?
- Recommendation 23 – board should establish a board risk committee separately from the audit committee for oversight of risk exposures and future risk strategy
- Recommendation 24 – board should be served by a CRO (Chief Risk Officer) who should report to the CEO and the board risk committee
- Recommendation 25 – the board should have access to external input to help with its work
- Recommendation 27 – the board risk committee should produce a separate risk report for the annual report and accounts
- Recommendation 26 – for strategic acquisitions or disposals, the board risk committee should oversee a due diligence appraisal
What is the Role of the Board?
- Leadership and prudential control of the firm
- Meeting its obligations to shareholders
- Making entrepreneurial decisions
- Chairman leads the board
- Company secretary ensures good information flows within the board and its committees
- NEDs scrutinize and challenge the board and help develop strategy
What is the Role of the Remuneration Committee?
- Develop a remuneration policy to attract, motivate and retain directors
- Appointing consultants to help decide remuneration
What is the role of the Audit Committee?
- Should comprise of at least 3 (or 2 for smaller firms) NEDs
- Members should have recent and relevant financial experience
- Focus on the correctness of financial statements and the effectiveness of internal controls
What is the role of the Risk Committee?
- Assist the board in assessing the different types of risk the firm is exposed to
- Must be composed of at least 3 members and majority should be NEDs
- Chairman must be a NED
- Help define risk appetite and to monitor the effectiveness of risk management across the firm
- Encourage a risk awareness culture
What is Due Diligence in Risk Oversight?
Due Diligence in Risk Oversight looks at risk scenarios and sets about an approach to deal with the risks:
- Risk Assessment Areas:
- Customer type and behaviour
- Products and services
- Delivery channel and location
- Questions
- Risk posed by customer product mix?
- Customer interface with the firm?
- Risk posed by customer?
- Monitoring
- Sudden increase in activity
- Strange transactions
- Peaks of activity at certain places
- Mitigation
- Systems to identify unusual activity
- Asking additional questions
- Applying customer due diligence
What is the importance of Culture and Leadership?
A firm’s risk culture encompasses the general awareness attitude and behaviour towards risk
- The CEO should lead by example to develop risk culture
- The internal control culture sets lines of responsibility and segregation of duties
- A good risk culture should be embedded within the firm
What is Moral Hazard?
The risk that the presence of a contract will affect the behaviour of one or more parties. E.g. and agent might act irrisponsibly to the principal if they know they won’t be affected. A bank will take silly risks if it knows the govn will bail them out.
- A party insulated from risk may behave differently
- Related to information asymmetry (one party has more info than another)
- Individual does not take full responsibilities for actions
What did the Financial Services and Markets Act 2000 give the FSA?
Regulatory powers and 4 objectives:
- Market Confidence – to maintain confidence in the financial system, included all regulated firms, markets and exchanges
- Financial Stability – contributing to the protection and enhancement of the UK financial system
- Protection of Consumers – to secure the appropriate degree of protection for consumers
- Reduction of Financial Crime – to reduce the extent to which the financial system can be used for crime
What did the Financial Services Act 2012 do?
Introduced a new regulatory structure:
- Prudent Regulation Authority – a prudential regulator established as a BoE subsidiary. Will take a judgement –based approach to assess business risk, financial strength, risk management/governance and resolvability
- Financial Policy Committee – a macro-prudential regulator established within the BoE
- Financial Conduct Authority – a conduct of business regulator. Will take a rules-based approach to ensure consumer protection, efficiency and choice and the protection and enhancement of the UK financial system
What is the EBA, its roles and responsibilities?
European Banking Authority -established in 2010 with considerable powers over domestic regulators.
Roles – act as a hub and spoke of EU and national bodies to safeguard
- The stability of the financial system
- The transparency of markets and financial products
- Depositors and investors
Responsibilities
- Preventing regulatory arbitrage
- Guaranteeing level playing field
- Strengthening international supervisory coordination
- Promoting supervisory convergence
- Providing advice to EU institutions
What is Risk-based Capital?
Risk-based capital is the blending of the assessment of the amount of risk faced by a firm against the level of capital to be held to provide resistance to that risk.
What requirements did Basel I make of capital – what were the benefits & limitations?
1988 Basel Accord made capital requirements more risk sensitive and commensurate with the degree of risk in bank’s balance sheets. The PRA adopts a risk-based approach and UK banks capital requirements have largely been dictated by Basel I.
Benefits:
- Helps to identify threats, weaknesses and opportunities
- Helps to align risk appetite with capital allocation
- Enhances strategic and tactical decision-making
Limitations
- Basel I doesn’t consider interest rate, legal reputation and operational risks
- Only as good as the reliability of data, validity of assumptions and quality of application that underpin it
What did Basel II aim to do?
Basel II (2004) aimed to make the framework more risk sensitive and representative of modern risk management
Concepts:
- More sensitive to the risks that firms face
- Reflects improvements in firm’s risk management
- Provides incentives for firms to improve risk-management
- Aims to leave overall capital held broadly unchanged
Framework:
- Pillar 1 – minimum capital required. Quantifying risks arising from firm’s credit, trading and businesses
- Pillar 2 – supervisory review. Establishing strong dialogue between a firm and the regulator on risks
- Pillar 3 – market discipline. Robust requirements on public disclosures given to the market
What was Basel III (2009)?
Basel III was devised as a result of the 2007 financial crises:
- From 2019 lenders require a 2.5% conversion buffer, leaving banks with a total core capital of 7% of their risk-weighted assets
- Tier-one capital ratio increases from 2% to 4.5%
- Increased capital charges for firms involved in derivatives and securities markets
- Liquidity coverage and net stable funding ratio introduced
- Leverage ratio – to counter excessive leverage
- Net stable funding ratio – ensuring stable funding
- Capital conservation buffer – restrictions on capital distribution
- Comprehensive risk capital charge – applied to correlation trading portfolios
- Required stable funding – assets that need stable funding
- Counter-cyclical buffer – protection against excess credit
- Incremental risk capital charge – includes default risk
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Risk Management Concepts16
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Risk Identification14
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Risk Assessment9
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Risk Mitigation5
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Monitoring and Reporting6
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Risk Management Framework I16
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Risk Management Framework II18
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Risk Management Framework III14
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Applying Credit Risk Practices24
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Defining Operational Risk20
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Regulatory Risk20
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The Impact of the Global Banking Crises 2007/89
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Cyber and Electronic Security Risks9
