Transcript Intro to Banking 8

Guy Hargreaves
ACE-102
Recap of yesterday
 Key risks managed by banks
 Tools used to manage bank balance sheet risks
 Pros and cons of regulations for balance sheet risk
management
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Today’s goals
 Appreciate the reasons for strong bank regulation
 Understand the history of bank regulation
 Describe the typical types of financial crises
 Discuss the causes and effects of the 2007-9 GFC
 Appreciate the impacts of financial crises on the real
economy
 Review current and future proposed bank regulation
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Why do we need bank regulation?
 Financial systems suffer periods of instability

Business cycle, fundamental changes, technology can all cause
instability
 The banking sector is vulnerable to this instability due
to its in-built high leverage
 An unstable banking system can cause “bank runs”
when depositors lose confidence
 Central bank regulation of banks and the banking
system is vital to minimise the chances of banking
system instability and to protect bank customers
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Types of bank regulation
 Bank regulations come in the form of either Systemic
Regulation of Prudential Regulation
 Systemic regulation is usually:
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Government deposit insurance
Lender of last resort
 Prudential regulation is usually:
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Capital rules
Liquidity rules
Code of conduct
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History of bank regulation
 Each local financial system has its own history of bank
regulation
 Globally a number of major regulatory milestones have
had widespread impact:
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1933 Glass-Steagall – separation of Investment and Corporate
Banking in the US (largely repealed in 1999)
1988 first Basel Capital Accord “BIS I”. Concept of Tier 1
(Equity) and Tier 2 (sub debt, hybrids, other) and Risk
Weighted Assets (RWAs). Tier 1 + Tier 2 capital = 8% * RWA
1996 second Basel Capital Accord “BIS II”. Three “Pillars” – 1:
capital, 2: supervisory review, 3: disclosure
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BIS II
 Currently the “global” banking system is supposed to be
operating under BIS II
 Pillar 1:
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Risk Weightings aligned to actual expected credit risk
Credit risk calculation could be “Standardised” or “Internal Ratings
Based”
Market and Operational risk also included
 Pillar 2:
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Boosting regulatory powers to review and supervise banks
 Pillar 3:
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More disclosure of risk, capital adequacy and risk management
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Financial Crises
 There are many types of financial crises, including:
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Banking crises
Currency crises
Speculative asset price bubbles
Economic crises
 2007-9 GFC was mostly a banking crisis but it came
from a speculative asset bubble
 Economic crises are usually deep recessions or
depressions where GDP falls sharply
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Banking Crises
 Loss of confidence in a bank or number of banks
leading to bank run where depositors withdraw funds
rapidly
 Often associated with periods of poor lending
decisions leading to high loan portfolio loss provisions
 High leverage in the banking system means
confidence is fragile

Small loan losses can quickly turn into a banking crisis
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Currency Crises
 A large increase in country risk can cause foreign investors
to lose confidence in the country
 Country risk might come from a local economic crisis or
perhaps political change
 Foreign investors will sell a currency quickly if they lose
confidence

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25%+ fall on relevant FX rate
Often the Central Bank will try to support the currency by increasing
local interest rates
 1997 Asian Currency Crisis is classic example of currency
crisis – began in Thailand and flowed across the region
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Currency Crises - IDR
Indonesian Rupiah – USD FX rate:
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Speculative Asset Price Bubbles
 A speculative asset price bubble is a large increase in
the price of an asset, often over longer periods, which
leaves the asset valuation out of line with underlying
fundamental valuations
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Dutch tulip bubble of 1637
1929 Wall St crash
1980s Japan property bubble
Late 1990’s “dot-com” bubble
US housing price bubble 2003-6
 Bubbles usually end with a large price crash!
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2007-9 Global Financial Crisis
GFC had its roots in US property prices
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2007-9 Global Financial Crisis
US property prices from 1987:
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Over-investment in property
 Both US Agency lenders (Fannie Mae and Freddie
Mac) lent aggressively to US home buyers in 2002-6
 Securitised lenders also lent aggressively over this time
– Investment Banks arranged funding of their using
securitisation
 Loans for “sub-prime” borrowers were made at 100%
LVR!
 By 2006 the US property market was a bubble financed
by lenders and investors all over the world, often using
large amounts of leverage
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The property bubble bursts
 In 2006 the US property market bubble burst and
mortgage borrowers started defaulting in large numbers
 Banks had massive exposure to the mortgage loan business
through loans and securitised products
 By 2007 banks around the world were reporting huge losses
and confidence in the global banking system had collapsed
 Extraordinary measures were taken by 2009 to rescue the
system
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USD 700m TARP recapitalised the US banking system
USD short term interest rates were lowered to near 0%
Banks and insurers were forced into mergers or government
ownership
Etc etc!
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Fed Funds
Fed Funds lowered to historic levels:
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Impact on the “real economy”
US GDP growth collapses during the crisis:
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Impact on the “real economy”
US unemployment rises sharply from 2008:
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Impact on the “real economy”
 US automobile industry goes bankrupt and needs
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government bailout
AIG – large international insurer - nationalised
Bank of America forced to buy Merrill Lynch
Property market collapse worsens
US government injects USD2 billion+ into the
economy through fiscal measures
Etc etc!
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Conclusion: improve bank regulation
 The 2007-9 wasn’t just a US crisis – Europe has had
enormous problems as well
 Result was fast track Basel / BIS III
 US passed “Dodd Frank” law
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Reduce bank trading
Increase derivative transparency through clearing
Allow for orderly bank closures
Rid system of “too big to fail”
Reform mortgage market
Toughen consumer finance protection laws
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BIS III
 Required Capital – increase required capital – Tier 1 up
from 4% to 6%
 Introduce Leverage Ratio – ratio of Tier 1 capital
divided by “total exposure” to be a minimum of 3%
 Introduce Liquidity Cover Ratio – High quality liquid
assets divided by net cash outflow over the next 30
days >100%
 Introduce Net Stable Funding Ratio – Long Term
Stable Funding divided by Long Term Assets (> 1-year)
> 100%
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BIS III
 Introduce counter-cyclical capital buffers – increase capital
in good times so banks have more protection for bad times
 Strengthen risk frameworks across a lot of areas of the
banks eg:
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Credit Valuation Adjustment (CVA) for swap counterparty risk
management
OTC derivative clearing through centralised exchanges
 BIS III is costly for banks and will be less efficient (ie a
burden for the global economy) - but should strengthen
the banking system
 Timetable for introduction 2011-19
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Banking of the future?
 Banking in the future may look nothing like the past!
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Same basic functions of financial intermediation and direct
finance will probably exist
“Fintech” or Financial Technology is changing the banking
landscape dramatically
2000: 300M internet users mostly on dial-up
2015: 3,000M internet users mostly on 4G smartphones
 Cryptocurrencies – what if Bitcoin is the future?
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P2P decentralised “trustless” “currency”
No Central Bank can control supply of cryptocurrencies
The “Blockchain” may change banking forever!
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Fintech at a glance
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Fintech is the place to be!
 Retail branch banking will die out with our parents!
 Everyone has a smartphone and can use it to bank
 Banking has been slow to change and adopt
technology in the past 20 years
 Disruption is the BIG economic theme of the 2010s
and probably the next two decades
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Think Uber, Paypal, iTunes Store, Amazon, Alibaba, Tencent
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