Version 192001 FINANCIAL ENGINEERING DERIVATIVES AND RISK MANAGEMENT

Version 1/9/2001 FINANCIAL ENGINEERING: DERIVATIVES AND RISK MANAGEMENT (J. Wiley, 2001) K. Cuthbertson and D. Nitzsche Lecture Regulation in the UK and USA © K. Cuthbertson, D. Nitzsche

Topics Reasons for Concern UK: Regulatory Framework US: Regulatory Framework for Banks and S&Ls US: Modernising the Financial System 1992 Onwards © K. Cuthbertson, D. Nitzsche

Reasons for Concern Increased global competition, narrowing of margins More firms raise money from the capital markets, which leaves banks with less credit worthy companies Collateral (e. g. in the form of land buildings) less secure, banking crises associated with falling property prices (e. g. in Japan in the 1990 s and Thailand in 1997/8) Margins on lending have been squeezed by increased competition and the ending of cartels The growth in ‘off balance sheet’ items, such as forwards and swaps has led to increased credit risk exposure. © K. Cuthbertson, D. Nitzsche

UK REGULATORY FRAMEWORK © K. Cuthbertson, D. Nitzsche

UK, REGULATORY FRAMEWORK STRUCTURAL REGULATION who is allowed to engage in activities “fit and proper persons”, capital base. CONDUCT REGULATION ensures ‘product quality’ eg. Good risk control, accounting, no misleading information FSA : Financial Services Authority~UK © K. Cuthbertson, D. Nitzsche

REPUTATION EFFECT ? Self Regulation ? © K. Cuthbertson, D. Nitzsche

UK Banking Act (1987): Board of Banking supervision to assist the Governor of the Bank of England in his supervisory responsibilities. To be licensed as a bank, requires a minimum level of paid up capital and those running the bank must be ‘fit and proper persons’. Bank auditors should have close liaison with the supervisors and banks are legally obliged to report large exposures (eg. to a specific borrower).

UK Banking Act (1987): Capital adequacy and liquidity ratios were to be monitored but there were no minimum mandatory targets to be set across the board. As in the 1979 Banking Act, depositor protection was retained. (This is now currently at £ 20, 000 per depositor, or 75% of a persons total deposits, whichever is the smaller). ‘CAMEL approach’: Capital Adequacy, Asset Quality, Management Quality, Earnings and Liquidity. Adopted Basle Accord of 1988, for credit risk and principle of subordination

UK Building Societies Act (1986) Loosened restrictions on the lending and deposits Allowed diversify (eg. selling insurance, buying and selling shares, entry into Estate Agency). A (fixed maximum) proportion of lending could now be unsecured (rather than solely backed by property) and they could enter the wholesale deposit market for a proportion of their deposit funds. UK Building Societies therefore became more like banks and they are now allowed to convert to full public liability companies (eg. Abbey National plc, Halifax plc).

Financial Services Act 1986 Security and Investment Board (SIB). The SIB was to oversee and certify the rule books of a group of self-regulatory organisations (SROs). If an individual (firm) is allowed to become a member of an SRO, then this becomes a ‘license to practice’. The rule books of the SROs were therefore the effective ‘entry hurdle’. Regulatory Capture

Financial Services Authority, FSA (1999/2001) Took over the resposibilities of the Security and Investment Board (SIB) and the group of self-regulatory organisations (SROs). Responsibility for regulation of banks and building societies also (later) transferred to FSA is now the ‘super regulator’ Overseas, compliance with Basle rules on market and credit risk for banks, as well as regulation of investment and life assurance funds. Bank of England retains responsibility for ‘systemic risk’ in the banking system

US REGULATORY FRAMEWORK FOR BANKS AND S&L’s © K. Cuthbertson, D. Nitzsche

USA : Bank and S&L Failures in 1980’s S&L’s failed with huge losses to the taxpayer Payouts from the Federal Savings and Loan Insurance Corporation (FSLIC), so it became insolvent. The defaults in banking were less severe numerous banks failed and again (some of) their deposits, covered by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (FDIC). The FDIC sustained losses in the 4 years to 1991 and also threatened to become insolvent.

USA : Bank and S&L Failures in 1980’s Regulatory procedures Corrective Action: only allow the bank to remain open if it can raise enough capital to satisfy minimum capital requirements within a reasonable period of time. Forbearance: allow the bank to continue operating with low capital and some additional restrictions on its behaviour so it can rebuild its capital base. Government Investment: the government provides some or all of the capital the bank needs to comply with minimum capital requirements.

USA MODERNISING THE FINANCIAL SYSTEM 1992 onwards

USA : MODERNISING THE FINANCIAL SYSTEM Increase Capital Ratio of Weak Banks by: Divesting assets (eg. Closing branches) Issue new equity Increase margins: r. L - r. D. This may imply increased profits Merge with “healthy” bank or non-financial company

Limit Deposit Insurance $100, 000 per individual Eliminate coverage for brokered deposits Don’t pay out to uninsured depositors (e. g. Continental Illinois) Investigate Risk Based Deposit Insurance Premiums Get private sector to insure some deposits

The Regulators annual on-site investigation accurate capital measures/reserving some market value reporting improve reporting from auditors

FIVE ZONES OF CAPITAL ADEQUACY Zone 1 : engage in wide range of activities new acquisitions granted (mergers) Zone 2 : regulator expects to move to Zone 1 will not allow new activities unless managers are adequate

FIVE ZONES OF CAPITAL ADEQUACY Zone 3 : dividend restrictions, remove management constraints on loans (type) Zone 4 / 5 : bank into conservatorship presumption that congress cannot stop/impede regulator

ENDS LECTURE © K. Cuthbertson, D. Nitzsche