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Now in this episode,
I will describe the Basel Process or the process of
global banking regulation that has been developing
for the last 30 years and again in order
to study the letter of that takes a lot of time and they have to be a specialist in that.
The spirit of that, we will emphasize,
but we will also see how the new requirements and the new developments of this process.
They were the reaction to
some important things and problems that occurred in capital markets worldwide.
So first of all,
I will start with the balance sheet of a bank once again,
in some what more detail.
So I will start with the liabilities side.
So on the right side here there is equity,
that in banking is most often called capital and here we have demand deposits,
we have time deposits,
we have some hybrid financing that may be some instruments that,
some features of equity,
some features of that,
it doesn't really matter much.
Now what happens on the asset side.
Well first of all, there are some reserves.
So this is the money that the bank cannot take and invest in anything and this
is used to prevent some potential bank run problems not in full,
but to make sure that this problem is not as acute.
Then we have loans and then we have securities of various kinds.
Then we may have derivatives and so on and so forth.
So there is the full universe of various investments.
Now, and there are two major ideas about the regulatory process.
So ideas are, number one solvency.
Solvency that basically means that the market value of
assets is greater than the market value of liabilities.
Remember what happened with S&Bills,
when the market value of assets
dropped significantly then we ended up in the situation of negative equity.
So the idea of solvency is to engage in
certain actions that would effectively prevent this situation from happening.
And then the other one is liquidity.
Because we know that,
that is no runs.
So although you might have a lot of assets that do we have
market value and maybe your equity capital is positive,
but when there are too many people coming and
requiring that you would give them cash back,
then you might face a problem.
So these are two major ideas,
I'm just reminding you about that.
And from that, we will go ahead and talk about the Basel requirements.
So, the requirements of regulation. I will put that like that.
They may fall into categories as well.
These are limitations.
So you have to make sure that you have certain ratios no less than this and that.
And then another one is procedure's because for example,
you can always saying that well this is
the right ratio but then they have to make sure that there is
an efficient way to ensure that this ratio is not only reached but also is supported.
Now the examples of that will be let's say some kind of reserve requirements,
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then reporting, such a thing as incentives.
They may be sort of here and there.
But overall this is about like this.
Now it's the time to draw a line and start talking about Basel process.
Now Basel process was started in Switzerland,
in Basel Switzerland in nineteen eighty eight by the introduction of
the so called Basel one requirements,
that happened in 1988.
So they primarily dealt with
solvency and they introduced some ideas like,
the risk weighted average.
So if we go back for a moment for this,
balance sheet, they basically ascribe some coefficients of the risk to these assets.
And if let's say, you hold a lot of derivatives that are very risky,
then the average market estimate of your assets will be much lower.
So if it is lower,
then you are forced to raise your capital or otherwise you risk insolvency.
Then also here, closely to that are capital requirements and also this,
that is about the same if you have,
this is leverage requirements.
So basically all that dealt with the idea that,
we have to prevent situations when a bank might find,
or a bank like institution that is covered by this kind of regulation.
That it does not find itself in the situation when
the market value of its assets falls short of the market value of liabilities.
Now, that
The time would go by, and then,
there was the development of that in Basel II 2004.
Well, you can say that nothing really bad happened in between 88 and 2004.
Well, with the exception of the dot com crisis there can hardly be closer link to this.
But then, the main emphasis has shifted a little bit because that time,
witnessed the introduction of a lot of new and very risky financial instruments.
So the major emphasis here was risk.
You can say, well, this is not exactly the solvency as liquidity.
Well, it is both to an extent.
So, what they did there were
refined capital requirements because
just straightforward capital requirements happened to be not very efficient.
Then, risk management systems,
because it happened to
be a problem to properly address the risk of these assets.
The question was, who measures this risk?
Because for example, if the institution does that using its proprietary measures,
proprietary models, then clearly,
they have an incentive to first of all,
not to do that transparently,
and second of all, to sort of support their own interests.
Then, also, there were some other things here.
But the general idea was to be sure that we deal with this risk properly.
And then finally, there is Basel III,
that is 2010 and 11 and on,
because this is a developing process.
And here, there was a lot of other things addressed.
First of all, again, at the first glance,
it seems to be close like capital adequacy.
Well, we said we already have that.
But like I said,
it's always like when you
introduce new financial instruments and they have to react properly.
Then, again, it was leverage revisited.
And the main emphasis was on liquidity here.
So, in our dichotomy,
we can say that this is liquidity.
And I would put in the red two huge issues that were introduced for the first time,
because that was after the acute phase of the global financial crisis.
This is stress tests.
So, the banks should pass these stress tests.
So, what if the economy takes a negative path?
What would happen with the assets,
the levels of this of this bank?
And would it still be able to
stay within these requirements for both solvency and liquidity?
And finally here, so,
I would put a big exclamation mark here.
And then, the laws, the issue of too big to fail was addressed here.
Well, we study this issue in much greater detail in our fifth week,
and some in the sixth week too.
So here, I would just say that,
it was for the first time recognized.
Now, what else can be said about this Basel process?
Well, I would say that clearly,
with this whole process is the reaction to
new high risk instruments
because I mentioned before that regulator was always behind,
and the financial institutions always ahead.
That means that, you introduced some regulation.
And then, the banks find a way,
so as to stay within these regulations but
still expose the investors to significant risks.
Now, the issue of too big to fail, like I said,
just was another challenge because basically,
this is blackmail on the side of the bank.
And they say, well,
we keep doing these things,
and if you don't help us,
if you don't save us if bad things happen, then,
you cannot afford it because we will bury under ourselves big segments of the market.
So here, I would also mention the criticism of this process.
Well, as always, some people say that restrictions are bad. We talked about that.
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But some people would say that it's the other way around.
So, these requirements
are not bold enough.
So basically, we are not in this case reaching the goal,
so we have to be tougher.
Because they said, these people said,
you allow this phenomenon of too big to fail to happen and to develop.
So, somehow, this regulation in this process,
it has failed to prevent that from happening.
Now, I would wrap this up by opening some other ideas.
So, here now, we have globalization of capital markets,
and we can no longer ignore some,
I would put Geo in brackets, political issues.
That unfortunately, sometimes these global political events,
they really influence not only the behavior of biggest financial institutions,
but also the risks that are potentially
incurred by the participants in the market process.
So, as you can see,
now it's a time to recall that there is a letter of regulation,
and there's a spirit of regulation.
We are talking primarily about the spirit of the reasons,
the ideas, the goals, and the meaning.
If you want to study the letter of that how exactly it's introduced,
what are these ratios,
then, this can easily be found in
the materials that are mentioned in handouts to this course.
But this is a very specific technical thing, and also,
it requires some legal background because all these requirements,
they have to be observed,
and at some point in time,
they may be enforced.
Now, I am completing the description,
the brief, and overall description of the idea of bank regulation.
And from now on, we are moving to another thing that
we have so far seem to have ignored here.
We will talk about the things that are for the most people are key in banking,
but the ones that we have not so far addressed.
This is the payment services,
and as we will see the development of the way that foreign banks operate.
Konstantin KontorDirector and Professor of Finance and Strategy
