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
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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 and buildings) less
secure, banking crises associated with falling property
prices (e.g. in Japan in the 1990s 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.
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UK
REGULATORY FRAMEWORK
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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
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REPUTATION EFFECT ? Self Regulation ?
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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).
© K.Cuthbertson, D.Nitzsche
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
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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).
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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
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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
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
© K.Cuthbertson, D.Nitzsche
US
REGULATORY FRAMEWORK
FOR
BANKS AND S&L’s
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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.
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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.
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USA
MODERNISING THE FINANCIAL SYSTEM
1992 onwards
© K.Cuthbertson, D.Nitzsche
USA : MODERNISING THE FINANCIAL SYSTEM
Increase Capital Ratio of Weak Banks by:
Divesting assets (eg. Closing branches)
Issue new equity
Increase margins: rL - rD. This may imply increased
profits
Merge with “healthy” bank or non-financial company
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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
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The Regulators
annual on-site investigation
accurate capital measures/reserving
some market value reporting
improve reporting from auditors
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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
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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
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ENDS
LECTURE
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