Financial Regulations of Financial Institutions

We mentioned in the previous learning outcome statement that financial institutions’ systemic importance results in heavy regulation of their activities. Financial regulation is a form of supervision, subjecting financial institutions to specific requirements, restrictions, and guidelines in an attempt to constrain excessive risks associated with these institutions.

Global and regional regulatory bodies are established to minimize systemic risk, to harmonize and globalize regulatory rules, standards, and oversight. The regulatory standards and regulations need to be consistent to minimize regulatory arbitrage around the world. Regulatory arbitrage exists when multinational companies capitalize on differences in jurisdictions’ regulatory systems. They aim to avoid unfavorable regulations.

The Basel Committee

The Basel Committee on banking supervision is one of the most crucial global bodies which focuses on financial stability. It is a standing committee of the Bank for International Settlements, made of representatives from central banks and bank supervisors from around the globe. It has an international regulatory framework for banks known as Basel III. Notable highlights of Basel III include minimum capital requirements, minimum liquidity requirements, and stable funding requirements. 

The minimum capital requirement prevents a bank from assuming so much financial leverage that it is unable to withstand loan losses (asset write-downs). Also, Basel III sets out that a bank should hold adequate high-quality liquid assets. This is to cover its liquidity needs in a 30-day liquidity stress scenario.

The minimum liquidity requirement ensures that a bank would have enough cash to cover a partial loss of customer deposits and other borrowings or other cash outflows.

Lastly, Basel III demands that a bank must have a minimum amount of stable funding relative to the bank’s liquidity needs over a horizon of one year. For example, longer-term deposits are more stable than shorter-term deposits. Also, funds from consumers’ deposits are regarded as more stable than funds raised in the interbank markets

Basel III has encouraged banks to focus on asset quality, hold capital against other types of risk (e.g., operational risk), and develop improved risk assessment processes as a result of preventing banks from assuming excessive financial leverage. It also presents fundamental changes regarding the quality and composition of the capital base of financial institutions. Besides, it has improved the ability of their capital base to sustain losses, so these are confined to the financial institutions’ capital investors, thereby reducing the risk of contagion.

Finally, there are many regulators with overlapping and differing responsibilities over financial institutions globally, making the global system of regulators and the resulting regulations complex. Also, as financial institutions’ operations expand globally, compliance requirements increase. For example, HSBC Holdings is one of the most global financial institutions. It discloses that their operations are “regulated and supervised by nearly 400 separate central banks and other regulatory authorities in those countries in which they have subsidiaries.” These authorities impose a variety of requirements and controls.

Question

Jefferson Smith is a recently hired actuarial analyst at JPMorgan Chase. Jefferson meets with his supervisor, Bansri Patel, to discuss the key aspects of financial regulations, particularly the framework of Basel III. Bansri tells Jefferson:

“Basel III sets out the minimum percentage of its risk-weighted assets that a bank must fund with equity. This requirement of Basel III hinders a bank from assuming too much financial leverage to make it unable to withstand loan losses or asset write-downs.”

The aspect of the Basel III structure that Bansri describes to Jefferson relates to the minimum:

   A. Liquidity requirements.

   B. Capital requirements.

   C. Amounts of stable funding requirements.

Solution

The correct answer is B.

The minimum capital requirement prevents a bank from assuming so much financial leverage that it is unable to withstand loan losses (asset write-downs).

A is incorrect. Basel III sets out that a bank should hold adequate high-quality liquid assets. This is to cover its liquidity needs in a 30-day liquidity stress scenario. The minimum liquidity requirement ensures that a bank would have enough cash to cover a partial loss of customer’ deposits and other borrowings or cash outflows.

C is incorrect. Basel III demands that a bank must have a minimum amount of stable funding relative to the bank’s liquidity needs over a horizon of one year. For example, longer-term deposits are more stable than shorter-term deposits. Also, funds from consumers’ deposits are regarded as more stable than funds raised in the interbank markets.

Reading 14: Analysis of Financial Institutions

LOS 14 (b) Describe key aspects of financial regulations of financial institutions.