Gleeson international regulation of banking; capital and risk requirements, 2e (2012)

INTERNATIONAL REGULATION OF BANKING INTERNATIONAL REGULATION OF BANKING Capital and Risk Requirements SECOND EDITION SIMON GLEESON Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Simon Gleeson, 2012 The moral rights of the author have been asserted First Edition published 2010 Second Edition published 2012 Impression: All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence Number C01P0000148 with the permission of OPSI and the Queen’s Printer for Scotland British Library Cataloguing in Publication Data Data available Library of Congress Cataloging in Publication Data Library of Congress Control Number: 2012944036 ISBN 978–0–19–964398–1 Printed in Great Britain by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work To Maxim and Josephine PREFACE Bank regulation is primarily about the quantification and restriction of the level of risk which banks are permitted to take However, it has for some time been an unfairly neglected area of law, since those who understand law are uncomfortable with the quantitative aspects of risk calculation, and those who understand risk quantification are not generally lawyers This situation was tolerable in the 1980s and 1990s, when bank capital regulation existed as a separate discipline broadly outside the main body of regulatory law However, today bank capital regulation is as much a part of mainstream law as the rules relating to market abuse or authorization, and lawyers must be able to find their way around it The current work is an attempt to provide a topographical map of the regulatory landscape Its aim is to describe and explain the concepts involved in bank capital regulation, to set out how they fit together, and to show how they contribute to the ultimate aim of regulating risk It is not intended to be a ‘how to’ manual setting out how to perform risk capital calculations—for that there are other and better sources It is, however, intended to enable lawyers who are called upon to construe the concepts in the context of legal requirements to understand the purpose and the aim of the provisions which they are being called upon to interpret The first edition of this book was finalized in the summer of 2009, a period when bank regulation was changing rapidly The second edition is published before the Basel III project has been finalized, and whilst the EU Capital Adequacy regime is in preparation The defence for both editions is the same— that an author on this topic who had decided in 1999 to wait for the regime to be finalized before commencing work would not yet have put pen to paper, and would see no prospect of doing so for at least the next four or five years The bones of the post-crisis settlement are now sufficiently wellformed to be capable of accurate description, and it is hoped that what the book loses in longevity it may gain in timeliness The conceptual nature of the content makes it slightly difficult to anchor the work in any particular legal system The basic concepts which surround bank risk regulation are still determined by the Basel Committee on Banking Supervision These are elaborated at the European level in directives, elaborated further by the European Banking Authority, and finally implemented (with—at least in the case of the UK—further clarificatory material) by national bank supervisors In theory at least, none of this clarification alters the fundamental concept However, it is an open (and unresolveable) question as to what extent guidance given at one tier is useful or relevant at a higher tier Non-UK readers, in particular, may take the view that too much emphasis is placed herein on the views of the UK regulatory authorities on contentious issues However, this can be defended on the basis that the UK is, in this area, one of the primary intellectual powerhouses of the global public sector, and even where other regulators take the view that the UK view should not be followed, it is unlikely that any regulator would take the view that the UK view should be disregarded An apology may also be ventured for the relative disregard of US regulatory concepts in this area At the time of writing the US was teetering on the brink of embracing the Basel regime for banks (but admittedly had been so teetering for some years) and the disregard seemed legitimate for a non-US work Events may prove this wrong I should record two debts of gratitude One is to OUP, who have put up with another round of ‘the dog ate my manuscript’ excuses from me for longer than any human being should be expected to tolerate The other is to my children, who have put up with the writing process for the same period, and to my wife, whose continued tolerance passes all understanding Thank you Simon Gleeson March 2012 Extracts from the Basel Accord and from the publications of other Basel committees are reproduced with the permission of the Bank of International Settlements All of these documents are available free on their website: CONTENTS—SUMMARY Tables of Legislation List of Abbreviations I THE ELEMENTS OF BANK FINANCIAL SUPERVISION Introduction to Banks and Banking Why Are Banks Supervised? Basel and International Bank Regulation Basel III The Bank Capital Calculation—Basel II The Bank Capital Calculation—Basel III II COMMERCIAL BANKING Credit Risk The Standardized Approach Model Based Approaches to Risk Weighting 10 The Internal Ratings Based Approach 11 Netting, Collateral, and Credit Risk Mitigation III INVESTMENT BANKING 12 The Trading Book 13 Securities Underwriting 14 Trading Book Models 15 Credit Derivatives 16 Counterparty Risk 17 Counterparty Credit Risk for Derivatives, Securities Financing, and Long Settlement Exposures 18 Securitization and Repackaging IV OTHER RISKS 19 Operational Risk Requirements 20 Concentration and Large Exposures V BASEL III REQUIREMENTS 21 Liquidity Requirements 22 The Leverage Ratio 23 Basel III, Derivatives, Clearing, and Exposures to CCPs VI BANK GROUP SUPERVISION 24 Group Supervision 25 Financial Conglomerates 26 Cross-Border Supervision of Bank Groups 27 Pillar Three—Disclosure Requirements Index CONTENTS—DETAILED Tables of Legislation List of Abbreviations I THE ELEMENTS OF BANK FINANCIAL SUPERVISION Introduction to Banks and Banking A Banks Considered as Risk Takers B A Prototypical Bank Business summary Risk analysis Credit risk Market and asset liquidity risks Funding liquidity risk Interest rate risk Operational risk Risk consolidation Economic capital Why Are Banks Supervised? A Basis of Bank Supervision—the Basel Principles B Capital Regulation C The Constraints on Bank Capital Regulation D The Quantum of Bank Capital Requirements E Does the Banking Crisis Prove that Risk Capital-based Regulation Failed? Quantitative risk modelling and the crash F Market Crisis and Regulation G Protecting the Public from the Consequences of Bank Failure Bank resolution regimes Basel and International Bank Regulation A The Basel Committee and the Basel Accord B Addressing Failures of Multinational Banks C International Institutional Co-operation in Bank Regulation Basel III A Policy Responses to the Crisis B Basel 2.5 Trading book reform Stress testing Pay and bonuses C Basel III Strengthening the global capital framework Enhancing risk coverage Leverage ratio Countercyclical buffers Systematic interconnectedness Systemic risk Introducing a global liquidity standard Monitoring tools Addressing reliance on external credit ratings and minimizing cliff effects Enhanced counterparty credit risk management requirements Stress testing Implementation and transitional arrangements The Bank Capital Calculation—Basel II A The Basic Bank Capital Calculation B What is Capital? C The Bank Capital Hierarchy D Capital Monitoring E ‘Gearing’ Rules F The Components of Capital G Tier Issuance Redeemability Permanence Power to defer payments Loss absorption Subordination Moral hazard Associate transactions Reserves Share premium account Externally verified profits Innovative tier Convertible and exchangeable instruments Deductions from tier H Tier Upper tier Lower tier Upper tier requirements Lower tier requirements Provisioning and expected loss I Deductions Qualifying holdings (holdings in non-financial undertakings) Material holdings (holdings in financial undertakings) Connected lending of a capital nature Expected losses and other negative amounts Securitization positions J Tier Upper tier Lower tier Deductions from tier K Capital Arising from Revaluation of Assets L Deductions for Investment Firms Committee of European Bank Supervisors, Consultation Paper 10, Final version 11 July 2005 Committee of European Bank Supervisors, Consultation Paper 10, Final version 11 July 2005 BIPRU 4.64(5) BIPRU 4.6.46 Basel, para 188 BCD Annex VIII part point 4, BIPRU 5.3.2 The UK for many years required legal opinions to cover the insolvency of the bank as well as the insolvency of the borrower as a result of its experience with the BCCI failure However, this has not been carried through into the Basel approach In other words, if the supervisor in country A permits its banks to use a per cent H in their repo transactions in A’s repo market, the supervisor in country B may permit its banks to the same in respect of trades on A’s repo market, regardless of whether the regulator in country B permits its banks to use per cent H in its own repo market Paragraph 686 of the Accord Paragraph 687 of the Accord Paragraph 687 of the Accord Paragraph 688 of the Accord See para 12.40 Roughly ‘credit quality step 3’—that is, rated Baa or higher by Moody’s and BBB by S&P BIPRU 7.3.42 BIPRU 7.4.22 It may be helpful to consult the Annex provided at the end of the chapter, which gives a guide to the most commonly encountered forms of option 10 See para 12.63 for an explanation of ‘in the money’ CRD Annex Part points 41–46 Note that valuation adjustments used in this way may not also be counted towards upper tier BCD Annex IV BIPRU 13.2 Netting may not be recognized in calculating such an exposure, which must be treated as if it constituted a separate netting set containing only itself Subject to a restriction that a rate of per cent may not be applied to any exposure arising under a resetting contract with a term of over one year, even if the next reset is within one year and a rate of per cent would otherwise be applicable under the table In such a case a per cent weighting is used instead Perfectly matching contracts included in the netting agreement may be taken into account as a single contract with a notional principal equivalent to the net receipts Note that a firm should be capable of establishing EE daily, and should be able to establish sufficient data points in the forthcoming year to adequately reflect the time structure of future cash flows BCD Annex III part point (b), BIPRU 13.7.7 Accord, para 538 Accord, para 539 Accord, para 540 BIPRU 9.1.9 BIPRU 9.3.2 A clean-up call is an arrangement whereby if the total pool of assets falls below a certain level (conventionally 10% of the initial value), the sponsor may elect to buy back all of the outstanding notes and collapse the structure They are used to avoid sponsors having to pay for the maintenance of a financing structure after most of the assets held within it have matured The FSA, in BIPRU 9.11.7 (4), suggests that this means access to pool composition at least daily Interestingly, the explanation given for this is to preclude the situation whereby a bank took a mezzanine resecuritization exposure, created two tranches (eg a junior tranche of 0.1% and a senior tranche of 99.9%), and claimed that the senior tranche should qualify for the senior column of resecuritization risk weights One must admire the ingenuity That exceed the amount of over-collateralization/reserves provided by the seller See paras 19.23 to 19.24 Articles 66, 106 to 117 and para of Annex V of the Banking Consolidation Directive and Arts 28 to 32 and Annex VI of the Capital Adequacy Directive Goodhart, The Central Bank and the Financial System (Palgrave Macmillan, 1995), p 405 This may happen in lease finance transactions The trading book holdings must be applied so that the lowest regulatory capital cost holdings are used to fill the 25% ‘free’ bucket This means that the calculation of the CNCOM must be done by applying the scaling factor to the most ‘expensive’ portions of the position Recognized means for this purpose recognized by the relevant regulator as being subject to appropriate supervision For an EU firm, a firm established and regulated in any other EU jurisdiction is likely to satisfy that criterion It will be recalled that the financial collateral simple method is only available to firms using the standardized approach, and may only be applied to exposures to which they apply that approach This is generally true even in non-financial groups Note that this is an entirely different risk from that which is addressed by the trading book incremental capital risk Incremental capital risk addresses the risk of credit risk migration—loosely the risk that positions will diminish in value because of deterioration in the credit risk of the issuer Liquidity risk is the risk that in the event of a disposal there will be no buyer at all (in which case the asset is valueless) or buyers at artificially low levels This risk is addressed primarily through valuation adjustments, but these in turn only address relative illiquidity Absolute illiquidity is a harder risk to model Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision, September 2008 Principles of Liquidity Risk Management, Institute for International Finance, March 2007 At the time of writing the UK liquidity regime is reasonably well concealed within the FSA rulebook The diligent reader is directed to the previous edition of the FSA’s bank supervisory rules, designated within its rulebook as IPRU(BANK) IPRU(BANK) has been repealed in its entirety apart from chapters LM and LS, which contain the FSA’s quantitative liquidity rules September 2008 issued by the Basel Committee on Banking Supervision ie historically, the market has shown tendencies to move into these types of assets in a systemic crisis Corporate bonds in this case only include plain vanilla assets whose valuation is readily available based on standard methods and does not depend on private knowledge, ie these not include complex structured products or subordinated debt If firms merge, the assets issued by the new firm receive the liquidity value of the respective firm whose assets had the least liquid characteristics before the merger The definition of ‘covered bonds’ used by Basel for this purpose is a simple copy-out of the EU definition found in art 52(4) of the UCITS directive (2009/65/EC)— ‘Covered bonds are bonds issued and owned by a bank or mortgage institution and are subject by law to special public supervision designed to protect bond holders Proceeds deriving from the issue of these bonds must be invested in conformity with the law in assets which, during the whole period of the validity of the bonds, are capable of covering claims attaching to the bonds and which, in the event of failure of the issuer, would be used on a priority basis for the reimbursement of the principal and payment of the accrued instrument’ The last word of this definition is clearly a transcription error—‘instrument’ should read ‘interest’, as it is in the UCITS directive Include those which are pledged to support asset-backed securities or covered bonds BIS and IOSCO Not all the capital of a CCP will be available in the event of a failure of the market which the CCP clears—not least because pressure on CCPs from their own regulators to ensure their survivability in the event of financial crises has resulted in limitations on recourse being created within the rules of some CCPs The question is therefore not what the total capital of the CCP is, but what element of the CCP’s capital is committed in the event of a default of the market concerned This is why DFCCP may be a lower number than the total capital of the CCP As defined in Section C of Annex of the Markets in Financial Instruments Directive (MiFID), Directive 2004/39/EC But not the operation of collective investment schemes BIPRU 8.7.25 BIPRU 8.7.29 Note that the AMA permits the recognition of insurance as a mitigant for operational risk When an AMA is applied on a consolidated basis, insurance provided by captives and affiliates will not be recognized unless it is laid off to an independent undertaking outside the consolidated group which meets the eligibility criteria Supervision of Financial Conglomerates, Papers prepared by the Joint Forum on Financial Conglomerates; February 1999, available on the BIS website In strict logic this figure might have been better set at 24 per cent, since in many corporate law systems a holding of 75 per cent of the equity of a company gives the holder absolute control CRD Art 3(1) See para 25.01 See Committee of European Banking Supervisors; Advice to the European Commission; CEBS/2008/04 (on the US) and CEBS/2008/05 on Switzerland BCD Art 72(1) A financial holding company for this purpose means a company whose primary purpose is either to conduct financial activities or to acquire holdings in entities whose purpose is to conduct financial activities Thus, a company will only be a financial holding company if the majority of its activities— whether conducted directly or through subsidiaries—are themselves financial 83/349/EEC This is made explicit in CRD Art 133(3) CRD Art 134 CRD Art 69(3) According to the relevant CEBS website, only the French Regulator has availed itself of this right—see CRD Art 129 CRD Art 130 CRD Art 125(1) 10 CRD Art 125(2) 11 Art 126(1) 12 Art 126(2) 13 CRD Art 126(3) 14 CRD Art 127(1) 15 See for the position as regards Switzerland, and as regards the United States 16 GENPRU 3.2.6 17 BIPRU 8.2.1 2006/48/EC Ibid, Art 72.1 Art 72(3) The costs of doing so would be very significant BCD Art 69 BCD Art 70 See Chapter for these definitions The internal models method estimate of exposure value: see para 17.33 ... summary Risk analysis Credit risk Market and asset liquidity risks Funding liquidity risk Interest rate risk Operational risk Risk consolidation Economic capital 1.01 In order to understand bank regulation, .. .INTERNATIONAL REGULATION OF BANKING INTERNATIONAL REGULATION OF BANKING Capital and Risk Requirements SECOND EDITION SIMON GLEESON Great Clarendon Street, Oxford,... Considered as Risk Takers B A Prototypical Bank Business summary Risk analysis Credit risk Market and asset liquidity risks Funding liquidity risk Interest rate risk Operational risk Risk consolidation