Prelims
The Banking Sector Under Financial Stability
ISBN: 978-1-78769-682-2, eISBN: 978-1-78769-681-5
Publication date: 4 December 2018
Citation
Ramlall, I. (2018), "Prelims", The Banking Sector Under Financial Stability (The Theory and Practice of Financial Stability, Vol. 2), Emerald Publishing Limited, Leeds, pp. i-xxiii. https://doi.org/10.1108/978-1-78769-681-520181011
Publisher
:Emerald Publishing Limited
Copyright © 2019 Emerald Publishing Limited
Half Title Page
THE BANKING SECTOR UNDER FINANCIAL STABILITY
Series Page
COMPLETE VOLUMES ON THEORY AND PRACTICE OF FINANCIAL STABILITY
Volume 1: | Understanding Financial Stability |
Volume 2: | The Banking Sector under Financial Stability |
Volume 3: | The Corporate, Real Estate, Household, Government and Non-bank Financial Sectors under Financial Stability |
Volume 4: | Economic Areas under Financial Stability |
Volume 5: | Tools and Techniques for Financial Stability Analysis |
Praise for The Theory and Practice of Financial Stability
Indranarain Ramlall’s proposal is a great attempt at giving a comprehensive view of financial stability from a theoretical, practical and policy perspective. It aims at providing future students with the tools to understand the framework in which financial stability is assessed and understood today by international organisations and central banks across the world. To my knowledge, this is the only book that covers such a wide range of topics related to financial stability. It, therefore, has the potential to become a good reference book on the topic. I believe that Indranarain Ramlall has made a great proposal to provide a ‘big picture view’ on financial stability. I look forward to reading the textbook!
Celine Tcheng, Central Bank of France
Financial stability has become a major concern for central banks, after the 2008 global financial crisis. More and more research is tackling topics regarding the role of the financial system in macroeconomic models and the implementation of macroprudential policy. Therefore, a comprehensive overlook of financial stability issues, such as the one offered by The Theory and Practice of Financial Stability can prove particularly useful for experts working in the financial system, central bankers included. The textbook covers a diverse set of topics from policy matters to risk assessment analysis.
Elena Banu, Central Bank of Romania
This book is a comprehensive work on one of the most actual topics in the aftermath of the Great Recession. It covers a wide range of topics on financial stability complementing theoretical frameworks with practical examples.
Starting with a conceptual description on financial stability, the book overviews a history of the major financial crises and Basel regulation rules. Particularly useful is an inquiry of the financial stability perspectives across different asset classes and economy sectors. Another beneficial feature of this book is a complete oversight of stress testing methodologies.
The book is a thorough compilation of topics on financial stability and definitely deserves a place on the bookshelves of central bankers, government and private institutions’ officials.
Vaidotas Sumskis, Bank of Lithuania
Dr Indranarain’s book is an actual textbook for interpreting interrelations between all aspects and sectors of the international economy and will surely be a highly useful tool for credit institutions, investors, practitioners as well as academics. From a Central Bank’s point of view this book provides an integrated approach to macroeconomic environment and the interactions between the various factors and an actual tool for assessing and measuring leading circumstances and indicators that affect financial stability and may cause vulnerabilities.
Vasiliki Vlachostergiou, Central Bank of Greece
This is a monumental work! I didn’t find anything missing. I think it will be useful for students, economic and finance professionals and policymakers.
Christophe Andre, OECD
Financial stability was always a priority for financial sector regulators and it has surpassed other objectives since the global financial crisis. Given various complexities associated with the financial stability and rapid developments over time, existing literature tends to deal with specific aspects of financial stability. It is very difficult to get a comprehensive book dealing with the wide range of concepts, different segments of financial sector, ever increasing variety of financial instruments and regulations associated with financial stability. The current book is a very good attempt to fill this gap through its comprehensive coverage of almost the entire gamut of financial stability related topics. This book should be useful for financial sector regulators, related ministries in the governments, researchers, multilateral institutions, other financial sector stakeholders and general public who are interested to know the complexities of the financial sector and financial stability.
Ajay Prakash-an expert in Financial Stability
Title Page
THE THEORY AND PRACTICE OF FINANCIAL STABILITY VOLUME 2
THE BANKING SECTOR UNDER FINANCIAL STABILITY
BY
INDRANARAIN RAMLALL
University of Mauritius, Mauritius
United Kingdom – North America – Japan – India – Malaysia – China
Copyright Page
Emerald Publishing Limited
Howard House, Wagon Lane, Bingley BD16 1WA, UK
First edition 2019
Copyright © 2019 Emerald Publishing Limited
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British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN: 978-1-78769-682-2 (Print)
ISBN: 978-1-78769-681-5 (Online)
ISBN: 978-1-78769-683-9 (Epub)
Dedication
Dedicated to God for making me an instrument of his own
List of Figures
Chapter 1 | ||
Figure 1.1 | Impact and Likelihood. | 5 |
Figure 1.2 | Example of a Risk Assessment Matrix. | 8 |
Chapter 2 | ||
Figure 2.1 | Structural Liquidity, Leverage Ratio and Financial Fragility. | 17 |
Figure 2.2 | Factors Driving Robust Structural Liquidity. | 17 |
Figure 2.3 | Net Stable Funding Ratio (NSFR) and LCR under Basel III. | 19 |
Figure 2.4 | Sources of Income to a Bank. | 20 |
Figure 2.5 | Sources of Income to a Bank. | 21 |
Figure 2.6 | Holistic Approach to Banking Sector Risk Management. | 25 |
Figure 2.7 | Internal and External Dimensions of Risks. | 26 |
Chapter 3 | ||
Figure 3.1 | Framework for Financial Stability Assessment in Banks. | 30 |
Figure 3.2 | Nature of Credit Risk. | 31 |
Figure 3.3 | Static and Dynamic Versions of Repayment Capacity. | 36 |
Figure 3.4 | Components of Credit Risk Models. | 40 |
Figure 3.5 | Classification of Credit Risk Models. | 41 |
Figure 3.6 | Elements Embedded in McKinsey Model. | 45 |
Figure 3.7 | Sensitivity and Scenario Analyses under Stress Testing. | 46 |
Figure 3.8 | Loans as Options: From the Perspective of the Lender. | 49 |
Figure 3.9 | Loans as Options: From the Perspective of the Borrower. | 50 |
Figure 3.10 | Distinction between Expected Losses and Unexpected Losses. | 55 |
Figure 3.11 | Three-pronged Approach to Loss Events Buffeting Banks. | 56 |
Figure 3.12 | Unexpected Loss as the Tail Risk. | 57 |
Figure 3.13 | Techniques to Compute PD. | 57 |
Figure 3.14 | Credit Risk Analysis: Single Party Risk versus Portfolio Risk. | 58 |
Figure 3.15 | Sources of Interest Rate Risk. | 60 |
Figure 3.16 | Components of Interest Rate Analysis. | 64 |
Figure 3.17 | Source of Liquidity Risk. | 81 |
Figure 3.18 | Sources of Liquidity Gap. | 81 |
Figure 3.19 | Key Risk Indicators under Operational Risk. | 86 |
Figure 3.20 | Forces which Impound on Capital Ratios. | 89 |
Figure 3.21 | Hierarchical Classification of Quality of Bank Capital. | 90 |
Figure 3.22 | Sources of Leverage Exposure. | 92 |
Figure 3.23 | CAMELS. | 101 |
Figure 3.24 | Financial Stability Risk Map. | 102 |
Figure 3.25 | Magnified Effects of Banks’ Balance Sheets on the Economy. | 108 |
Figure 3.26 | Deposits Decomposition of a Bank. | 109 |
Figure 3.27 | Deposits Focus. | 110 |
Figure 3.28 | Stable Sources of Deposits to a Bank. | 111 |
Figure 3.29 | Factors Influencing Structure of a Bank’s Balance Sheet. | 111 |
Figure 3.30 | Factors Driving Capital Ratio of a Bank. | 112 |
Figure 3.31 | Demand and Term deposits. | 115 |
Figure 3.32 | Funding of EU Banks. | 115 |
Figure 3.33 | Fund-based versus Non-fund-based Balance Sheet Items. | |
Chapter 4 | ||
Figure 4.1 | Feedback Process between Declining Asset Prices and Bank Credit. | 121 |
Figure 4.2 | The Process Embedded in Monetary Policy. | 122 |
Figure 4.3 | Interest Rate Channel of Monetary Policy. | 125 |
Figure 4.4 | Exchange Rate Channel of Monetary Policy. | 125 |
Figure 4.5 | Expectations Channel of Monetary Policy. | 126 |
Figure 4.6 | Credit Channel of Monetary Policy. | 126 |
Figure 4.7 | Asset Price Channel of Monetary Policy. | 128 |
Chapter 5 | ||
Figure 5.1 | Pillars of Basel III. | 131 |
Figure 5.2 | Components of Basel III. | 134 |
Figure 5.3 | Extensive Analysis of Basel III. | 134 |
Figure 5.4 | US Implementation of Basel III. | 141 |
Chapter 6 | ||
Figure 6.1 | Two-dimensional Regulatory Matrix under Microprudential Regulation. | 147 |
Figure 6.2 | Objective of Macroprudential Policy. | 151 |
Figure 6.3 | Types of Macroprudential Data. | 153 |
Figure 6.4 | Business Cycles and Financial Cycles under Tinbergen’s Rule. | 158 |
Figure 6.5 | Microprudential and Macroprudential Regulations before and after the Crisis. | 170 |
Figure 6.6 | Aims under Microprudential and Macroprudential Regulations. | 171 |
Chapter 7 | ||
Figure 7.1 | Effect of Higher Capital Requirements on Banks. | 186 |
List of Tables
Chapter 1 | ||
Table 1.1 | Liability Structure of US Bank Holding Companies, 2009. | 3 |
Table 1.2 | Risk Mitigation Policies Initiated by Banks. | 9 |
Table 1.3 | Three-pronged Risk Classification. | |
Chapter 2 | ||
Table 2.1 | Inverse Relationship between Liquidity Shortfall Likelihood and Liquidity Ratio. | 16 |
Table 2.2 | Stylised Balance Sheet and Weights to Compute the Net Stable Funding Ratio (NSFR). | 18 |
Table 2.3 | Distinction Between Global and Local Banks. | 23 |
Chapter 3 | ||
Table 3.1 | Covered Bonds versus Securitisation. | 35 |
Table 3.2 | Combination of Debt-to-equity Ratio and Debt Service Coverage Ratio. | 37 |
Table 3.3 | Credit Risk Transition Matrix. | 43 |
Table 3.4 | Analogy between Merton and KMV Models. | 49 |
Table 3.5 | Comparison between Structural and Reduced-form Models of Credit Risk. | 52 |
Table 3.6 | Comparisons of Credit Risk Models on Various Parameters. | 53 |
Table 3.7 | Example of Repricing Analysis for Different Maturity Periods. | 60 |
Table 3.8 | Gap Analysis under Different Conditions. | 66 |
Table 3.9 | Duration of a Bond Based on Coupon Rate of 10% and Yield Rate of 10%. | 68 |
Table 3.10 | Duration of a Zero-coupon Bond Based on Coupon Rate of 10% and Yield Rate of 10%. | 69 |
Table 3.11 | Duration of a Bond Based on Coupon Rate of 20% and Yield Rate of 10%. | 70 |
Table 3.12 | Duration of a Bond Based on Coupon Rate of 10% and Yield Rate of 20%. | 71 |
Table 3.13 | Duration of a Bond Based on a Higher Maturity Period. | 72 |
Table 3.14 | Effects of Maturity, Coupon Rate and Yield Rate on Duration. | 73 |
Table 3.15 | Relationship between Bank’s Net Worth and Duration Gap. | 75 |
Table 3.16 | Applied Duration Analysis to a Bank. | 77 |
Table 3.17 | Liquidity Risk Over Different Maturities. | 79 |
Table 3.18 | Currency Risk Analysis. | 85 |
Table 3.19 | Leverage Ratio Computation. | 91 |
Table 3.20 | Sensitivity of 2014 EU-wide Stress Tests to the Choice of the Capital Metric. | 94 |
Table 3.21 | Minimum Stressed Supplementary Leverage Ratios for US Systemic Banks (%). | 95 |
Table 3.22 | The KRI Database. | 97 |
Table 3.23 | Banking Soundness Index. | 103 |
Table 3.24 | IMF Core Financial Soundness Indicators. | 104 |
Table 3.25 | Different Weights Compositions for Banking Sector Stability Index. | 104 |
Table 3.26 | Indicators used for Construction of Banking Stability Map and Banking Stability Indicator. | 105 |
Table 3.27 | Balance Sheet Analysis of Banks. | 107 |
Chapter 5 | ||
Table 5.1 | EAD, PD and LGD under Different Approaches. | 140 |
Chapter 6 | ||
Table 6.1 | Examples of System-wide Macroprudential Instruments. | 155 |
Table 6.2 | Examples of Sector-specific Macroprudential Instruments. | 156 |
Table 6.3 | Distinction between Financial Cycles and Business Cycles. | 158 |
Table 6.4 | Two Dimensions of Systemic Risk. | 160 |
Table 6.5 | Differences between Macroprudential and Microprudential Approaches. | 167 |
Table 6.6 | Financial Cycle and Stylized Policy Reactions. | 173 |
Table 6.7 | Mapping Macroprudential Policies to Banks’ Lending Policies. | 174 |
Table 6.8 | Significance of G-SIBs across Countries in the World. | 176 |
Table 6.9 | G-SIBs Activities in the World. | 178 |
Chapter 7 | ||
Table 7.1 | Highlights of Property-cooling Measures in Selected Asian Countries Since the Global Financial Crisis. | 184 |
Chapter 8 | ||
Table 8.1 | Differences between European Union and United States under Different Financial Perspectives. | 190 |
Table 8.2 | Bloomberg Poll 2014 taken Shortly after Publication of 2014 EU-wide Stress Test. | 201 |
Chapter 9 | ||
Table 9.1 | Risk Category and Status. | 206 |
Table 9.2 | Rating Grade and Probability of Default Range. | 207 |
Table 9.3 | Type I and Type II Errors. | 209 |
Table 9.4 | Example of Reporting Outcomes of Stress Testing. | 211 |
List of Acronyms
- ALCO
-
Asset Liability Management Committee
- ALM
-
Asset Liability Management
- BIS
-
Bank for International Settlement
- CAMELS
-
Capital, Assets, Management, Earnings, Liquidity and Sensitivity to market risk
- CAR
-
Capital Adequacy Ratio
- CCAR
-
Comprehensive Capital Analysis and Review
- CRD
-
Capital Requirements Directive
- CRR
-
Capital Requirements Regulation
- DTI
-
Debt to Income
- EAD
-
Exposure of Default
- EaR
-
Earnings at Risk
- ECB
-
European Central Bank
- EDF
-
Expected Default Frequency
- EL
-
Expected Losses
- ESRB
-
European Systemic Risk Board
- EU
-
European Union
- FSB
-
Financial Stability Board
- FSC
-
Financial Stability Committee
- FSIs
-
Financial Soundness Indicators
- FSOC
-
Financial Stability Oversight Council
- GAAP
-
Generally Accepted Accounting Principles
- GDP
-
Gross Domestic Product
- G-SIBs
-
Global Systemically Important Banks
- IFRS
-
International Financial Reporting Standards
- IMF
-
International Monetary Fund
- IRB
-
Internal Ratings-based
- KRIs
-
Key Risk Indicators
- LCR
-
Liquidity–Coverage Ratio
- LGD
-
Loss Given Default
- LTV
-
Loan to Value
- NBFIs
-
Non-bank Financial Institutions
- NPLs
-
Non-performing loans
- NSFR
-
Net Stable Funding Ratio
- PD
-
Probability of Default
- RAM
-
Risk Assessment Matrix
- RWAs
-
Risk-weighted Assets
- SCAP
-
Supervisory Capital Assessment Program
- SIFI
-
Systemically Important Financial Institution
- SMEs
-
Small and Medium Enterprises
- SPV
-
Special Purpose Vehicle
- UL
-
Unexpected Losses
- VaR
-
Value at Risk
Preface
Most economies in the world are characterised by a bank-based financial system, that is, the financial intermediation process is mostly performed by banks. It is therefore critically important to undertake a full-fledged analysis of the banking sector with respect to financial stability risks. By virtue of many issues being involved in the banking sector, a whole book is altogether being devoted to the banking sector in this series of five books on financial stability. Readers will appreciate from the reading that banks are unique in their nature-they assume higher risks on the back of borrowing short and lending long while they are endowed with lower capital buffers, explained by a low equity to total assets ratio. Balance sheet analysis of banks becomes a key element in financial stability risk assessment. Sources of banks’ funding also pose risks to financial stability. The more banks resort to short-term wholesale funding, the higher are the risks to financial stability should a shock manifest.
Regulatory frameworks are also being given due consideration with focus on Basel III as a major advancement in dealing with the shortcomings which prevails in the US Subprime crisis of 2007. To bolster capital of banks, Basel III came up with countercyclical capital buffer and buffer for systemically important financial institutions. In the same vein, not only capital, but liquidity concerns were also given prominence following the introduction of two key liquidity ratios, namely, the net stable funding ratio and the liquidity coverage ratio. Another key regulatory issue tackled by the authorities pertains to host-home cross-border banking supervision in view of abating regulatory arbitrage.
At the end of the day, there appears to be a growing consensus among policy-makers, academicians and researchers that a bank-based financial system may exacerbate the detrimental effects of a crisis. The rationale is based on the notion that should banks be affected, then, this unleashes a squeeze in loanable funds as to cut short the level of borrowings and investments by economic agents such as households and corporates. Consequently, the non-banking sector should also be given prominence as they can intervene to substitute for the fallback in lending by banks to ensure that no curtailment in the level of economic activities. The book also focuses on microprudential and macroprudential regulation. On the same wavelength, different risks which impact on banks are covered in a comprehensive manner along with different risk maps.
The book has been written as a reference material to cater for the needs of both new and experienced professionals such as central bankers, researchers, economists and policy-makers who are involved in the field of financial stability. As a matter of fact, many central banks now have a financial stability unit or a department but so far there is no textbook which weaves through the various aspects of financial stability. Central bankers can use the book to beef up the analytical part of their financial stability reports by incorporating new tools of assessments. The book appeals to courses/programmes on financial stability as provided by Yale School of Management (Macroprudential Policy or Financial Stability Regulation/Master of Management studies in Systemic Risk), Goethe Business School (Financial Stability and Regulation/Executive Education course) and Florence School of Banking and Finance (Banking and Financial Stability course). To date, there are no textbooks or referenced materials which undertake an intensive and coherent approach to financial stability. For example, there is no such framework as to how financial stability, as a process, should be performed. This book attempts to provide all key issues in a highly comprehensive and critical manner. In that respect, the book is expected to be widely used worldwide, both by professionals and researchers.
The author expects the book to be particularly useful to economists, policy-makers, researchers and students in the sphere of financial stability in the banking sector. As at date, there is no textbook on financial stability which weaves through all aspects of financial stability-from theory to practice. This series of five books on financial stability attempts to fill in such a vacuum. Comments and suggestions can be made to i.ramlall@uom.ac.mu/iiramii3@gmail.com. The author seizes this opportunity to thank an anonymous referee from the London School of Economics for his suggestions and reviews made by professionals from central banks and reputable organisations.
Dr Indranarain Ramlall
June 2018
- Prelims
- Chapter 1 Banks, Risks and Risk Management
- Chapter 2 Banking Sector and Financial Stability
- Chapter 3 A Framework for Financial Stability Risk Assessment in Banks
- Chapter 4 Banks, Macroeconomic States, Asset Prices, Household Sector and Monetary Policy
- Chapter 5 Basel III
- Chapter 6 Microprudential and Macroprudential Regulation
- Chapter 7 Banks and Policies
- Chapter 8 Differences between US and European Union under Different Financial Perspectives
- Chapter 9 Some Practical Issues in Credit Risk Modelling
- References
- Index