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Prelims

Indranarain Ramlall (University of Mauritius, Mauritius)

The Banking Sector Under Financial Stability

ISBN: 978-1-78769-682-2, eISBN: 978-1-78769-681-5

Publication date: 4 December 2018

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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

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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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No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. Any opinions expressed in the chapters are those of the authors. Whilst Emerald makes every effort to ensure the quality and accuracy of its content, Emerald makes no representation implied or otherwise, as to the chapters’ suitability and application and disclaims any warranties, express or implied, to their use.

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 . 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

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