FIN3703A

Financial Markets
02: Financial Institutions II: Banks

Dr. YUE Ling

1 Sem1 AY2022/23
 FIN3703A

Financial Institutions II: Banks

I. Financial Intermediaries
fed fund rate is set by the central bank(there is a range fed rate)

II. Risk and risk management in Banking

1. Interest rate risk
2. Liquidity risk
3. Other risks

III. Central Banks

IV. Basel Committee on Bank Supervision

1. Basel I (July 1988)
2. Basel II (June 2004)
3. Basel III (2019)

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 Financial Intermediaries

I. Financial intermediaries
Financial intermediation: Intermediate between suppliers and
demanders of funds
e.g bond mature at different time
• Maturity intermediation
• Denomination intermediation
• Risk intermediation

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 Risks in Banks

II. Risks and risk management in banking

Different sources of risk:
1. Interest rate risk
2. Liquidity risk
3. Other risks
• Credit risk
• Foreign exchange (FX) risk
• Trading risk or market risk
• Operational risk

Three steps in risk management:

• Identify risk
• Measure risk
• Manage risk

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 Interest Rate Risk

Balance Sheet of U.S. Commercial Banks

(items as a percentage of the total, 2016)

Reserves and cash items 16 Blank Checkable deposits 10

Securities Blank Blank Nontransaction deposits Blank

U.S. government and agency 14 Blank Small‐denomination time deposits 50

State, local govt and others 6 Blank (<$100,000 + savings deposits) Blank

Loans Blank Blank Large‐denomination time deposits 10

Commercial and industrial 13 Blank Borrowings 19
Real estate 25 Blank Bank Capital 11
the debt that bank owes
Consumer 8 Blank e.g bank owes to other bank Blank Blank
liquidity risk

Other 9 Blank Blank Blank

Other Assets (e.g., buildings) 8 Blank Blank Blank

Blank 100 Blank Total 100

Source: Table 17.1 Balance Sheet of All Commercial Banks (items as a percentage of the total, 2016), Financial Markets and
Institutions, 9e, Mishkin and Eakins. Pearson Education, 2018.

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 Interest Rate Risk

S&L crisis in the 1980s Y

L
1 2 3 1 2 3(ideal scenario no risk)
0 0 1m 1 1 1
D 1m 0 0 1 1 1
gap -1m 0 1m 0 0 0

• Maturity gap st interest and lt loan (huge risk) a

bank profit from interest margin

• Short term deposits banks have no interest rate because it can offer high i/r to depositor
and loan at high i/r

• Long term fixed mortgage loans banks will lose money if theres a mismatch of maturity due to
pre-selling

• Fluctuation of interest rates fee for selling financial instrument = p1q1 -p0q0

p1q1(price sold qty sold)

p0q0(cost and qty produced)

• Lifting of deposit rate ceiling (Regulation Q)

• Increase risk of loan portfolio

• Decrease in real estate prices => default

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 Interest Rate Risk

1. Interest rate risk

• Due to maturity mismatch, banks suffer from interest rate risks.

• Interest income and expense

• Interest income received from assets (e.g., loans)
• Interest expense incurred from liabilities (e.g., deposits)

• Interest rate sensitive assets and liabilities

• Remaining maturity
• Repricing

• Gap analysis: interest rate fluctuation & net interest income

• For a given horizon (e.g., 1 day, 1 week, etc):
• Gap = rate sensitive assets – rate sensitive liabilities

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 Interest Rate Risk

Gap report there is no loans for 1 day to consumer but floating i/r
change every month. however for simplicity banks put
1day to differentiate floating vs fixed

($’m) 1 Day 1 Wk 1 Mth 3 Mths 1 Yr > 1 Yr Total

Assets:
SGS 0 30 60 20 100 0 210
Other MM 2 1 3 5 0 0 11
Fixed Rate Loans: 0
Corporate 5 20 50 200 100 100 475
Housing 5 10 30 50 200 1,000 1,295
Vehicle 1 2 3 5 10 30 51
Floating Rate Loans: 0
Corporate 300 0 0 0 0 0 300
Housing 1,000 0 0 0 0 0 1,000
Total Assets Repricing 1,313 63 146 280 410 1,130 3,342
doesnt exist. N/a
Liabilities: 1mth fd will not have any number beyond 1month
demand Interbank Borrowings 200 20 0 0 0 0 220
instrument Saving Account 600 0 0 0 0 0 600
1-mth FD 20 30 50 0 0 0 100
3-mth FD 50 70 60 50 0 0 230
6-mth FD 20 120 150 140 0 0 430
1-Yr FD 120 20 15 20 30 0 205
Total Liabilities Repricing 1,010 260 275 210 30 0 1,785

Gap Position 303 (197) (129) 70 380 1,130

net bank exposure to i/r. the net bank exposure is 303 for 1 day and -197 for 1 wk

interest of asset * qty - interest of deposit amt of deposit.

difference of Asset repricing - liability repricing
8 If new A&L incurred in the next year, we have to calculate the repricing of A&L
 Interest Rate Risk

Gap report
Which is better: positive or negative gap position?

• Positive gap position:

• Benefits when interest rates ↑ / ↓
• Suffers when interest rates ↑ / ↓

• Negative gap position:

• Benefits when interest rates ↑ / ↓
• Suffers when interest rates ↑ / ↓

• Does a matched gap position mean no interest rate risk?

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 Interest Rate Risk

Duration
• Gap report: shortcoming
• Time value of money is not taken into account
• Does not give a comprehensive view of how the net value of
the bank (assets and liabilities positions of the bank) will be
affected by a change in interest rate

 Solution = Duration (Macaulay’s duration)

𝐶 𝐶 𝐶
1∗ 2∗ ⋯ 𝑇∗
1 𝑖 1 𝑖 1 𝑖
𝐷
𝐶 𝐶 𝐶
⋯
1 𝑖 1 𝑖 1 𝑖
𝐶
∑ 𝑡∗ ∑ 𝑡 ∗ 𝑃𝑉𝐶𝐹
1 𝑖
𝐷
𝐶 ∑ 𝑃𝑉𝐶𝐹
∑
1 𝑖
• Duration is a cash-flow-weighted average of the time-to-maturity.

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 Interest Rate Risk

Duration: example
∑ ∗
• Duration (Macaulay’s duration): 𝐷 ∑
• Example: 3-year coupon bond, face value = $1,000, coupon rate =
10%, annual coupon payment

Years Cash flow (CF) Present Value of CF (i = 10%) t x PVCF

1 100 100/1.1 100/1.1 *1

100/1.1^2
2 100 100/1.1^ 2 * 2

3 1100 1100/1.1^3 1100/1.1^3 * 3

Total 1000
2735.54

2735.54/1000 = 2.74 years

• Duration = _______________________

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 Interest Rate Risk

Duration: properties
• Duration (Macaulay’s duration):
∑ 𝑡 ∗ 𝑃𝑉𝐶𝐹
𝐷
∑ 𝑃𝑉𝐶𝐹
(zero coupon bond)

• Portfolios with all cash flow at termination will have duration = t

______________.
t

• Discounting penalizes later cash-flows more. Hence, portfolios

previous
with more cash flows earlier, all things constant, will be more / less
slide sensitive to interest rate change. Such portfolio also have a
shorter / longer duration than portfolios with more cash flows later.

• The longer the duration, all else constant, the more / less
vulnerable the portfolio is to changes in interest rates.

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 Interest Rate Risk

Duration
• Macaulay’s duration:
∑ 𝑡 ∗ 𝑃𝑉𝐶𝐹
𝐷
∑ 𝑃𝑉𝐶𝐹

• Modified Duration
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝐷
1 𝑖

• Price change: i/r decrease bp increase.

% price chagne Δ𝑃/𝑃 𝑀𝑜𝑑𝐷 ∗ Δ𝑖

$ price change Δ𝑃 𝑀𝑜𝑑𝐷 ∗ Δ𝑖 ∗ 𝑃

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 Interest Rate Risk

Duration
• Example: 3-year coupon bond, face value = $1,000, coupon rate =
10%, annual coupon payment.

Years Cash flow (CF) Present Value of CF (i = 10%) t x PVCF

1 100 90.91 90.91
2 100 82.64 165.29
3 1100 826.45 2479.34
Total 1000 2735.54
p0

• Duration = _______________________
2735.54/1000= 2.73554

• If 𝑖 ↑ 1% (that is Δ𝑖 =_____):
1%

𝑀𝑜𝑑𝐷 _________
D/(1+i0) = 2.7355 /(1+0.1) = 2.4868

Δ𝑃 ______________
-2.4868 * 1% * 1000 = -24.87

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 Interest Rate Risk

Duration gap
𝑀𝑉
𝐷 𝐷 ∗𝐷
𝑀𝑉

Δ𝑖
Δ𝑀𝑉 𝐷 ∗ ∗ 𝑀𝑉
1 𝑖

Δ𝑀𝑉 Δ𝑖
%Δ𝑀𝑉 𝐷 ·
𝑀𝑉 1 𝑖

• Proof (for your interest):

Δ𝑀𝑉 Δ𝑀𝑉 Δ𝑀𝑉
Δ𝑖 Δ𝑖
𝐷 ∗ ∗ 𝑀𝑉 𝐷 ∗ ∗ 𝑀𝑉
1 𝑖 1 𝑖
𝑀𝑉 Δ𝑖
𝐷 ∗𝐷 ∗ ∗ 𝑀𝑉
𝑀𝑉 1 𝑖
Δ𝑖
𝐷 ∗ ∗ 𝑀𝑉
1 𝑖
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 Interest Rate Risk

Duration gap: example

Base on following information, determine the duration gap for Bank
A:
• DAssets = 2.70, DLiabilities = 1.03
• MVAssets = 100, MVLiabilities = 95

• Answer: 𝐷𝐺𝑎𝑝 __________________

2.7 - (95/100 * 1.03) = 1.7215

• What is the change in market value of net worth as a percentage

of assets if interest rate rise from 10% to 11%?

• Answer:
• ∆𝑖 1%

• 𝑖0 10%

D gap * change in i/(1+i0)* MV asset

• Thus, %Δ𝑀𝑉 -1.7215* 0.01/(1+0.1) *100 = -1.565%

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 Interest Rate Risk

Exercise: Duration and Bank Value

Part I:
• Bank ABC has the following 2 bond-like loans:
• Loan 1: $1m loan fixed for 3 years at 10%
• Loan 2: $1m loan fixed for 5 years at 12%
• The market interest rate is now at 5%. What is the duration of the
bank’s loan portfolio? If the market interest rate increases by 1%
now, what will be the percentage change of the present value of
the portfolio?

Part II:
• ABC has $1.5m of liabilities (at market value) with a duration of
2.68 years. How much will the value of the bank change due to the
change in interest rate?

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 Interest Rate Risk

Duration gap: properties

𝑀𝑉
𝐷 𝐷 ∗𝐷
𝑀𝑉
Δ𝑖
if interest rate rise, mv
Δ𝑀𝑉 𝐷 ∗ ∗ 𝑀𝑉
decrease. look at -ve sign
1 𝑖

• Positive duration gap benefits (suffers) from decreases

(increases) in interest rates
• Negative duration gap benefits (suffers) from increases
(decreases) in interest rates
• So which is better? as shareholder, if i/r rise, shareholder benefit because of Dgap and MVbank.
But it depends on interest gap position

• Immunization: achieving zero duration gap to immunize against

shifts in interest rate immunisation works only if i/r is consistent(flat yield curve)
yield curve move parallel up/down, aka st &lt i/r move at the same amount

• Does matched gap, a zero gap, a zero duration gap means no

interest rate risk?
basis risk - different financial asset move differently or move at a different extent from market condition e.g recession
embedded option
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 Interest Rate Risk

(1) Basis risk

Interest rates in different instruments do not always move together
and in the same magnitude.

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 Interest Rate Risk

(2) Embedded option risk

• Pre-withdrawal
• More likely when interest rate _______
rise

• Depositors exercise option and withdrawal on fixed deposits

before maturity and re-deposit at higher rate

• Prepayment
• More likely when interest rate _______
falls

• Borrowers exercise option and prepay loan and refinance at

lower rates

• In either case, interest margin _______

falls

• Solutions: Penalty for pre-mature withdrawal and prepayment

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 Interest Rate Risk

Managing interest rate risks

• Decision based on the gap analysis: target is 0 gap (matched gap)
• Decision based on the duration gap analysis: target is 0 duration
gap (immunization)

Balance Sheet Strategies

• Positive gap: get rid of assets and increase liabilities
• Decrease assets: sell or securitize
• Increase liabilities: borrow more funds
• Negative gap: increase assets and get rid of liabilities
• Increase assets: buy or issue more loan
• Decrease liabilities: reduce debt
• Weigh between the probability, direction, and magnitude of the
change of the interest rates with the cost involved
• There are easier ways to manage interest rate risk…

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 Interest Rate Risk

Off balance sheet strategies

• Futures not necessarily euros. it means any non USD currency
if interest rate rise, futures price decrease, we short futures, vice versa.
• Eurodollar futures
• SOFR futures LIBOR london interbank overnight rate
SOFR secured overnight financing rate( treasury backed repo rate)

sep-dec
libor is beginning aka sep and imm is known on beginning
• Swaps sofr get out on last trading day on dec and imm is known on last trading day

• Transaction hedge
• Balance sheet hedge

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 Interest Rate Risk

Off balance sheet strategies: (1) Futures

• Example: bank expects
• Interest rate falls by 100 basis points (1%) in 6 months time
• Bank net interest income (NII) falls by U$75,000

• Strategy:
• Buy / Sell 6-month futures contracts of a short-term interest
rate instrument, e.g., 3-month Eurodollar (LIBOR), to hedge
the fall in NII due to interest rate decrease
if interest rate decrease in 6 mth, bill price increase
hence we buy 6 month futures. we have the rights and obligation to buy the bill in 6 month.
e.g 3month eurodollar libor

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 Interest Rate Risk

Off balance sheet strategies: (1) Futures

• Price of Eurodollar futures: International Monetary Market (IMM)
price is used
• IMM = 100 – R
• R = London interbank offered rate (LIBOR) for spot settlement
(quoted in annual rate) per annum
• E.g., a price quote of 97.45 signifies a deposit rate of 2.55 imm =
percent per annum.
100-97.45 = 2.55

• When IMM increases, price of futures increases.

• Notional amount (par) per futures contract is $1 mill.

• Futures contract value = $2,500 × IMM

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 Interest Rate Risk

Off balance sheet strategies: (1) Futures

• Futures contract value = $2,500 × IMM

• Today: IMM = 95.0000, interest rate = 5%

• 𝐹 = $2,500 × 95.0000 = $237,500
• 6 month later: if i/r = 4%, then ……
imm = 100-4= 96
• 𝐹 = _______________________
2500*96= 240k

• Gain in futures trading = _______________________

240k-237.5k = 2.5k

• Thus, if the bank plans to fully hedge the gap ($75,000), then it
should buy/sell ______contracts
75k/2.5k= 30

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 Interest Rate Risk

Off balance sheet strategies: (1) Futures

• Problem of hedging with futures: if there are contracts of mar, june and dec
and i want to hedge until april. i buy june and sell the contract on april.
do not buy mar future contract

• Symmetric: when interest rate does not move as expected,

the position is still hedged

• Cross-hedge may not be perfect (hedging loans, eg. prime

peg loans, with another instrument, Eurodollar in this case)
counterparty risk, currency risk,
liqudiity benefit of using libor/sofr

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 Interest Rate Risk

Off balance sheet strategies: (1) Futures

• USD LIBOR is scheduled to cease to be provided or
representative from end-June 2023
• Transitioning from Eurodollar futures to Secured Overnight
Financing Rate (SOFR) futures transition to sofr because of libor scandel. libor was a survey of i/r
collected from various banks which is prone to manipulation, scandel in
2012

• SOFR futures uses IMM price: IMM = 100 – R

• When IMM increases, price of futures increases.
• Notional amount (par) per futures contract is $1 mill.

3‐Month SOFR Futures 1‐Month SOFR Futures

Contract Value $2,500 x IMM $4,167 x IMM

R business‐day compounded  arithmetic average of SOFR 
SOFR per annum during  during contract delivery 
contract Reference Quarter month
example timeline: sep-dec
sofr - rate disclosed at dec as it is calculated daily
libor -rate is disclosed at sep as it is a survey
libor contract last trading day is before sep, meaning i have to own it from now to before sep.
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sofr contract - last trading day is end of dec. i have to own it until end of dec.
 Interest Rate Risk

Off balance sheet strategies: (1) Futures

• Example: What is the futures trading profit when a long CME 3-
month SOFR futures contract increases from 97.8725 to 97.8800.
The face value of the contract is $1 mill.
• Profit = $2,500 × (𝐼𝑀𝑀 𝐼𝑀𝑀 )
= $______________
= $__________
2500*(97.88-97.8725) =$18.75

timeline june-dec
sofr 1st price before june
sofr 2nd price at dec
• IMM price increases by 1 point
•  R decreases by 1 percent per annum
•  the value of 3-month SOFR futures contract increases by
$2,500 rwhich
=6
means i/r is 6%
3m interest rate = 6%/4 = 1.5%

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 Interest Rate Risk

Off balance sheet strategies: (2) Swaps

• (2.1) Use interest rate swaps for transaction hedge:

• Example 1: client wants fixed rate loans but bank wants floating
assets
Pay 5 yr 3% fixed (swap rate)
Swap 
Bank
Counterparty
Pay 5 yr SIBOR (floating)

Pay 5 yr 5% fixed No principal is exchanged between the bank 

and the swap counter party. Only the interest 
payments.
Client
Problem:  prepayment risk
• Client _____________
if client prepay in advance, bank do not earn interest from clients and
pays interest to counterparty

• Swap counter party: __________ credit worthiness. e.g default risk

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 Interest Rate Risk

Off balance sheet strategies: (2) Swaps

• (2.2) Use interest rate swaps for balance sheet hedge:

• Example 2: if bank expects a fall of 100 basis points in interest

rate in 6 months time and therefore a fall of $75,000 in net interest
income (NII). Suppose SIBOR today is 3.5% and the swap rate is
3%.

• Strategy:
• Swap $15m: pay SIBOR (floating) and receive fixed (3%)
• In 6 months, if interest rate decrease 100 basis points, then
SIBOR = 2.5%
• Swap income in 6 months = ________
(3%-2.5%) *15m = 75k

if interest rate rise NII falls, hence we should sell swap, i.e we buy floating
sell fix swaps.

in swaps there is only 1 cashflow. its netted.

e.g i pay 3% fix and i buy 2.5%+sibor, after calculating the difference, one
party pays only

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 Interest Rate Risk

Managing interest rate risks

Asset Liability Management (ALM):
• The ALM function of the financial institution manages the interest
rate risk.

• The Asset and Liability Committee (ALCO) is a senior

management committee that oversees the function.

• A good ALM system will go a long way in providing timely and

useful information for decision making
• Comprehensive: include full portfolio of assets and liabilities
• Flexible: simulate different interest rate scenarios
• Clear and simple: reports, tables, and charts that top
management can understand

53
 Risks in Banks

II. Risks and risk management in banking

Different sources of risk:
1. Interest rate risk
2. Liquidity risk
3. Other risks
• Credit risk
• Foreign exchange (FX) risk
• Trading risk or market risk
• Operational risk

Three steps in risk management:

• Identify risk
• Measure risk
• Manage risk

54
 Liquidity Risk

2. Liquidity Risks
• Banks must have sufficient liquidity to meet obligations (especially
withdrawal) failure of which will lead to bank runs. Banks cannot
have cash flow problems!!!

55
 Liquidity Risk

Reserves requirement

• Reserves requirement = 10%, Excess reserves = $0 million

this bank needs to top up money?

top up by 9m through sale of securities or repo borrowing and discount window or security loans or fed funds
repo and fed funds borrowing is not the same

• Deposit outflow of $10 million. How much reserve to top up?

56 Source: Mishkin and Eakins. Pearson Education, 2018.

 Liquidity Risk

Sources of liquidity

After Selling Loans

57 Source: Mishkin and Eakins. Pearson Education, 2018.

 Liquidity Risk

Liquidity risks
• Sources of liquidity: sell securities, borrow, Central bank’s
discount window (borrower of last resort).

• Liquidity needed:
• Short-term requirement
• Seasonal requirement
• Structure changes in liquidity requirement

• Liquidity regulation: to offset unplanned cash outflow/withdrawal. if hit below mcb, need to borrow

• Minimum Cash Balance (MCB)min in percentage of totalassets(ta is denominator)

• Minimum Liquid Assets (MLA)
singapore adopted the basil requirement
• Liquidity Coverage Ratio (LCR) denom = liqduity rquired
• Net Stable Funding Ratio (NSFR) stable funding ratio for a period(90days)
• Singapore: MAS Notices 758, 613 (formerly), 649, 652

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 Liquidity Risk

Liquidity regulations in Singapore

• MAS Notice 758: Minimum cash balance (MCB) to be kept with MAS =
3% (used to be 6%) of liability base
• [Formerly] MAS Notice 613: Minimum liquid assets (MLA) to be kept with
MAS = 16% of liability base (cancelled and replaced)
• MAS Notice 649: Minimum liquid assets (MLA) and liquidity coverage
ratio (LCR) requirements: Combining Basel III liquidity requirements with
requirements in Notice 613
• SGD MLA requirement: liquid assets in SGD ≥ 16% of all SGD
qualifying liabilities
• All other currencies MLA requirement: liquid assets in any currencies
≥ 16% of qualifying liabilities in all currencies
• SGD and all other currency Liquidity Coverage Ratio (LCR)
requirement (short term)
• MAS Notice 652: Net Stable Funding Ratio under Basel III

Source: MAS, https://www.mas.gov.sg/regulation/Banking#_regulations-and-guidance

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 Liquidity Risk

Price of liquidity
sell up/down

• Liquidity for loans and investments the prices of goods and services that are exchanged
between companies under common control. For
example, if a subsidiary company sells goods or renders
• The price of liquidity: funds transfer pricing services to its holding company or a sister company, the
price charged is referred to as the transfer price

• Funds are not free

• What is the appropriate cost of funds?
• The rate the bank has to pay to source for outside funds
• Instill loan pricing discipline (e.g., liquidity premium table)
• Evaluating corporate loan division
banks dont care profit but sales. banks dont care about
how much money they make, they reward employees for
high high loans.

e.g logically if a 5year loan is 8% a 8year loan must be

more than 8%, however bankers can lower it to less than
8%
hence top management needs to regulate bankers by
instilling loan pricing discpline by asking for liqudiity
premium, e.g min 5 year loan they ask for 2%premium
(6+2) and 8y loan it could be 3%premium(8+3)

62
 Risks in Banks

II. Risks and risk management in banking

Different sources of risk:
1. Interest rate risk
2. Liquidity risk
3. Other risks
• Credit risk
• Foreign exchange (FX) risk
• Trading risk or market risk
• Operational risk

Three steps in risk management:

• Identify risk
• Measure risk
• Manage risk

63
 Other Risks

3. Other Risks
Credit risks: Default risk
• Risk of default of any counterparty:
• Retail borrowers (e.g. residential, hire purchase, share
financing, personal loans, credit cards)
• Corporate borrowers (eg. loans to SMEs)
• Issuers of securities (eg. bonds and commercial paper
issuers)
• Swap counterparties

• How do we measure credit risks?

• PD (probability of default)
• LGD (loss given default)

• Central focus of the Basel Accords

64
 Other Risks

3. Other Risks
Forex risks:
• Risk due to fluctuations of foreign currencies
• Commonly managed by derivatives
• For example: An US exporter exports 1000 TVs to Singapore,
the payment will be made 3 months from today. To lock the
exchange rate, enter USD/SGD FX futures / forward contracts
of buying/selling S$ with the delivery date is 3 months from
today.

us supplier sold tv in sg and receive income from tv in sgd, hence us supplier needs to sell usd/sgd fx futures with delivery date 3 month from today

65
 Other Risks

3. Other Risks
Trading risk or market risk:
• Market risk due to trading activities of the treasury desk

• Tools:
• VaR (value at risk)
• EaR (earnings at risk)
• EVE (Economic Value of Equity)
• RiskMetrics
• Mark-to-Market
these tools exist but we do not need to know them in details.
possibly mcq- what are some tools to market risk

67
 FIN3703A

Financial Institutions II: Banks

I. Financial Intermediaries

II. Risk and risk management in Banking

1. Interest rate risk
2. Liquidity risk
3. Other risks

III. Central Banks

IV. Basel Committee on Bank Supervision

1. Basel I (July 1988)
2. Basel II (June 2004)
3. Basel III (2019)

69
 Central Banks

III. Central banks

• A central bank, reserve bank, or monetary authority is an
(supposedly) independent entity responsible for the monetary
policy of its country or of a group of member states (e.g. EU)
• Primary/core responsibility: to maintain the stability of the
national currency and money supply
• Supervisory powers, to ensure that banks and other financial
institutions do not behave recklessly or fraudulently
• Examples
• Federal Reserve System (Fed) in the USA
• European Central Bank (ECB) in the European Union
• Monetary Authority of Singapore (MAS)

govt - f.p if govt has no money they can raise tax of issue tbill(borrow)

c.b - m.p print

big loophole, if govt has no money, they will borrow(issue t.bill) to C.B and C.B will print money

70
 Central Banks

Central bank independence

head of MOF - lawrence wong who also happen to sit on the board of MAS

Government ‐ Treasury  Central bank

department or Ministry of 
Finance
F.P M.P
taxes(main osurce of income) Print money(buy Tbill from govt)
issue t bil(borrow( from C.B) if there is an urgent need OMO
for big amount of money

71
 Central Banks

Functions of a central bank

Functions of a central bank (not all functions carried out by all
banks):
• Issuance of currency
• Implementation of monetary policy
• Controlling of money supply
• Act as a Lender of Last Resort
• Setting of official interest rate sg MAS C.B does not set official interest rate, we influence the fx
• Managing foreign exchange and gold reserves
• Managing foreign exchange rate
• Regulation and supervision of the banking industry

• Note: Not all functions are carried out by all central banks.

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 Central Banks

Monetary policy instruments

Main monetary policy instruments available to central banks to carry
out their functions:

• Bank reserve requirement: e.g. the minimum reserves each

bank must hold to satisfy withdrawal demands

• Interest-rate policy

• Open market operation: buying and selling government

securities, or other instruments

• IOR and ON RRR rates

fedfundrate always above ior to prevent abtrigage competeiton
repo similar ior
interest on reserve(IOR), banks earn interest from the bank, used as tightening policy
• IOR: interest on reserves
• ON RRR: overnight reverse repurchase agreement
after 2008, fed wanted banks to put money with the fed(RRR) but the amount placed with fed is rising higher and higher. simply because its safer.

however with so much money placed with fed, the money isint going to the citizen

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 Central Banks

Regulation of the banking industry

• Permissible financial activities:
• Commercial banking activities: e.g. full banks, qualifying full
banks, finance companies, etc
• Investment banking activities: e.g. Glass Steagall Act, Gramm-
Leach-Billey Act
• Interest rate ceiling on deposit/loan
• Geographic restrictions on branches
• Capital requirement
• Liquidity requirement
• Deposit insurance:
• US$250,000 per depositor (FDIC)
• €100,000 per depositor (EDIC)
• S$75,000 per depositor (SDIC)
• Others

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 FIN3703A

Financial Institutions II: Banks

I. Financial Intermediaries

II. Risk and risk management in Banking

1. Interest rate risk
2. Liquidity risk
3. Other risks

III. Central Banks

IV. Basel Committee on Bank Supervision

1. Basel I (July 1988)
2. Basel II (June 2004)
3. Basel III (2017)

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 Basel

IV. Basel Committee on Bank Supervision

• Three series of banking regulations (Basel I, II and III) set by the
Basel Committee on Bank Supervision (BCBS)

• BCBS is an international committee formed to develop standards

for banking regulation, founded in 1974 by central banks from the
G10 countries.

• Purpose:
• Ensure banks have enough asset capital
L&E
to meet obligations and
absorb unexpected losses y0 10
y1 +2
8&2
8&2+2
y2 -1 8&2+2-1
• Promote financial stability y3 -4 8&2+2-1-4
7 8& -1 (bankrupt)
basel does not want banks to go bankrupt, hence they
impose rules to reduce bank decision to pursue risky activity
• History of the Basel Committee (link)

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 Basel

1. Basel I (July 1988)

• “International Convergence of Capital Measurement and Capital
Standards”, BCBS, 15th July 1988

• Definition of capital: two-tiers

• Structure of risk weights (for assets)

(capital/ risk weighted assets) >=8%

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Basel I (1988) definition of capital

• Two-tier capital: not required to know the exact difference just need to know the difference
tier 1 is more stable/impt, and if there is any deduction, we deduct tier 1 first
• Tier 1: tier 1 is used to absorb losses in normal situation. tier 2 will be deduced when banks are in big problem.
banks should meet the requirement on tier 1 first
• Common shareholders’ equity
• Disclosed reserves (retained earnings and disclosed reserve - same meaning
• Minority interest in common shareholders’ equity of
consolidated subsidiaries

• Tier 2:
• Undisclosed reserves
• Asset revaluation reserves
• General provisions/general loan loss reserves
• Hybrid (debt or equity) capital instruments: eg. preference
stocks and convertibles
• Subordinated debt

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 Basel

Basel I (1988) definition of capital

• Deductions from Tier 1 and 2:
• Investments in unconsolidated banking and financial
subsidiary companies
• Investments in the capital of other banks and financial
institutions (discretion of national authorities)

• Maximum of tier 2 = 100% of tier 1

this is because basel does not want banks to hold excess illuqid reserve or capiatl that is unstable, hence impose limit on tier 2

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 Basel

Basel I (1988) risk weights of assets

• Standard: to reach capital to weighted risk assets of 8% by end
1992
• Risk weights of assets:
Weight Assets items
On balance sheet
0% • Cash
• Claims on central banks
• Claims on Organization for Economic Co-Operation and
Development (OECD) governments or central banks
50% • Fully secured mortgage loans 1 size fits all. some mortage loans are lent to low income

100% • Claims on non-OECD governments and banks

• Premises, plant and equipment and other fixed assets
• All other assets

Off-balance-sheet asset items are also assigned to risk categories via

conversion factor.

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 Basel

Basel I (1988)
• Standard: the ratio of capital to risk-weighted assets is at least 8%
(compliance by end of 1992)

• Example:
Assets $’m
Cash  100
Claims on OECD governments 150
Secured mortgage loans 500
Claims on non‐OECD governments 50
Other assets 200

• Risk-weighted assets:
• $100m x 0% + $150m x 0% + $500m x 50% + $50m x 100% +
$200m x 100% = $500m
• Thus, required capital:
• $500m x 8% = $40m

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 Basel

2. Basel II (June 2004)

• What was wrong with Basel I?

• Summary of revision in Basel II:

• 3-pillar system
• Pay due regard to particular features of the present
supervisory and accounting systems in individual member
countries
• Maintain the 8% capital to risk-weighted assets (1st pillar)

capital 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

adequacy 8%
formula 𝐶𝑟𝑒𝑑𝑖𝑡 𝑅𝑖𝑠𝑘 12.5 ∗ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑅𝑖𝑠𝑘
market risk = changes in price of securities

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 Basel

Basel II
(2004) formula on slide 88

dont need to know what is foundation and adnvanced

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 Basel

Basel II (2004)
Greater use of assessments of risk provided by banks’ internal
systems as inputs to capital calculations

• Credit risk:
• Standardized approach
• for many banks
• similar to the 1988 method
• Internal-Rating-Based (IRB) approach
• allowed for sophisticated banks
• Rely on internal estimates of risk components:
• PD (probability of default)
• LGD (loss given default)
• EAD (exposure at default)
• M (effective maturity)
• Complex rules and risk-weighted functions

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 Basel

Basel II (2004)
• Market risk: risk resulting from trading activities
• Standardized measurement method
• Internal models approach

• Operational risk: risk of loss resulting from inadequate or failed

internal processes, people and systems or from external events.
• Basic indicator approach
• Standardized approach
• Advanced measurement approach

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 Basel

Basel II (2004)
• More national discretions. Too much?

• Two addition pillars:

• 2nd pillar: Supervisory review process
• 3rd pillar: Market discipline

• To be achieved by end-2007 by G-10

• MAS implemented Basel II at the same time as the G-10 countries

(The Group of Ten is made up of eleven industrial countries: Belgium,
Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,
Switzerland, the United Kingdom and the United States)

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 Basel

3. Basel III (2017)

• Responding to the 2007-09 financial crisis, BCBS issued the
proposed standards of Basel III in Dec 2010 and completed its
Basel III post-crisis reforms in 2017. As of 2022, it is still in the
process of implementation, with most of the reforms being phased
in between 2013 and 2019.

• Major changes
• Liquidity requirement
amount of requirement and quality of capital
• Higher capital requirement
less risky assets become riskier in recession, hence the denominator of capital

• Countercyclical buffer adequacy increase which means the capital needs to increase to meet the 8%. hence
during good times basel want banks to put more money as buffer and during bad time,
it will demand less money, since these money needs to be used to save itself
• Systemically important banks (G-SIBs, D-SIBs)
g = global
d = domesitc

• BCBS summary – Basel III (link)

• How much capital is enough?

based on the 8 %

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