PRUDENTIAL REGULATION

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 contents

a. Call for regulation

b. Types of regulation
c. European organisation

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a. Why regulation?

Introduction: why prudential supervision?

- Special role of banks in the economy

savings & investments; growth
- existence of banks is based on trust & trust must be maintained
via avoidance of bank defaults
via ring fencing to avoid contagion
- Protection of the consumer
a. Why regulation?

• Disadvantages of “simple” regulation.

– moral hazard,
– asymmetric information
– adverse selection

• Need for adequate regulation

a. Why regulation?

Within a simple theoretical model it is possible to show that a viable banking

sector can endogenously be created assuming only
– Cost control
– & information advantage (moral hazard)
– & creation of new products

(see also previous chapter: reasons for intermediaries to exist)

However, the introduction of uncertainty creates the need for regulation, because
the uncertainty undermines the trust in the banking system.
Uncertainty in this context means the lack of certainty of being able to retrieve
the money back from the bank.
a. Why regulation?

Illustration: Effectiveness of deposit guarantee system

theory

reality

100% guarantee
b Types of regulation

– Prudential:
• Charter/bank licence & rules
• Solvency rules.
• Liquidity rules.
– Market behaviour.
– Product & service regulation.
– Compliance (tax, money laundering,…)
– Crisis management architecture
b. Types of regulation: zoom on Basel III

• PILLAR I: minimum CAD: credit risk – operational risk

– Basic approach
– Advanced approach
• PILLAR II: supervisory review
• PILLAR III: disclosure - market discipline.
 b. Types of regulation: zoom on Basel III

• > 12,0% (or 10,5% for non sifi)

Tier 2: 2%
capital ratio versus 8% before
Hybrid T1: 1,5% GFC
Countercyclical
between (0% ,2,5%)
• Different forms of capital
Combined buffer

Capital Conservation
CET1 2,5%
• Capital requirements to be determined by
Sifi buffer CET1 1,5% the regulator according to the specific
Pillar 2 risks (P2R) micro and macro factors
CET1: xx%
• Pillar 2 (SREP) is institution specific
Min CET1 in Pillar
1: • CAD therefore changes in function
4,5% of risks and over time.
b Types of regulation: zoom on Liquidity

• LCR (liquidity coverage ratio) > 100% of outflow in 30 days

• NSFR (net stable funding ratio) > 100% of outflow in year.
b Types of regulation: other

Market behaviour.
Product and service regulation
• AML, Compliance, Operational Risks
b Types of regulation: crisis management

Crisis management architecture

Central bank, as lender of last resort

Deposit guarantee scheme.
• Resolution: orderly failure, monetization and "bail-in”

Government –Treasury in case of bail-out

c Organization in Europe / Belgium

ESRB
(European
systemic Risk
Board) macro
prudential
oversight of the
financial system
in the EU.

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c Organization in Europe / Belgium

single
rulebook

capital
requirements

Deposit
guarantee
schemes

bank recovery
and
resolution

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c Organization in Europe / Belgium

Reduce the probability of a

bank failure and reduce the
costs for society of a failure
SSM by monitoring closely

 Solvency and liquidity

 Business model
 Risk management
ECB NSA (or practices and models
NCA)  Also forward looking
(stress tests)
 Macro economic
evolutions

by having the authority to

force banks to change (part
of) the business plan, to
increase capital ratio etc…

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c Organization in Europe / Belgium

If there still is a failure

• reduce the cost for society,

i.e. break the doom loop,
(bail in)
• cure the problem of moral
SRM •
hazard and as a result
enhance the credibility of
the deposit insurance
scheme.
• Force banks to make their
testament and to prepare
their resolution in an
orderly fashion (prevent
panic and contagion)

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c Organization in Europe / Belgium

Twin peaks
model

FSMA NBB NBB+ECB

Consumer protection Insurance

Anti Money Laundering
Bank regulation
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c Organization in Europe / Belgium

The European Commission monitors the functioning of financial

markets in Europe.

EMIR: European Market Infrastructure Regulation: Regulations

on Over The Counter derivatives.

• Central clearing parties

• Trade repositories

The aim is to
increase transparency
reduce credit risk
reduce operational risk.

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Quiz
1. Is it possible to avoid moral hazard problems using
regulation?
2. Explain why the SREP is an adequate measure to regulate
banks.

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