Financial institutions and markets

Published:

Executive summary

This objective of the report is to present the current bank regulatory system, the weaknesses existing in the general bank regulatory system and the potential weakness the Australian bank sector may suffer. Based on the second research of the information and data released by financial authorities, this report attempted to identify the current bank regulatory system and the potential risks the current bank sector may suffer. The findings suggest the general Australian bank regulatory system maintain the Australian bank sector in a satisfactory condition, however, from the failure of Lehman Brother and the recent financial crisis, the regulators should be aware that Australian banks should be required to keep enough capital for counterparty credit risks of the transactions from credit default swaps as an important portion in the whole adequate capital requirement. We recommend that regulators should pay more attention to the requirement of capital for counterparty risks and set some more accurate measures to calculate the exposure at default and improve the charges to credit default swaps.

Introduction

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Over the recent years, financial market has enormous changes. Before the crisis, banks had accumulated huge profits from the innovation of financial services such as the transaction of credit default swaps. However, since the weakness of bank regulation, the fourth big investment bank in the U.S. collapsed at the first below in front of the huge debt but without capital to absorb the losses result from the counterparty default of the credit default swaps. Moreover, due to the close interrelation between banks in the world, the worldwide bank industry is thumped by the default of Lehman Brother. Therefore, it is essential to see that counterparty default risk can not be ignored in today's financial world. This report is commissioned by the chairman of Australian Prudential Regulation Authority to analyse the weakness of current banking regulation so that the bank regulation system could be improved. This report will include the Australian bank regulation framework, the reasons of the existing of bank regulation, the main aspects that banks regulated the weakness in the current banking regulation and current finance situation in Australia. The data and information are all gathered from some financial authorities.

Regulatory framework

Australian bank regulatory system is set to mainly manage the risk taking of ADIs to ensure the safety of depositor's funds and the overall stability of the bank sector. A recent study (Brimble et al.2007, pp. 509-510) concludes that, in Australia, banks are mainly supervised by Australian Prudential Regulation Authority according to the Banking Act 1959. Probability and Impact Rating System(PAIRS) is one of the essential tools to assess the probability that a regulated institution(not only banks) will fail and the impact such a failure would have on the financial system. The other tool is the Supervisory Oversight and Response System (SOARS), whose prime duty is to decide the response APRA should make to the results of PAIRS ratings. Both of the two systems play an important role to assist APRA in regulating and supervising Australian bank sector.

Reasons for bank regulation

The reason that bank regulations are indispensable is that it has significant impacts on ensuring the safety and soundness of the banking industry and even the nation's economy as a whole. Capital adequacy requirements and adequate liquidity requirements are mainly used in the Australian prudential bank regulatory systems to gain public confidence on banks and public willingness to accept the liabilities that banks owing, even if those liabilities pay low interest rates. (Brimble et al.2007 p. 517) By doing so, these primary tools of regulations greatly reduce such occurrences of bank failures which usually caused by illiquidity and inadequate capital. Simultaneously, it remarkably decreases the potential bank panics produce by contagion and consequent deceleration of economy caused by bank failures. Therefore, bank regulation is very essential to the regular operation of banks and the health of the whole bank sectors.

Prudential regulations

Australian banks are usually regulated by several main aspects, namely liquidity, capital adequacy and other prudential and regulatory controls within the bank regulation system.

Adequate liquidity requirements

Enough liquid resources are very essential to the regular operations of deposit-taking institutions. Liquidity problems results from insufficient funds for transactions may cause bank runs even bank panics. Banks are required to implement the liquidity management strategy, as Brimble et al.(2007, p. 517) defined in their book, liquidity strategy management is a compulsory strategy that banks must ensure it has adequate funds to meet its obligations as and when they fall due.

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Capital adequacy requirement

As another main requirement to regulate banks, the capital adequacy requirement, which requires banks to maintain adequate levels of capital to keep operating in the event of unexpected troubles or difficulties, is an indispensable aspect regulated banks should consider about. Capital is the core of a bank's power. Since it is able to support banks' business by providing a buffer to absorb unexpected losses from its activities and enable those banks continue to operate normally within a sound and viable condition while the problems they encountered are resolved. Regulators set 8 percent as the least capital adequacy ratio banks should maintain, which is calculated upon different kinds of risks that banks may suffer, such as credit risks, market risks and operational risks. (Brimble et al.2007 pp. 518-524) However, if some risks are not considered appropriately by banks, there would be some problems arise. This would be discussed in detail in the next section.

Other regulatory controls

Brimble et al.(2007, p. 525) point out that banks are also regulated by some other additional requirements in some aspects, such as the authorization of banks, ownership and control of banks, associations with nonbanks, the ownership and control of banks, limitations on exposures they can assume, external review and attestation of reports.

In summery, liquidity management strategy, capital adequacy requirements and some other regulatory controls are the vital pillars of the Australian bank regulatory framework which keep Australian bank sector in a healthy condition.

Weakness of the bank regulation

Through the development and innovation of the financial services and transactions of banks, some weaknesses of the current bank regulation system have been exposed by the worldwide financial crisis. And the regulators should consider the exposed weaknesses carefully when they are attempting to improve the bank regulation system.

Ignored factor-Counterparty credit risk

As it is mentioned above, regulated banks are supposed to maintain capital adequacy to help them absorb unexpected losses while the emergent problems happening. In addition, the capital adequacy ratio is estimated upon different kinds of risks banks may suffer. However, insufficient regular capital for counterparty credit risk in the current system may cause serious troubles.

It is defined by the Bank of International Settlements(2009):

Counterparty credit risk is the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows.

In other words, there is a risk a great loss an entity may suffer, if the counterparty it has transactions involved with default.

Trigger of counterparty credit risk--Credit default swaps

Large counterparty exposures can be created by the credit-default swaps. APRA(1999) stated that a credit-default swap is a kind of credit derivative instrument that is designed to transfer the credit risk of an asset (the reference asset) from the protection purchaser to the protection seller without transferring legal ownership of that asset. As Figure 1 shows, under the swap, the protection buyer pays the protection seller either a periodic or an up-front fee. Nevertheless, if a credit event occurs on the reference asset, the protection seller is responsible for the credit-event payment for the possible loss suffered. As we know, the protection buyer is dependent on the protection seller for payment when a credit-event occurs, and given the potentially large size of this payment, the credit-default swaps create the counterparty exposures. Accordingly, the bank (protection seller) is actually facing big counterparty exposure when credit default swaps occupy a huge part in their business. Once they have no insufficient capital to absorb the losses, the banks may suffer big failures. This can be illustrated by the collapse of Lehman Brothers and the crisis it triggered, which will be detailed later.

Lessons from bank failure

Lehman Brother had been an active, market-making participant in CDS markets, so its default caused a significant deterioration in market liquidity. Those with direct counterparty exposure to Lehman also faced considerable uncertainty and complexity. (United States House of Representatives 2008) Finally, it brought the contagion to the whole bank sector. We can get the lesson from the crisis that counterparty credit risks may cause a series of problems like dominos if banks aggregate their business on credit default swaps too much and ignore the big possibility of default of the counterparties. Therefore, a sufficient capital for the counterparty credit risk is an indispensable consideration in the capital adequacy requirements of the banks.

Potential risks in Australia

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Credit-default swaps are the most commonly traded credit derivatives in Australia. According to the Australian Financial Review released in 2002, the Australian market in credit default swaps dramatically increased 55 percent from $18 billion to about $28 billion from 2000 to 2001. And the credit default swaps market in Australia is growing at an extremely rapid speed, which increased the potential counterparty exposure as well. Since credit default swaps are always done over-the-counter, there is no central exchange, no regulator to speak of, and no known reserving. To avoid the reoccurrence of the failure of Lehman Brothers and contagion, there should be some careful regulations to require related capital to absorb the losses suffered from the counterparty credit risk arising from CDS in the Australian banking regulation system.

Conclusion

Through researching the annual reviews and data from some authorities like APRA, RBA and BIS, this report has analysed the current bank regulation system and the weaknesses existing in the general bank regulation system. It is concluded that bank regulators should pay more attention to require sufficient capital for counterparty risks and take some measures to regulate those banks which involving in the credit default swaps with large counterparty exposure.

Recommendation

Through study the lessons from the recent bank failures, in my opinion, more measures should be taken to strengthen bank capital for the counterparty credit risks so that the losses are able to be absorbed in time. More improved calculation of exposure at default is supposed to be used to promote more robust collateral management practices. All in all, it is recommended that the regulators should pay more attention to the adequate capital requirement for counterparty credit risks and charges for credit default wraps to prevent the reoccurrence of collapse of the fourth big investment bank followed by financial crisis.

Bibliography

  • Brimble, M., Kidwell, David S., Beal, D., Blackwell, D.W., Willis, D., Whidbee, D. & Peterson, R.A. 2007, Financial markets, institution John Wiley & Sons Australia, Ltd Australia.
  • Capital-adequacy treatment of credit derivatives 1999., electronic version, APRA
  • <http://www.apra.gov.au/ADI/upload/Capital-adequacy-treatment-of-credit-derivatives-April-1999.pdf>
  • Causes and Effects of the Lehman Brothers Bankruptcy 2008, electronic version, United States House of Representatives
  • < http://research.chicagobooth.edu/igm/docs/Zingales-Testimonies.pdf>
  • Strengthening the resilience of the banking sector,2009., electronic version, Bank of International Settlements Department,
  • < http://www.bis.org/publ/bcbs164.pdf>
10. Appendices