5550 Recap 2
Recap 02 — The Importance of Capital and the Basel Accord
Transformation and Risk
According to Paul McCulley:
[T]he essence of banking is maturity, liquidity and quality transformation: holding assets that are longer, less liquid and of lower quality than the funding liabilities.
Transformation is where banks make their money, and transformation entails risk. Thus the tension that underlies international banking: The banks are trying to ramp up risk in order to make more money, while the regulators are trying to keep the risk in check so as to prevent a banking crisis.
The risks arising from liquidity and maturity transformation can be minimised if the central bank is willing to act as lender of last resort. However, that still leaves credit risk. While credit risk can generate profits in the good times, it also has the ability to generate losses in the bad times. If a bank’s losses exceed its capital, all the liquidity in the world still can’t stop the bank from failing.
To stop a bank from failing, IN ADDITION to the central bank’s acting as the lender of last resort, the bank itself must hold adequate capital. [Do the following two diagrams help explain this concept? If so, how?]
And central banks and regulators around the world, through the Basel Committee on Banking Supervision (‘BCBS’), have committed to monitoring the capital levels of internationally active banks.
Basel Committee on Banking Supervision [Who Are These Guys?]
The BCBS was born of crisis, the one triggered in 1974 by the failure of the Herstatt Bank. That crisis illustrated the interconnectedness of banks, and regulators saw that it was in their best interests to make a global effort to enact “standards governing … international banks”. [What happened when the Herstatt Bank failed?]
The BCBS made capital their focus. Capital is a solvency issue: Are the bank’s assets, risky as they are, sufficient to repay the bank’s liabilities (deposits included)? In this
Transformation and Risk
According to Paul McCulley:
[T]he essence of banking is maturity, liquidity and quality transformation: holding assets that are longer, less liquid and of lower quality than the funding liabilities.
Transformation is where banks make their money, and transformation entails risk. Thus the tension that underlies international banking: The banks are trying to ramp up risk in order to make more money, while the regulators are trying to keep the risk in check so as to prevent a banking crisis.
The risks arising from liquidity and maturity transformation can be minimised if the central bank is willing to act as lender of last resort. However, that still leaves credit risk. While credit risk can generate profits in the good times, it also has the ability to generate losses in the bad times. If a bank’s losses exceed its capital, all the liquidity in the world still can’t stop the bank from failing.
To stop a bank from failing, IN ADDITION to the central bank’s acting as the lender of last resort, the bank itself must hold adequate capital. [Do the following two diagrams help explain this concept? If so, how?]
And central banks and regulators around the world, through the Basel Committee on Banking Supervision (‘BCBS’), have committed to monitoring the capital levels of internationally active banks.
Basel Committee on Banking Supervision [Who Are These Guys?]
The BCBS was born of crisis, the one triggered in 1974 by the failure of the Herstatt Bank. That crisis illustrated the interconnectedness of banks, and regulators saw that it was in their best interests to make a global effort to enact “standards governing … international banks”. [What happened when the Herstatt Bank failed?]
The BCBS made capital their focus. Capital is a solvency issue: Are the bank’s assets, risky as they are, sufficient to repay the bank’s liabilities (deposits included)? In this