Banking Regulation and

Risks
M009LON

Banking Regulation and Risk

Lecturer: Dr. Xiaowen GAO

Email: ab0400@culc.coventry.ac.uk
Office hour: Monday 2-3pm
Room 402

Module Learning Outcomes

On completion of this module you should be able to:

Demonstrate a critical understanding of the risks in banking and the need

for banking regulation
Evaluate the relationship between risk and minimum capital requirements,
and the risk-based regulatory framework
Demonstrate a theoretical understanding of the methods for the
measurement and management of credit risk, market risk and operational
risk.
Demonstrate a critical understanding of the requirement for the
measurement and management of liquidity risk and interest rate risk in the
banking book
Critically assess the ways in which the treasury function should ensure that
minimum capital requirements are maintained.

Module Overview
Why are financial institutions special

Risks of financial institutions

Capital Adequacy and Basel Accord I,II, III
Interest rate risk
Credit Risk
Market Risk
Operational Risk
2007-2010 Financial Crisis and Current Issues in Risk
Management
Management of Risk

References
Textbooks

Saunders, A and Cornett, M. (2011) Financial Institutions Management: A

risk Management Approach. McGraw Hill.

Other Reading

Apostolik, R., Donohue, C. & Went, P. (2008) Foundations of Banking Risk,

Wiley Finance.
Sironi, A. and Resti, A. (2007) Risk Management and Shareholders Value in
Banking: From Risk Measurement Models to Capital Allocation Policies,
Wiley Finance.

Module Learning Structure

Teaching Style:

Knowledgecast (Knowledge and Understanding ) - 1 hour

Seminar (Q&A) 1 hour
Group activities ( Application &Problem Solving/Bloomberg training) 2 hours

Assessments:

Mid-term group presentation

Final assignment: Coursework 3500 words

Unit 1 Outline
In this unit we will cover:
The special role of FIs in the financial system and the
functions they provide
Why the various FIs receive special regulatory attention
What makes some FIs more special than others

Types of Financial Institutions

Depository Institutions:
Commercial Banks, Savings Institutions, Credit Unions

Non-depository Services:
Securities Brokerage and Investment Banking
Mutual Funds and Hedge Funds
Insurance Companies

Without FIs

Without FIs: Low level of fund flows

Higher monitoring cost
Less liquidity
Liquidity: the ease of converting an asset into cash

Substantial price risk

Price risk: the risk that the sale price of an asset will be lower than the
purchase price of that asset

With FIs

Brokerage function
Acting as an agent for investors:
Reduce information cost
Full service vs. discount brokers e.g. Bank of America Merrill Lynch

Reduce transaction costs through economies of scale

Encourages higher rate of savings

 Asset transformation function:

FIs purchase the financial claims issued by corporations equities,
bonds, and other debt claims (primary securities) and finance these
purchases by selling financial claims (secondary securities) to
households
Secondary securities: securities issued by FIs and backed by
primary securities
Better manage information cost, liquidity and price risk
e.g. Such as Closed-end funds, ETF, Mutual funds,
insurance policies
These secondary securities often more marketable

Role of FIs in Cost Reduction

Monitoring costs:
Investors are exposed to agency costs
Reason: incomplete information
Agency costs: the risk that managers of firms that receive savers funds will take actions
with those funds contrary to the best interests of the savers

Role of FI as Delegated Monitor

FI likely to have a greater incentive to collect information
Economies of scale in obtaining information

FI as an information producer
Greater monitoring power and control by issuing
secondary securities e.g. short term loans
Acting as delegated monitor, FIs reduce information
asymmetry between borrowers and lenders

 Liquidity and Price Risk

Secondary claims issued by FIs have less price risk
Demand deposits and other claims are more liquid
More attractive to small investors
FIs have advantage in diversifying risks

Other Special Services

Reduce transactions costs
Maturity intermediation

Other Aspects of Specialness

Transmission of monetary policy
Monetary policy actions: open market operations
Setting the discount rate
Setting reserve requirements

Credit allocation
Areas of special need such as home mortgages, farming
Intergenerational transfers or time intermediation (Pension
funds, life insurance)
Payment services
Denomination intermediation (money market funds, mutual
funds)

Specialness and Regulation

FIs receive special regulatory attention
Reasons:

Negative externalities of FI failure

(Negative externalities refers to action by an economic agent imposing costs
on other economic agents)

Regulation of FIs
Safety and soundness regulation:
Regulations to increase diversification
No more than 10 percent of its equity to a single borrower

Minimum capital requirements

Minimum capital ratio: minimum capital to risky assets ratio
The greater the capital the greater the protection against
insolvency risk

Deposit Insurance fund

US $250,000
UK 85,000

Monitoring and surveillance

On-site examination
Off-site examination

Summary

Three types of costs without FIs

Two additional functions of FIs
Specialness of FIs
Four layers of Safety and Soundness Regulation

Seminar

What are five risks common to financial institutions?

Explain how economic transactions between household savers of funds and

corporate users of funds would occur in a world without financial institutions?

Identify and explain the two functions FIs perform that would enable the smooth
flow of funds from household savers to corporate users.

What are five areas of institution-specific FI specialness and which types of

institutions are most likely to be the service providers?

What forms of protection and regulation do regulators of FIs impose to ensure

their safety and soundness?

Group Activity
Group Presentation
Conduct research on the following financial crises:

Savings and loans crisis 1980s

Stock market crash 1987
Asia crisis 1997 to 1998
Dotcom bubble 1999 to 2000
Global financial crisis 2007 to 2008

What are the causes of these crises and are they avoidable from your point of
view?