D. The deregulation of US banking industry preceded the 2008 Financial Crisis by
ID: 1213597 • Letter: D
Question
D. The deregulation of US banking industry preceded the 2008 Financial Crisis by less than a decade.
1. What were the objectives of original Glass-Steagall Act in 1933?
2. What were the consequences of its repeal in 1999?
3. Why are there increasing demands to reinstate Glass-Steagall today? Do you agree? Why or why not?
E. In the aftermath of the 2008 Financial Crisis, the Basel 3 Accord sought to reduce systemic risk.
1. What are the most serious problems with Basel 2?
2. What are the most significant regulatory improvements of Basel 3?
3. Which provisions do you believe are most important? Which ones are least important? Explain with examples.
Explanation / Answer
Ans- An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment banking business. The Glass-Steagall Act was sponsored by Senator Carter Glass, a former Treasury secretary, and Senator Henry Steagall, a member of the House of Representatives and chairman of the House Banking and Currency Committee. The Act was passed as an emergency measure to counter the failure of almost 5,000 banks during the Great Depression. The Glass-Steagall lost its potency in subsequent decades and was finally repealed in 1999.
It has following objectives-
Glass-Steagall was enacted as an emergency response to the failure of nearly 5,000 banks during the Great Depression. In 1933, all U.S. banks closed for four days. When they reopened, they only gave depositors 10 cents for each dollar. Where did the money go? Many banks had invested in the stock market, which crashed in 1929. When depositors' found out, they all rushed to their banks to withdraw their deposits.
Even sound banks usually only keep one tenth of the deposits on hand. They will lend out the rest because they know that normally that's all they need to keep on hand to keep their depositors' happy. However, in a bank run, they must quickly find the cash.Today, we don't have to worry about bank runs because the FDIC insures all deposits. Since people know they will get their money back, they don't panic and create a bank run.
2. 1. What are the most serious problems with Basel 2-
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Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. Under the Basel II framework, regulators allow large banks with sophisticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold by the regulators as a buffer against unexpected losses.
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Bank capital-asset ratios are near historically low levels, typically at about 7 per cent of total assets (on a non risk-weighted basis). During the past five years, several so-called “quantitative impact studies” (QISs) have been conducted under the auspices of the Basel Committee on Banking Supervision to explore the consequences of shifting from Basel I to Basel II for large banks. These studies show that bank capital requirements will fall further for many banks when the Basel II rules are fully implemented. In the US, the QIS results indicate potential reductions in required capital of more than 50 per cent for some of the largest banks.
The turmoil on financial markets, which has caused large banks to take substantial losses and search for significant new capital, indicates that Basel II should not be implemented, if at all, without first making a number of important changes. We advocate the following improvements in order to correct some of its deficiencies.
First, we urge the Basel committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use their internal models for calculating regulatory capital.
Second, we advocate the additional adoption of a meaningful non risk-weighted leverage ratio requirement, as currently applicable in the US, to supplement Basel II risk-weighted capital requirements. Consistent with the FDIC chairman, we believe that it is important to have a minimal capital cushion in the banking system, even when risk-based Basel II capital rules indicate lower risk. Strong capital allows banks to recognise losses and put problems behind them in times like the ones we are now experiencing. And strong capital gives banks the flexibility to serve as shock absorbers to our economy during difficult times.
Third, we recommend that the Basel II approach using banks’ own risk models should be complemented by a credible and effective form of market discipline. While Basel II contains information disclosure requirements, at the same time it fails to create incentives for professional investors to use this information in an optimal way. As long as professional investors holding bank liabilities have the perception that large banks are too big to fail – or that all deposits will be fully protected against loss, as in the Northern Rock case – they will have the idea that their money is not really at stake. This will mitigate their incentives to use the disclosed information. A mandatory requirement for large banks to issue credibly uninsured subordinated debt as part of the regulatory capital requirement could enhance market discipline, thereby mitigating banks’ incentives to reduce capital.
2. What are the most significant regulatory improvements of Basel 3-
Basel III is a set of international banking regulations developed by the Bank for International Settlements in order to promote stability in the international financial system. The purpose of Basel III is to reduce the ability of banks to damage the economy by taking on excess risk.
The most important improvement in Basel III are listed below:
Increased Capital Requirements
The rules aim at improving both the quality and quantity of capital.
According to the Basel III rules, banks will need to increase their tier-one capital ratio (ratio of equity capital to risk-weighted assets (RWA)) from 2% to 4.5%. This should be done by 2015. In addition to this, by 2019, banks will be required to add an additional conservation buffer of 2.5%. This means that they will have to hold core capital equal to 7% of their risk-weighted assets.
The minimum total capital requirements has increased from 8% to 10.5% (including the conversation buffer)
There are also significant changes in what qualifies as Tier 1 capital. For example, common equity and retained earnings should form the predominant component of Tier I capital.
The reasoning behind this move is that if banks have higher capital cushion, they will be in a better position to take the effects of a downturn.
Reduced Leverage
The leverage limit for banks has been set to 3%, i.e., a bank’s total assets (including both on and off-balance sheet assets) should not be more than 33 times bank capital.
Liquidity Reforms
To complement its “Principles for Sound Liquidity ”Risk Management and Supervision, the Basel Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity:
Capturing Risks
With Basel III, the objective of BCBS is to ensure that all the risks are fully covered in the Pillar 1 framework. It increases capital requirements for risks that were not adequately captured in the Basel 2 framework. Treatments of some of the exposures are listed below:
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