Financial Stability, Regulation, and Supervision

There are two dimensions of systemic risk. The first one is the grift links among financial institutions. The second one is procyclical credit growth -rapid credit growth during high GDP growths or vice versa amplifies business cycles in an economy, leading to severe concerns in the financial sector.

The origin of a banking crisis is severe balance sheet weaknesses in one or several banks, which are big enough to affect the whole banking sector. The currency crisis is the collapse of the exchange rate system following a speculative attack on the domestic currency. Generally, the term ‘financial crisis’ is used to encompass both. If you dig a little deeper, it is likely to find titles such as balance of payments and capital account crises -both point to extreme difficulties in financing the current account deficit, which causes a sharp depreciation and spills over the rest of the economy overnight. In some theoretical models that try to explain crises, distinguishing banking and currency crises may not be possible.

On the eve of a crisis, risk aversion tends to increase. In this environment, we generally observe a rise in the risk premium and interest rates, as well as pressure on the domestic currency to depreciate. With the crisis burst, the domestic currency depreciates in a flexible exchange rate regime. Suppose it is a fixed exchange rate regime or a variant. In that case, authorities devalue the domestic currency and either try to stick to the previous exchange rate regime, albeit at a higher exchange rate, or shift to a flexible one. Simultaneously, risk appetite for the financial assets of that country declines sharply, and interest rates jump. No matter how the crisis is shaped, it quickly spreads to nonfinancial and financial corporations.

These are maturity mismatch, nonperforming assets, insufficient capital, low capital-to-assets ratios, and currency mismatch.

A short-term maturity mismatch arising from the positive gap between short-term liabilities and assets can lead a bank to face liquidity problems, especially in financial distress. From this perspective, ‘short-term’ refers to one-month or shorter maturities.

If some corporations face severe problems and have difficulties repaying their debt, the creditor banks’ capital can erode. In banks with an initial inadequate capital level, such a problem can lead these banks to bankruptcy.

CDS can be taken as insurance that the person who purchases the risky bond buys to hedge the risk. The higher the risk is, the higher the insurance premium one will pay.

Banks with currency mismatches can face significant issues during periods of sharp changes in exchange rates.

High interconnectedness among banks, procyclical credit extension behavior of banks, and liquidity shortages render the financial system susceptible to a financial crisis.

In rapid credit growth periods, credit quality can decline. Furthermore, the interconnectedness among banks can increase too much. Consequently, rapid credit growth can create issues for the financial sector.

Systemic risk causes a significant liquidity bottleneck in the financial system. Here is how it works: In times of heightened uncertainty about the future and heightened risk perception, a bank’s knowledge is insufficient to evaluate the counterparties’ soundness. This phenomenon creates a crisis of confidence among financial institutions. This bank wonders which counterparties have high risk and abstain from supplying liquidity to other banks. As such questions become more common, the liquidity problem becomes widespread.

The current price of a financial asset is determined by two main factors: Economic fundamentals and expectations about the future value of its price. If the latter predominates, the current price of a financial asset may gradually deviate from the level indicated by economic fundamentals. The gap between the two can grow over time and become a bubble.

It was designed to respond to the global financial crisis. BIS states that the financial leverage was relatively high before the crisis, liquidity buffers were inadequate, and risk management was poor. These factors led to a mispricing of credit, liquidity risks, and excess credit growth. The new standards were issued in December 2010. Most of the new standards were expected to be effective between 2013-2019, which include stricter capital requirements, leverage ratio, liquidity buffers, countercyclical capital buffers, and additional requirements for systematically important banks.

Basel 1 is a capital measurement system. It was released in July 1988 to be implemented by the end of 1992. It set capital to risk-weighted assets ratio at a minimum of 8 percent.

Banking regulation sets standards for the soundness of banks and the banking system. Bank supervision is the enforcement of these standards. The aim is to strengthen the micro and macroprudential stability of the banking system.

The capital adequacy ratio is the capital ratio to the sum of the risk-weighted assets. The sum

of risk-weighted assets is the sum of three items: the amount subject to credit risk, the amount

subject to market risk, and the amount subject to operational risk. Regulatory and supervisory

authorities require a capital adequacy ratio above a certain threshold.

This ratio aims to ensure that a bank has enough buffer for its losses before becoming insolvent

by limiting the impact on the soundness of a bank of maturity mismatch, currency mismatch,

nonperforming assets, and inadequate capital.

The leverage ratio is a bank’s capital measure divided by its exposure measure. The BRSA (Banking Regulatory and Supervision Authority) measures the exposure as the sum of assets, off-the-balance sheet operations, derivatives, and collateralized financial operations.

The liquidity ratio is the ratio of assets with a time-to-maturity of 30 days to liabilities with a time-to-maturity of 30 days. The BRSA sets the minimum liquidity ratio for domestic currency assets at 100 percent and foreign currency liabilities at 80 percent.

It aims to ensure that relationships and balances are established between foreign exchange assets and liabilities of banks and to enable the banks to keep a foreign exchange position at a level consonant with their own funds. Thus, it addresses the currency mismatch problem.