Prudential Regulation Research Articles

A market consistent approach to the valuation of no-negative equity guarantees and equity release mortgages

AbstractThis paper provides a new market consistent approach to the valuation of no negative equity guarantees and equity release mortgages. The paper provides a new approach to the estimation of volatility inputs. The proposed approach to volatility produces a volatility term structure that is dependent on the age and gender of the borrower. Illustrative valuations are provided based on the Black ’76 put pricing formula and mortality projections based on the M5 Cairns–Blake–Dowd mortality model. Results show interesting ramifications for industry practice and prudential regulation.

A pathway model to five lines of accountability in cybersecurity governance

In an in-depth field study, we investigate cyber security governance configurations vis-à-vis the five lines of accountability (5 LoA) – that is, the Three Lines Model extended by the accountability of executive management and the board of directors (IIA, 2020). The aim is to explore the configurations adopted by organizations in governing cybersecurity, and why it would matter for cyber security whether the five lines of accountability are adopted. We define the type of the 5 LoA adoption by: (i) the segregation of the lines that spans from blended to segregated and (ii) the level of engagement of those in line roles that ranges from low to high. In this way, we identify four types of adoption of the 5 LoA: ‘no adoption, ‘ostensible’, ‘implicit’, and ‘explicit’ adoption. We theorize how the type of adoption of the 5 LoA is affected by the interplay of institutional forces and organizations’ need for efficiency and effectiveness, and develop a pathway model for organizations’ adoption of the 5 LoA. We find that organizations that adopt the 5 LoA with clear segregation between these lines (‘ostensible’ and ‘explicit’ adoption) are those subject to prudential regulation (coercive forces), whereas efficiency motives and mimetic forces drive organizations to seek fluidity and flexibility by ‘blending’ the segregated lines (‘implicit’ adoption) to ensure fast reactions to changing environment. Regardless of the segregation between lines and whether they are blended or not, we found that all organizations see scope to improve the level of engagement in the 5 LoA to improve the effectiveness of cyber security governance.

Information acquisition and rating agencies

For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings was compromised by the evolution of the industry to a form where issuers pay for ratings. In this paper we consider both an investor-pays and an issuer-pays set-ups and show that if the investor-pays version can overcome the free-rider problem it is efficient, and otherwise leads to under-provision of information; while if the issuer-pays can force disclosure, it is efficient, but otherwise it leads to less revealing information because of the systematic distortion in revealed information along with over-investment in information. We show that in both these arrangements credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. We argue that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them.

The Coordination Between Macro-Prudential Supervision and Monetary Policy — From the Perspective of Financial Stability

The onset of the 2008 economic crisis forced central banks to acknowledge that the monetary policy and micro prudential policy-based financial regulatory framework is insufficient to avert systemic risks. Compared with the low efficiency of micro prudential supervision in preventing and controlling financial systemic risks and the weakness of a single monetary policy tool in controlling financial systemic risks, the current theorists agree that monetary policy and macro prudential supervision policies are effective in coordinating and resisting financial risks. The link with both macro prudential regulation and monetary policy, as well as how to collaborate and coordinate the two policies, are thus major issues that we must address. Based on this background, this paper systematically combs and analyzes the necessity of coordination between monetary policy and macro prudential policy and the practical experience of relevant research on coordination mode through theoretical research on macro prudential regulation and reference of relevant policies at home and abroad. This paper uses the literature research method and comparative analysis method to analyze the macro prudential policy and monetary policy in depth. The theoretical basis of macro prudential regulation and monetary policy is formed by classifying, summarizing and sorting out the relevant researches on macro prudential regulation and monetary policy made by scholars from various countries. The implementation of macro prudential policies in developed economies like the United States and the United Kingdom, as well as their monetary policy coordination models, are compared and introduced in this dissertation. It also examines the traits and practical application of macro prudential and monetary policy cooperation in various nations. Based on the systematic risk theory, micro prudential supervision, macro prudential supervision theory and monetary policy, combined with the current situation of financial regulatory structures in various countries, using the literature research method and comparative analysis, this paper mainly draws the following conclusions: The financial system can only continue to run smoothly under a combined application of macro and micro prudential regulation; Systemic hazards can be efficiently prevented and mitigated by macro prudential oversight methods; Traditional monetary policy is unable to preserve both financial system stability and monetary stability; According to international experience, the central bank’s coordination of monetary policy and macro prudential policy can better play the complementary effects of the two programs.

How Should Crypto Lending Be Regulated Under EU Law?

The collapse of Genesis is the latest in a cascade of failures of crypto lenders. The last year has seen numerous major crypto lenders, such as Celsius, Voyager and BlockFi, going out of business in domino-like fashion. The failures have revealed the vulnerabilities of crypto-market lenders’ business model, most notably the liquidity and maturity mismatches in their loan portfolios, and their markedly weak corporate governance. The present article explores avenues to regulate crypto lending within the framework of EU financial services regulation. It argues that crypto lenders should be taken as falling within the definition of credit institutions under EU law, and thus, as a result, should be subject to the stringent licensing and prudential requirements introduced by the Capital Requirements Directive and Regulation. Prudential regulation is one of the ways that have been suggested for the regulation of crypto-market operators, alongside the investor protection framework. Taking into account that crypto lenders easily operate on a cross-border basis and that prudential regulation is fully harmonized in the EU, we take an EU-wide perspective and focus our analysis on EU law, rather than member state laws. In addition, prudential regulation can deal with any systemic risk issues with which investor protection regulation cannot deal. However, in order to avoid moral hazard and not give investors the false impression that crypto lenders are safe too-big-to fail institutions, we suggest that crypto lenders should not enjoy the full protection of prudential regulations. In particular, they should not be offered lender of last resort support and they should not be allowed to subscribe into a deposit insurance scheme. Even though it is often said that crypto markets pose no risk to the regulated sector due to limited interconnectedness, it should be noted that due to the high leverage of crypto investors, the real risk to the regulated sector comes from the possibility of crypto investors massively liquidating their positions in other asset markets.

Prudential regulation and bank solvency based on flexible distributions: An example for evaluating the impact of monetary policy

AbstractThis paper proposes new risk measures by accurately estimating the components of solvency risk and focusing on prudential policy implementation. We use semi‐nonparametric statistics to model the stylised facts of the probability density functions, particularly the higher‐order moments of three variables: the solvency decline rate, the tier decline rate and the portfolio growth rate. The proposed measures allow the evaluation of the impact of expansionary monetary policy on the risk‐taking transmission channel and implementation of the minimum solvency ratios required by banking regulators based on the estimation of quantile risk metrics. Using a database of Colombian solvency indicators, we show that the liquidity injection measures employed in response to the COVID‐19 pandemic led to a significant increase in portfolio risk in the banking system. The proposed methodology is suitable for micro‐ and macroprudential regulation at different levels of portfolio risk aggregation.

Critical condition for deposit insurance to partially or fully substitute for raising capital under cyclical economic environment

<p><big>Regulation of financial institutions has two key purposes: Solvency (prudential regulation) and consumer protection. Prudential regulation is implemented mainly by capital requirements, but governments also provide insurance for customer deposits, as a backup tool. In this article, we discuss the critical conditions for deposit insurance and capitalization to act as substitutes for each other, under cyclical economic environment. We make two assumptions. The first one is that deposit insurance is fairly priced and there is no moral hazard. The second one is that insurance creates incentives for moral hazard among insured banks, resulting in increased risk taking. We also discuss the critical conditions for deposit insurance and capitalization to be complementary under different proportions of deposit insurance.</big></p>

A Review on the Impact of Shadow Banking on Financial Markets Prudential Regulation

Abstract The evolution of shadow banking sector in terms of structure (concentration of institutions), expanded connections with banks, and in terms of activities there was an increase of the systemic relevance of these entities. The aim of this paper is to review the relevant literature on the topic and the progress that has been made regarding the implementation of macro-prudential policies since the global financial crisis of 2008. As the financial crisis highlighted, shadow banking sector should be considered a source of systemic risk and it is essential to identify its potential effects to the financial sector downturn. We examine the empirical studies that have been carried out in the recent literature on the structure and effects of nonbank financial sector regulation. Based on our findings, the main results pointed out that the academic research conducted in this field focused on the link between shadow banking and systemic risk. The collapse of one financial institution has the potential to have widespread effects and could trigger a series of failures that directly threatens the stability of the whole financial system.

Banks as Liquidity Providers in the Interbank Market

Abstract The paper analyzes structural differences in banks' ability and willingness to supply liquidity in the interbank market given the existing prudential regulation using a partial equilibrium model. The results show differences in the Liquidity Coverage Ratio (LCR) effectiveness for two types of banks' business models. First, for the more traditional one (with structural liquidity surplus), the LCR measure enables banks to lend more in the interbank market (by letting them subtract possible cash inflows from the expected outflows under a liquidity stress scenario) but at the cost of allowing them to maintain lower default limits (thresholds on the maximum liquidity shock the banks can withstand without entering default). Second, banks with structural liquidity deficits that need other funding sources than retail deposits, like subsidiaries that receive finance from their parent banks, face tighter requirements on high-quality liquid assets, keep higher default limits and lend less in the interbank market. For this business model, often seen in emerging markets, including Romania, the LCR measure fosters banks' resilience to liquidity shocks. However, this LCR functionality might encourage them to overlook contagion risk from their parent and parent banks' economies, especially under favorable financial conditions. Prudential authorities should complement the LCR measure with other instruments (like liquidity stress test) that better assess banks' liquidity risk due to maturity mismatch. Banks' liquidity risk management can partially mitigate the differences in LCR effectiveness through precautionary holdings of additional liquidity buffers. Banks with higher risk aversion prefer maintaining a higher no-penalty limit (the maximum liquidity shock the bank can accommodate without a penalty fee) and an increased default threshold and are less willing to lend in the interbank market.

Unravelling the Drivers of Profitability in Pakistani Islamic Banking: An Investigation of Key Factors

his study examines the impact of financial institution-specific profitability variables on the performance of Islamic banks in Pakistan from 2017 to 2021. The study finds a positive and statistically significant relationship between the gearing and capital adequacy ratios, with a significance level of 5% in both statistical multivariate regression models. Asset management is found to be statistically significant in model I and insignificant in model II, with a positive relationship in both cases. The bank’s size is found to have a negative and negligible relationship in all models, which may be due to the fact that most Islamic banks in Pakistan have been losing money in recent years. Additionally, as the State Bank of Pakistan tightens its prudential regulations, capital sufficiency is found to have significant correlations in both models. This study provides new information to scholars and practitioners to improve the financial and economic literature on Islamic bank profitability.

Financing the orderly transition to a low carbon economy in the EU: the regulatory framework for the banking channel

AbstractAmong the largest economies of the world, the EU not only has set the most ambitious and legally binding objectives for the reduction of the GHG emissions but also it has accompanied these objectives with a “state of the art” regulatory framework in the realms of investor protection and safety and soundness. Our paper focuses on the bank financing channel and highlights regulatory areas for improvement. To mobilize the necessary funds worldwide, a degree of interoperability of regional taxonomies is required, which calls for international cross-pollination and coordination to mitigate financial risks and the risk of harmful market fragmentation (BCBS 2022, FSB 2022). Also, the full interoperability between the international and the EU corporate reporting standards is a desirable objective. A building bloc methodological approach would make such interoperability easier having the sustainability impact perspective of the “double materiality objective” as an additional layer of the international requirements well understood to all investors in EU undertakings. As per the inclusion of climate risks in prudential regulation, it is completed for Pillar 3 disclosures relating effectively with the EU Taxonomy. Climate risk’s long-term horizon still needs to be implemented in Pillar 2 by linking bank transition plans with stress testing based on climate risk scenario analysis covering both transition and physical risk. The inclusion of climate risks in Pillar 1 faces challenges similar to those of supervisors internationally. Fostering global ambition is an explicit objective of the EU. Its leadership on the realms of investor protection and prudential regulation of climate risks should ideally inform international cooperation and impregnate international standards. This will secure that investments for the fulfillment of the EU climate objectives will flow from in and outside the EU.

Bank regulations and surges and stops in credit: Panel evidence

Prudential bank regulation complicates monetary policy because it has cyclical effects on the growth of bank credit, which can be a channel through which monetary policy is transmitted to the economy. Employing a panel of 36 advanced and developing countries for the period 1973–2015, we find that changes in regulation have been procyclical with respect to credit surges and counter-cyclical with respect to credit stops. As a result, monetary policy risks being too loose over the credit cycle. The economic effects of prudential regulation on credit have been meaningful given the large-scale bank liberalizations undertaken by many countries. The result is robust to dealing with a wide range of sensitivity tests and endogeneity concerns. In designing regulations, policymakers need to consider transmission mechanisms through which they might affect the real economy and undermine the goals of monetary policy.

Determinants of Bank Profitability in the Context of Financial Liberalization: Evidence from Morocco

This article aims, in the context of financial liberalization, to examine the impact of several internal and external factors in relation to the profitability of banks listed on the Moroccan stock exchange. The study uses the panel data method on a sample of the six banks with the largest market shares over the 2010–2019 period to investigate the influence of ownership structure, bank governance, capital structure, prudential regulation, and also a macroeconomic variation on bank profitability. Accordingly, the empirical results indicate a negative relationship between concentration, foreign ownership, and bank profitability. Further, high capital structure ratios, especially solvency, liquidity, and capitalization ratios appear to have an undesirable effect on the performance of Moroccan banks. In contrast, the impact of domestic institutional ownership is positive, implying that profitability is more favored by domestic ownership than by foreign ownership. Our findings also highlight the importance of independent directors and board size. Therefore, liberalizing ownership and opening up the board to the expertise of outside directors is essential for the banking sector’s development. In terms of policy implications, central banks and regulators need to ensure that banks rigorously adhere to specified leverage and fixed capital adequacy ratios while ensuring optimal liberalization for bank performance.

ANALYSIS OF ROBUST CHAIN LADDER METHOD IN ESTIMATING AUSTRALIAN MOTOR INSURANCE RESERVES WITH OUTLYING DATASET

Reserves are one of the most crucial components for an insurance company to make sure it has enough money to pay off all the incurred claims. The presence of outliers in the incurred claims data harbors risk on inaccurately predicting reserves to cover claim amounts, usually achieved by the standard chain ladder reserving method. To remedy the effect of the outliers, the robust chain ladder reserving method is used by setting the median value to predict estimated reserve. On this research, we utilized both methods on various datasets. The purpose of this paper is to determine the best method that can be utilized by insurance company in various scenario to obtain the most optimized reserved estimate that can minimize the risk of being unable to pay the insurance claim or even the risk of over allocating reserves that could pose profitability issue. The primary data used are the Australian domestic motor insurance claims from 2012 to 2017, obtained from Australian Prudential Regulation Authority (APRA). The dataset is then manipulated to have outliers. After calculating the estimation, the result is compared to assess the strength of the methods using Mean Squared Error (MSE) and Root Mean Squared Error (RMSE) calculation. In conclusion, we found that the robust chain ladder reserving method works better in an outlying dataset. We also identify cases in which robust chain ladder are not appropriately used.

Regulation of Markets that Pose a Less Systemic Risk—The Crypto Asset Market Is an Example

It has been argued that ‘Some markets pose a such little systemic risk to the overall financial system that they should never be regulated.’ However, even markets that are small and pose less systemic risk should also be regulated scientifically and appropriately. The crypto-asset market is currently one of the markets that the Financial Conduct Authority regulates to a lesser extent, so this paper uses this as an example to analyse the various risks that the crypto-asset market may pose in terms of consumer protection, financial crime, and systemic risk, and then explores a series of regulatory measures that the Financial Conduct Authority is currently taking to address these risks, such as consumer protection guidance, anti-money laundering directives, regulatory The discussion then explores the range of regulatory measures currently being taken by the FCA to address these risks, such as consumer protection guidance, anti-money laundering directives, regulatory sandboxes, etc. Finally, the need for effective regulation of financial markets is analysed in terms of enhancing consumer confidence, promoting financial innovation, and protecting good financial competition. In this way, it is concluded that the financial regulatory system should have to adhere to prudential regulation and strict supervision to maintain market order and prevent excessive risk-taking.

Determinants of commercial bank’s non-performing loans in Bangladesh: An empirical evidence

Non-performing loan (NPL) is a red flag, providing signal of jeopardize for a country’s economy. With respect to increase in NPLs, banking sector of Bangladesh has trapped in gridlock. This problem has become an alarming issue for bank’s sustainability. The present study investigates the determinants of commercial bank’s NPLs in Bangladesh. Due to data deficiency, the study collects data from 30 sampled commercial banks in Bangladesh over the period from 2011 to 2020, as during 2011, the total scheduled commercial banks in Bangladesh were 34. The study performs Random Effect Regression Model, Fixed Effect Regression Model, and one step GMM system to get the robust and significant result. The study reports that firm-specific factors like lag of NPLs, loan loss provision to total equity ratio, equity-to-total asset ratio, capital adequacy ratio, net loan to total deposit and borrowing ratio, return on equity, and macroeconomic factors such as inflation, and GDP ratio are the crucial determinants of NPLs in Bangladesh. The study concludes that commercial banks should operate its activities more efficiently and avoid reckless lending along with mandatory capital requirement in order to reduce NPLs and to ensure profit for their shareholders. The analysis of the study would provide insight guidelines regarding bank’s credit risk management procedures and systems to country’s regulatory body in order to design and adopt required prudential regulations in credit policy.

Prudential regulation tools

Prudential regulation tools

Endogenous money supply, global liquidity and financial transactions: Panel evidence from OECD countries

Research background: Endogenous money creation is an inherent feature of today?s economies and widely accepted phenomenon. As the various theories of money rely on the money quantity equation, most empirical research is heading towards the analysis of the two-way relationship between the quantity of money and nominal GDP. In today's world, with the extraordinary development of the financial sector, money is used not only for transactions in the real economy, but increasingly also for purchasing financial assets. This observation was absorbed by Werner in the quantity theory of disaggregated credit. Purpose of the article: The aim of the paper is to join the debate on endogenous character of money supply by tasting a disaggregated equation of money. It assumes that the domestic money supply is positively determined not only by growth in GDP-based transactions but also by growth in non-GDP-based transactions (financial transactions). Additionally, it is assumed that in the age of globalization it can be also positively influenced by the global liquidity. Methods: Testing of the above-mentioned hypotheses takes place with the use of panel unit roots tests, panel Granger causality test and panel estimations (OLS, models with fixed/random effects, GMM). In the study, annual data from 2002 to 2018 for OECD countries were chosen for statistical research. Findings & value added: The article confirms the hypothesis that real and financial economic activity together with global liquidity positively influence domestic credit and thus money supply. As the amount of money in an economy is driven not only by the real economy but also by the financial economy, prudential regulations that restrict leverage (and thus control the amount of credit) and limit risk-taking during price bubbles periods should be therefore considered. In the research, the reaction of domestic money supply to the changes in US money supply is positive. It confirms the importance of spill-over effect of expansionary policy in major economies to other economies.

Prudential Regulation and Climate Change

Prudential regulators seek to ensure that the institutions (banks, insurers, pension schemes) making financial promises to their customers are capable of meeting those promises. Over time that has caused them to take an increasingly holistic view of the risks faced by those entities. It should be no surprise, therefore, that risks caused by climate change have emerged over the past decade as requiring concerted attention, both from the institutions and the prudential regulators who supervise them. Institutions and prudential regulators urgently need to design frameworks and processes that capture and assess the risks from climate change in a way that is tractable, rigorous and capable of integration into their existing frameworks and processes. This paper maps briefly how the practice of prudential regulation has evolved in recent years across a number of major jurisdictions (the United Kingdom, the European Union, Australia, South Africa and Singapore) to engage with the risks from climate change. This has value in its own right. Climate change is the most urgent existential risk currently facing mankind. However, the analysis in this article also provides a case study of how prudential regulation itself needs to be conceived, and in particular the need for prudential regulators to be ready continually to address nascent types of risk, the precise dimensions and nature of which emerge only over time.

Control dynamics in rogue trading: Sovereignty and exception-to-the-rule attitudes in the contemporary financial sphere

Sovereignty, for Derrida (2005, 2009), is defined by an exception-to-the rule attitude: the sovereign is the one who decides on an exception. A sovereign can thus “go rogue” and behave as an outlaw, transgressing the rules of his own community. This article applies this conception of sovereignty to analysis of the Kerviel-Société Générale (SocGen) rogue trading affair. It examines the exception-to-the-rule attitude found in the actors of the financial sphere (the trader, the bank, the State) and the underlying control dynamics. Our results show that the trader acts as a rogue when he takes the exceptional right to place himself above his bank’s rules on position-taking. The bank is equally rogue when it reserves the exceptional right to place itself above the prudential regulations governing its sector. The State goes rogue too, granting the banking supervisory body the exceptional right to administer criminal justice. Following Boltanski (2011), our analysis explains these exception-to-the-rule behaviors by the contradictory logics that drive them. Two logics are identified in the financial sphere: the market logic, and the prudence logic. We highlight that fraud, and more generally the exception-to-the-rule attitude, result from the ambivalence generated by the coexistence of these contradictory logics of action, which are notably conveyed through control mechanisms. The study concludes that the State has a major role to play in this respect. More specifically, we raise the point that the neoliberal style of the penal State contributes to the occurrence of fraud.