Question

1. Pick two items each from the 4 risk-weight categories of assets (so 8 items in total) and explain why they receive that particular weighting.

2. What do you believe has been the biggest plus and the biggest minus of the effects of technology on the banking industry? (Please support each answer with examples)

Answer 1

Risk-Weighted Assets

The minimum capital that banks should keep as a reserve to reduce the risk of insolvency

Risk-Weighted Assets

Risk-weighted assets is a banking term that refers to an asset classification system that is used to determine the minimum capital that banks should keep as a reserve to reduce the risk of insolvency. Banks face the risk of loan borrowers defaulting or investments flatlining, and maintaining a minimum amount of capital helps to mitigate the risks.

The different classes of assets held by banks carry different risk weights, and adjusting the assets by their level of risk allows banks to discount lower-risk assets. For example, assets such as debentures carry a higher risk weight than government bonds, which are considered low-risk and assigned a 0% risk weighting.

Understanding Risk-Weighted Assets

When calculating the risk-weighted assets of a bank, the assets are first categorized into different classes based on the level of risk and the potential of incurring a loss. The banks’ loan portfolio, along with other assets such as cash and investments, is measured to determine the bank’s overall level of risk. This method is preferred by the Basel Committee because it includes off-balance sheet risks. It also makes it easy to compare banks from different countries around the world.

Riskier assets, such as unsecured loans, carry a higher risk of default and are, therefore, assigned a higher risk weight than assets such as cash and Treasury bills. The higher the amount of risk an asset possesses, the higher the capital adequacy ratio and the capital requirements. On the other hand, Treasury bills are secured by the ability of the national government to generate revenues and are subject to much lower capital requirements than unsecured loans.

Setting Rules for Risk Weighting

The Basel Committee on Banking Supervision (BCBS) is the global banking regulator that sets the rules for risk weighting. The first step in international banking regulation started with the publication of the Basel I framework, which set the capital requirements for banks. It was followed by the Second Basel Accord of 2004 that amended the banking regulations on the amount of capital banks should maintain against their risk exposure. Basel II recommended that banks should hold adequate capital that is at least 8% of the risk-weighted assets.

The financial crisis of 2007/08 exposed the inefficiencies that existed in the banking industry that led to the collapse of large US banks. The main cause of the crisis was investments in sub-prime home mortgage loans that carried a higher risk of default than bank managers expected – or at least acknowledged.

Following the global financial crisis, the BCBS introduced the Basel III framework, which aimed to strengthen the capital requirements of banks. It also established new requirements for funding stability and liquid assets. Basel III requires banks to group their assets by risk category so that the minimum capital requirements are matched with the risk level of each asset. The framework is scheduled to take full effect on January 1, 2022.

How to Assess Asset Risk

When determining the risk attached to a specific asset held by a bank, regulators consider several factors. For example, when the asset being assessed is a commercial loan, the regulator will determine the loan repayment consistency of the borrower and the collateral used as security for the loan.

On the other hand, when assessing a loan used to finance the construction of coastal condominiums, the assessor will consider the potential revenues from the sale (or rental) of the condos and if their value is sufficient to repay the principal and interest payments. This is assuming that the condos serve as collateral for the loan.

If the asset being considered is a Treasury bill, the assessment will be different from a commercial loan, since a Treasury bill is backed by the government’s ability to continually generate revenues. The federal government has higher financial credibility, which translates to lower risk to the bank. Regulators require banks holding commercial loans on their balance sheet to maintain a higher amount of capital, whereas banks with Treasury bills and other low-risk investments are required to maintain far less capital.

Capital Requirements for Risk-Weighted Assets

Capital requirements refer to the minimum capital that banks are required to hold depending on the level of risk of the assets they hold. The minimum capital requirements set by regulatory agencies such as the Federal Reserve and the Bank for International Settlements (BIS) are designed to ensure that banks hold enough capital, proportionate to the level of risk of the assets they hold. The capital acts a cushion of cash if the bank incurs operational losses in the course of the operations

the biggest plus and the biggest minus of the effects of technology on the banking industry :-

The banking system plays one of the most crucial roles in the global economic system. The banks act as the intermediary in between the depositors and the borrowers of an economy. In fact the banks channelize the savings of the depositors to the entrepreneurs. This is however the basic function of the banking system. With the globalisation of the trading activities during the past few decades, the banks are playing the pivotal role in smooth functioning of the entire global economic system along with the other institutions like insurance company, investment banks, financial companies, merchant banks and others. The banking system forms the corner stone of the modern economic system and the economic health of any nation as well as that of the global economy has become so interconnected, that if there is any turmoil in the major banks of the world economy, the entire global economy faces major crisis which may sometimes lead to global financial meltdown as has been recently seen in 2008 throughout the world.

Pros and cons of the banking system:

The most important function of the banking system of a country is to maintain the financial stability and establishing a system to ensure efficient functioning of the financial system of a country. The Central Bank of a country is the only institution entitled to issue currencies and control the circulation of the same. The Central Bank supervises the entire financial system of a country and implements its policy through the Commercial Banks both under the control of the government or private players. Controlling the inflation of the country, maintaining the price stability, supporting the financial needs of the Government of the country, controlling the lending power of the Commercial Banks by changing the reserve ratios, formulating policies and implementing the same for fostering the overall financial as well as economic development of the country are all the major functions of the Central Bank of a country.

The financial and economic policies of the Central Bankare implemented through the Commercial Banks of the country. The banks act as the most important financial intermediaries inthe economic system of a country, apart from the insurance companies and other financial intermediaries. As financial intermediaries, the banks take deposits from the firms and households in the economic system and mobilise this savings to the borrowers like the firms and the households, thereby channelizing the surplus funds from various economic agents to the agents with deficiency of funds. Thus the banks directly affect the economic development of a nation by acting as the biggest source of the loan capital for the entrepreneurs and also for the Governments, if required. One unique feature is the credit creation facilitiesof the banks. Use of cheque without actual transaction of currencies help the banks to lend more, than its deposits permit, and thus the circulation of money as well as the amount lend for the developmental activities could considerably be increased without printing of the currency notes. In underdeveloped countries, the banks perform a great deal activities for the development of the particularly backward sectors like agriculture. In the developing countries the banks provide a huge loan to the agricultural sector to equip it with the modern technology to increase the crop production and also to increase the cultivable lands by investing in the development of the irrigational facilities. The banks plays the most important role in the infrastructural development like construction of houses and other infrastructural facilities contributing directly to the development of the countries as well as its inhabitants.

While collecting the deposits the risk of holding money is transferred from the households to the banks and thus banks act as the custodian of money. Moreover, the money deposited in the current account or the demand deposits account could be withdrawn by the depositors at the time of need. However, in case of demand deposits there is usually a limitation up to which the money can be withdrawn per day. The online banking system and the recently introduced mobile banking system have made the monetary transactions possible from anywhere in the world and without going to the branch of the bank where you have deposited your money. One very important part of these credit card transactions, the online banking systems orthe mobile banking systems is that, these policies of executing any kind of instant and hassle free transactions have contributed significantly to the development of the global trade and commerce. Now a sound banking system in a country with its global networking has made it possible for any kind of transactions beyond the national boundaries of the countries. In doing so, banks also act as the foreign exchange hubs which automatically converts the foreign exchange as per the requirement of the parties involved in the transactions of the currencies of various countries, subject to the conditions set by the Central Banks of the respective countries as well as in synchronization with the global banking system. Thus the transactional aspects of the trade barriers have completely been washed off by the global banking system and in doing so the banks play the most important part in fixing the exchange rate of the various foreigncurrencies as well as in maintaining the stability of the foreign exchange market. Globalisation of trade and commerce has truly been impossible without a sound banking system.

The bank performs a great deal of agency functions like collecting and clearing of cheques, collecting dividends, interest warrant and making payments for your insurance bill, rent or any other payments which could be made by the banks. The banks act as the agency of the Government so far as various government payments are concerned like tax collection and payment of refund of tax to the economic agents of the country.

The bills for various utility services like gas, electric etc. are also used to be paid by the bank depending on the instructions of the depositors. Various merchant banking facilities, like the issue of credit cards, debit cards, and allowing cashless transactions through them are all there to make the life smooth and easy for the inhabitants of the country. The banks also act as the trustee of the government in various boards, when they fund and purchase a considerable portion of the shares of the big corporations, important for the development of the country. So far as the stock market is concerned, the banks play major role in acting as the broker to woo the investors for investing in the stock market as well as the banks themselves invest considerable funds to purchase stocks of various companies to contribute significantly to the development and stability of the stock market of a country which is the main indicator of the economic stability of a country.

However, like any system banking system all over the world is not without some fatal flaws and the policy makers are putting their continuous efforts to make this system flawless, which of course probably impossible given the ever increasing complexity of the global financial system. One important fact is the coordination of the banking systems prevalent in different nation. The banking system of every nations runs with different sets of objectives and the controlling powers also differ in characters.In the developed countries some leading banks are controlled by the private players whereas the nationalised banks play the predominant role in the countries which are less developed or are developing. The lack of coordination of different banks, due to their preference for the national economic interest, acts as an hindrance to bring the global banking system in one platform.

The use of the modern banking technology still suffers from severe flaws so far as the security of the net banking as well as mobile banking are concerned. These systems are yet to be full-proofed to be accepted as the most authenticated banking system by the world at large.

The increasing involvement of the banks in the complex financial systems like the stock market, the derivatives market, the foreign exchange markets are increasing the products and services of the banks but, at the same time, is also increasing the vulnerability of the banking system as the exposure of the banks are being increased to the free market forces of the global financial market.

The Fractional Reserve banking is the key in today’s banking system and the Federal Reserve explain it as –

The fact that banks are required to keep in hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a lone (a higher percentage interest rate) than is paid to depositors for use of their money. If the banks did not lend out their available funds after meeting their reserve requirements, depositors, might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to "create" money –

This fractional reserve system, when uncontrolled, indulges the infusion of excessive money into the system causing the speculation in the global asset market. The creation of bubble of the belief of the system that these hugely circulated money is backed up by their claims on the gold, gets deteriorated when such bubble bursts as happened in the sub-prime market in the 2008 financial crisis in US, which eventually gripped the entire global economy. When such panic occurs amongst the depositors and simultaneously when it is discovered by them that the banks have got no or enough gold back up to meet the claims of the claim they have against the banks, the depositors instantly lose their confidence and bank runs occur. Thus this fractional reserve system when allowed to be applied by the Commercial Banks without proper regulations, allows the banks to continuously create money and to infuse the same into the financial system and thus destabilise the entire banking and financial system.

Thus though banking system is the single most important system to roll out the development drive of the national as well as global economy, there are lot more complicated issues, yet to be addressed, to make the system full-proof so that the banks, instead of engineering the global financial crisis, act as the protector of the same to save the entire global economy from being destabilised.