ECON30005 · Money and Banking
Banking Risk and Financial Regulation
Week 5 catalogues the risks banks run — credit and solvency risk, liquidity risk and runs, interest-rate risk, plus operational and systemic risk — and explains why bank capital is the cushion that absorbs losses. It sets out the rationale for prudential regulation: Basel III capital and liquidity requirements, deposit insurance and the lender of last resort, together with their moral-hazard drawbacks. Expect true/false on the ratios and safety nets, short essays on why capital matters, and a Basel-ratio calculation.
What this chapter covers
- 01Credit risk and solvency risk: default losses eat capital; negative net worth means insolvency
- 02Liquidity risk and the run chain: funding stress → fire sales → loss of confidence → bank run
- 03Interest-rate risk: borrowing short and lending long at fixed rates; present value p = D/(1+i)^t falls when rates rise (SVB 2023)
- 04Operational and systemic risk (contagion through interbank links, common exposures and fire sales)
- 05Bank capital as a loss-absorbing cushion; the resilience-versus-return-on-equity trade-off
- 06Basel III capital requirements: leverage ratio ≥ 3%, CET1 ≥ 4.5%, Tier 1 ≥ 6%, CAR ≥ 8%, +2.5% conservation buffer
- 07Basel III liquidity requirements: Liquidity Coverage Ratio and Net Stable Funding Ratio (each ≥ 100%)
- 08Government safety nets: deposit insurance and lender of last resort, and their moral-hazard costs (too-big-to-fail)
Checking a bank against the Basel III minimums
- +1(a) Capital Adequacy Ratio (CAR) = (Tier 1 + Tier 2) / RWA = (60 + 20) / 640 = 80/640 = 12.5%. The Basel III minimum CAR is 8%, so the bank clears it comfortably.
- +1(b) Leverage ratio = Tier 1 capital / total (unweighted) exposures = 60/1000 = 6.0%. The Basel III minimum is 3%, so it passes. Note the leverage ratio ignores risk weights — it is a simple backstop against gaming the risk model.
- +1(c) Tier 1 capital ratio = Tier 1 / RWA = 60/640 = 9.375%. This clears the Tier 1 minimum of 6% and the CET1 floor of 4.5%. With the 2.5% capital conservation buffer the effective total requirement is about 10.5%, which the 12.5% CAR also clears.
- +1Interpretation: capital absorbs losses before depositors are touched, so higher ratios mean more resilience (but lower return on equity). The risk-weighted ratios (CAR, Tier 1) penalise risky assets; the unweighted leverage ratio is a floor that cannot be lowered by shifting into low-risk-weighted assets. This bank meets every minimum.
Key terms
- Bank capital
- The owners' stake (equity plus retained earnings) that absorbs asset-value losses before depositors are affected. More capital means more resilience but lower return on equity — the central regulatory trade-off.
- Solvency (credit) risk
- The risk that borrower defaults erode asset values below liabilities, leaving negative net worth. Capital absorbs losses first; when losses exceed capital the bank is insolvent.
- Liquidity risk
- The risk that a bank cannot meet short-term obligations without large losses because funding cannot be rolled over, forcing fire sales at discounted prices — the chain that can end in a bank run.
- Interest-rate risk
- The exposure created by funding long-term fixed-rate assets with short-term liabilities. Since an asset's present value p = D/(1+i)^t falls as rates rise, a rate spike can cut asset values sharply (as at Silicon Valley Bank in 2023).
- Capital Adequacy Ratio (CAR)
- (Tier 1 + Tier 2 capital) / risk-weighted assets; the Basel III minimum is 8%, and with the 2.5% conservation buffer the effective requirement is about 10.5%. It penalises risky assets via risk weights.
- Government safety net
- Deposit insurance (guaranteeing deposits up to a limit) plus the central bank as lender of last resort (emergency liquidity to solvent-but-illiquid banks). Safety nets prevent panics but create moral hazard (too-big-to-fail).
Banking Risk and Financial Regulation FAQ
Why is bank capital so important?
Capital is the buffer that absorbs losses before depositors and other creditors are hit. When loans go bad, the losses first reduce equity; only if losses exceed capital does the bank become insolvent. So a well-capitalised bank can weather a downturn, while a thinly capitalised one fails at the first shock. The trade-off is that more capital lowers return on equity, which is why banks resist holding it and why regulators mandate minimums.
What is the difference between the leverage ratio and the Capital Adequacy Ratio?
Both compare capital to assets, but the denominators differ. The Capital Adequacy Ratio divides Tier 1 plus Tier 2 capital by risk-weighted assets, so safer assets require less capital. The leverage ratio divides Tier 1 capital by total unweighted exposures, ignoring risk weights entirely. The leverage ratio is a deliberate backstop: it stops a bank from appearing well-capitalised simply by loading up on assets that carry low risk weights.
How do deposit insurance and the lender of last resort help, and what do they cost?
Deposit insurance guarantees deposits up to a limit (for example the Financial Claims Scheme in Australia), which removes the incentive for insured depositors to run and so prevents self-fulfilling panics. The central bank as lender of last resort supplies emergency liquidity to solvent-but-illiquid banks, stopping fire sales. The cost is moral hazard: knowing they are backstopped, banks and their creditors take more risk, and very large banks may expect to be rescued (too-big-to-fail) — which is why the safety net is paired with capital regulation.
Can AI help me with banking risk and regulation in ECON30005?
Yes. Sia can drill the Basel III ratios and their denominators, explain the run chain and interest-rate-risk mechanism, and help you structure a short essay on why capital matters. Use it to rehearse the calculations and concepts; it does not sit graded assessment for you, and you should confirm the rules on Canvas.
Exam move
Split the week into risks, capital and regulation. Be able to list and distinguish the risks — credit/solvency, liquidity (and the run chain), interest-rate (with the present-value mechanism and the SVB 2023 illustration), operational and systemic — because these are ready true/false and short-essay material. Memorise the Basel III headline numbers (leverage ≥ 3%, CET1 ≥ 4.5%, Tier 1 ≥ 6%, CAR ≥ 8%, +2.5% buffer → ~10.5%; LCR and NSFR ≥ 100%) and practise plugging balance-sheet figures into CAR, the leverage ratio and the Tier 1 ratio, watching the risk-weighted versus unweighted denominators. For essays, rehearse the safety-net trade-off: deposit insurance and the lender of last resort prevent panics but create moral hazard. This links straight into Diamond-Dybvig, where deposit insurance removes the run equilibrium. Confirm the assessment structure on Canvas.
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