6 Bank Supervision by Norm Setting and Intervention 6.1 Institutions ...

Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 

6 Bank Supervision by Norm Setting and Intervention 

6.1 Institutions of Bank Supervision 

Since 2002: Creation of a regulatory authority for financial institutions covering 

the entire financial spectrum by combining the formerly separate supervisory 

authorities for lending, insurance and security trading. 

Exchange supervision remains under the responsibility of the federal states 

Cooperation with Deutsche Bundesbank 

166

Bank 

SSupervision 

Executive 

Director 

LLautenschlägerr 

Major bannks 

Landesbankken, 

savings bannks, 

Bausparkasssen 

Credit bannks, 

specializeed 

banks, brokkers, 

mortgagge 

banks 

Genossenscchaft 

sbankenn 

Policy 

departmeent 

Prof. Dr. Hanns-Peter 

Burghoff, 

University of Hohenheim, H Bank Management 

Bundeesanstalt 

für Finannzdienstle 

eistungsauufsicht 

(BBaFin): 

Inside 

Ad dministrationn 

Executive 

Director 

Sell 

Money 

launder-ing 

Informationtechnology 

Risk and 

financial 

market 

analysis 

Investor 

and 

consumer 

protection 

Integrity of 

the 

financial 

system 

Cross 

section, 

risk 

modeling 

Central 

tasks 

Prresident 

Sanio 

PR and 

innternal 

auditt 

Internal 

topics 

167 

Assurance/ 

Pennsion 

Fund 

Supervision 

Execuutive 

Director 

N.N. 

RRetirement 

annd 

health 

insurance 

LLife 

insurance, 

burial fundss 

National 

accident andd 

indemnity 

insurance 

International 

insurance 

companies 

Policy 

department 

Supervision oof 

Securities 

Executive 

Director 

Caspari 

Takeoverss, 

major 

shareholdeer 

Insider andd 

market 

monitoringg 

FDI and 

good 

conduct 

rules 

Investmentt 

funds

Supervisory Norm Setting 

Sources of law: 


Kreditwesengesetz (KWG) 

Laws and ordinances 

Announcements of the BaFin 

Mainly: implementation of international law-setting 

a) European Union (“Richtliniengesetzgebung”): 

Level playing field 

b) Basel Committee on bank supervision: 

Operability of the international financial markets 

168


International Harmonization and Basel Committee: 

Developing free global markets of goods and capital 

Highly interdependent national markets because of cash flows and 

capital flows 

Global necessity for harmonized bank supervision legislation 

E.U. bank supervision law 

E.U. security supervision law 

Bilateral contracts 

169 

Basel Committee 

Forums of national bank supervisory 

authorities

Self-CConceptiion 

of thhe 

Basel CCommit 

ttee: 

The Basel 

Commmittee 

onn 

Bank Suupervision 

n 

The Baasel 

Commmittee, 

established 

by the ce entral-bankk 

Governoors 

of the Group 

of Tenn 

countries 

at the eend 

of 19774, 

meets regularlyy 

four timmes 

a year. 

It has 

about tthirty 

techhnical 

worrking 

grouups 

and tas sk forces wwhich 

alsoo 

meet reg gularly. 

The CCommitteee's 

membeers 

come from Be elgium, Canada, 

Frrance, 

Ge ermany, 

Italy, JJapan, 

Luxxembourgg, 

the Nethherlands, 

Spain, S Swweden, 

Swiitzerland, 

United 

Kingdoom 

and UUnited 

Stattes. 

Counttries 

are re epresentedd 

by their central ba ank and 

also byy 

the authority 

withh 

formal reesponsibil 

lity for thee 

prudential 

supervi ision of 

bankinng 

business 

where thhis 

is not tthe 

central l bank. Thhe 

present Chairman n of the 

Commmittee 

is MMr., 

Presiddent 

and CEO of the t Federral 

Reservve 

Bank of o New 

York. 

The CCommitteee 

does nnot 

possesss 

any fo ormal suupranationnal 

super rvisory 

authorrity, 

and iits 

concluusions 

do nnot, 

and were w neveer 

intendeed 

to, hav ve legal 

force. Rather, iit 

formulaates 

broadd 

supervis sory standdards 

andd 

guidelin nes and 

recommmends 

staatements 

countriies' 

supervvisory 

techhniques. 

Prof. Dr. Hanns-Peter 

Burghoff, 

University of Hohenheim, H Bank Management 

of best ppractice 

in i the exxpectationn 

that ind dividual 

authoriities 

will take stepss 

to impleement 

the em througgh 

detailedd 

arrangem ments - 

statutoory 

or otheerwise 

- wwhich 

are best suite ed to theirr 

own natiional 

syste ems. In 

this waay, 

the Coommittee 

encouragees 

converg gence towwards 

commmon 

appr roaches 

and coommon 

standards 

wwithout 

atttempting 

detailed hharmonizaation 

of member 

m 

? 

170


Basel Committee and Equity Standards 

Basel I: 

Basel equity recommendation 

(1988, Basel Capital Adequacy Framework) 

Consistent equity requirements for international banks 

Amendment of equity requirements: inclusion of market risks 

(1996, Amendment) 

Standardized measuring methods and internal models to capture interest risks, 

stock price risks, foreign exchange rate risks and commodity price risks 

Basel II: 

A New Capital Adequacy Framework, in consultation since June 1999 

Three pillars concept: 

Pillar 1: Minimum capital requirements (particularly special norm for 

credit risks) 

Pillar 2: Supervision of equity norms (qualitative supervision) 

Pillar 3: Market discipline (due to transparency) 

171

Basel III: 


Basel III - Representation of a fundamental amplification of global capital 

standards 

Key features: 

Substantially raise the quality of banks’ capital 

Considerably raise the required level of banks’ capital 

Reduction of systemic risk 

Allow sufficing time for a smooth transition to the new requirements 

a) Better capital quality 

Greater focus on common equity (i.e. core capital) 

Stricter definition of core capital: 

Under Basel III, the deductions of certain types of assets of 

questionable quality from capital base (i.e. Tier 1 and Tier 2) 

will be stricter as they will be deducted directly form core 

capital 

Accentuation of the definition of Tier 1 capital: 

Now Tier 1 capital includes common equity and other 

qualifying financial instruments based on tight criterion 

172


b) More capital (Basel II requirements in brackets) 

Increase of the minimum core capital requirements: 

4.5% (2%) 

Increase of the Tier 1 minimum capital requirements: 

6% (4%) 

Requirement to hold a capital conservation buffer of 2.5% of core capital 

c) System-oriented overlay 

Countercyclical capital buffer with a range of 0 to 2.5% to tackle system- 

wide risks 

Target is to reduce pro-cyclicality of the financial system: 

Buffer will have to be built up during periods of huge 

aggregate credit buffer 

During the downturn of the financial cycle buffer will have 

to be released 

(In development: Basel IV) 

173


6.2 Characterization of Bank Supervision Norms 

Interaction between preventive and protective actions 

Preventive 

actions 

...are essential to keep banks from 

taking too high risks. This would 

increase the costs of protective 

actions. 

...establish trust among the 

depositors and thus are 

preventive. 

174 

Protective 

actions


Forms of Bank Supervision Norms 

Discretionary 

actions 

Self-regulation 

through market 

forces 

Protective actions 

Regulation of the banking 

sector 

Contractual 

intervention 

Selective 

norms 

175 

Governmental 

regulation 

Preventive actions 

= norm setting 

Quantitative 

norms 

Comprehensive 

norms 

Qualitative 

norms

Preventive Actions 

I. Quantitative Norms, e.g. 

Equity norms 

Liquidity principles 

Dictate of diversification 

- Disaggregation of risk 

- Distribution of risk 


176

II. Qualitative Norms 

Business limitations 

Accreditation requirements 

Information publishing 

Accounting regulation 

Other rules of regulation: 


- Minimum requirements for the operation of trading transactions (MaH) 

- Minimum requirements for the forming of the internal revision 

- Minimum requirements for the credit business (MaK) 

Aggregation of these minimum requirements into one minimum requirement for 

the risk management (MaRisk) 

177


Supervision Standards and Risk Categories 

Bank 

Shareholder Market 

Qualitative standards 

Target risks Organizational risks Operational risks 

Qualitative standards 

178 

Quantitative and 

qualitative standards

Protective Supervision 

Deposit Insurance: 


Minimum amount of coverage specified by the European Union: €20.000 

In Germany: protection schemes of 

“Sparkassen” (DSGV) (institution guarantee) 

“Volks- und Raiffeisenbanken” (institution guarantee) 

Private banks (deposit insurance) 

with more extensive protection. 

Lender of last resort in Europe 

ECB is not allowed to 

National central banks are only limited able to 

Tommaso Padoa-Schioppa (1999) “Nowadays and in our industrial economies, 

runs may occur mainly in textbooks” 

179

Norm violation 

without additional 

threat 


Exposure and Intervention 

Threat to the 

outstanding debits of 

creditors 

180 

Threat of bankruptcy 

for an individual bank 

Intervention Level A: Banking System/Market Structure 

Bankruptcy 

retention of the 

BaFin 

Threat of general 

market failure 

Moratorium for 

some or all banks 

Suspension of 

monetary 

transactions 

Shutdown of banks 

Shutdown of 

security exchanges 

Intervention Level B: Individual Bank/Bank Management/Business Structure 

Deadline for norm 

compliance 

Restrictions for 

lending and 

investment 

Restrictions of 

dividend payout 

Intervention Level C: Bank Employees/Organization/Corporate Governance 

Supervisors of the 

BaFin 

Suspension of the 

management 

Direct instructions 

to the management 

Suspension of the 

management 

Intervention level D: Relationship between Bank and Clients 

Suspension of 

deposit taking and 

lending 

Prohibition of 

disposition and 

payments 


individual 

compulsory 

actions 

Abandonment of 

customer 

transactions 

Moratorium for an 

individual bank 


individual 

compulsory actions


6.3 Structure and Development of Equity Norms 

Design of an Equity Norm 

Risk measure R 

Risk limitation basis: equity EK 

EK 

(A) X 

or (B) EK Y R 

R 

X, Y in percent 

(A) Expressed as coefficient 

(B) Expressed as value coverage 

Initial point: principle I (1983): Y = 1800% (18 times) 

Today: X = 8%, equivalent to Y = 1250% 

Why should the risk of a bank be limited by equity norms? 

181

Functions of Equity 

Financing function 

Loss compensation in case of 

- Going concern 

- Liquidation 

Information function 

Creation of trust 

Commitment of behavior 


Derivative function of bank supervision: risk limitation 

182

Liable Equity/Regulatory Capital 


Equity on the balance sheet 

(pure accounting value) 

Effective or market-related equity 

(available for loss compensation) 

Market value of equity 

(depends on valuation of the capital market) 

Current Definition of Regulatory Capital: 

Equity on the balance sheet + adjustments 

Convergence to effective equity 

The liable equity describes the actual value of an equity norm, whereas the 

target value is derived from the risky portfolio of the bank. 

183


Elements of Liable Equity According to KWG 

1. Core capital 

Equity on the balance sheet plus additional items 

(e.g. extraordinary items for general banking risks, unbound shareholder capital, 

proven unrealized profits from interim financial statements) 

2. Additional capital 

Adjustments according to the concept of effective bank equity 

(i.e. provident funds, revaluation surplus from securities and real estate, 

liabilities from profit participation rights, long-term subordinated liabilities, 

“Haftsummenzuschlag”) 

The liable equity consists of the core capital and the additional capital 

3. Tier 3 capital: 

Short-term earnings or reserves sensitive to market price changes 

(Net income of the trading book, short-term subordinated liabilities, residual of 

the additional capital that is not acknowledged due to volume restrictions) 

184


Capital Requirement (Target Value of the Equity Norm) 

Regulatory Capital Economic Capital 

Minimum capital to avoid market 

failure 

185 

Economic capital according to the risk 

management of the bank 

Verifiable and comparable Subjective computation 

Standardized methods of calculation Individual and complex methods of 

calculation 

Public Internal 

Static Dynamic 

Rarely binding Binding 

(see Estrella 1995) 

Temporal Consistency of Capital Optimization and Regulatory Capital 

Short-term 

optimal capital 

Free-rider 

problem and 

selfcommitment 

problem 

Long-term 

optimal capital 

Internal versus 

external costs 

of a banking 

crisis 

Minimum 

supervisory 

equity capital


Development Stages of Supervisory Equity Norms 

a) Norms Concerning the Balance Sheet Structure and Gearing Ratio 

In theoretical models: minimal equity ratio 

Supervisory gearing ratio: 

xi = Accounting value of the risky assets within the risk class i 

i = Risk weights of the assets within the risk class I 

EK = Liable equity according to the supervisory definition 

m 

 

i1 

R R Y EK , with 

i i x 

186


b) Norms to Limit Open Positions in Major Risks 

Rj = Risk measure of the particular major risk j 

EK 

R 

j 

X 

Problems: 

j 

j 

- Selection of the appropriate major risks 

- Problem of aggregation 

Possible solution: Determination of the total risk by adding the equity used for 

covering the single risks 

187


Example: German Equity Norms until 1997 

Major Risk 

Norm 

Default Risk 

(Credit rating risk) 

Principle I 

Interest Rate Risk 

Principle Ia 

Currency Risk and 

Noble Metal Price Risk 

Principle Ia 

Stock Price Risk or 

Index Price Risk 

Principle Ia 

Large Credit Risk 

(“cluster risk”) 

§ 13 KWG 

Shareholding Risk 

§ 12 (5) KWG 

+ Liquidity norms: 

Threat to long-term 

Liquidity 

Principle II 

Threat to medium-term 

Liquidity 

Principle III 

Description of the major risk limited by supervisory 

Losses due to the failure of debtors 

Losses due to changes of interest rates 

Losses due to price fluctuations on currency markets and 

noble metal markets 

Losses due to price fluctuations on stock exchanges 

Losses due to the failure of large debtors 

Losses due to the price fluctuations in non-bank shares 

Long-term investments are not covered by long-term financial 

resources and the long-term precipitation of medium-term and 

short-term financial resources 

Medium-term investments are not covered by the mediumterm 

precipitation of medium-term and short-term financial 

resources and the finance excess of the long-term liquidity 

standard 

188

Literature for Chapter 6: 


Burghof, H.-P. und B. Rudolph (1996): Bankenaufsicht, Wiesbaden. 

Freixas, X. und J.-C. Rochet (1997): Microeconomics of Banking, Cambridge (Mass.), 

Kapitel 7. 

Hartmann-Wendels, A. Pfingsten und Th., M. Weber (2000): Bankbetriebslehre, Kapitel F. 

Original Sources 

Bundesaufsichtsamt für das Kreditwesen: Grundsätze über die Eigenmittel und die Liquidität 

der Kreditinstitute vom 20.1.1969, aktuelle Fassung. 

Burghof, Hans-Peter (1998): Eigenkapitalnormen in der Theorie der Finanzintermediation, 

Berlin. 

Chari, V.V. und Raci Jagannathan (1988): Banking Panics, Information, and Rational 

Expectation Equilibrium, in: JoF, Vol. 43, S. 749-763. 

Chen, Yehning (1994): The Role of Information Externalities in Bank Runs, Diss., UCLA. 

Diamond, D. W. und P. Dybvig (1983): Bank Runs, Deposit Insurance, and Liquidity, JPE, 

Vol. 91, S. 401-419. 

Estrella, Arturo (1995): A Prolegomenon to Future Capital Requirements, in: Federal Reserve 

Bank of New York Economic Policy Review, Vol. 1, No. 2, Juli, S. 1-12. 

Jacklin, Charles J. und Sudipto Bhattacharya (1988): Distinguishing Panics and Informationbased 

Bank Runs : Welfare and Political Implications, in : JPE, Vol. 96, S. 568-592. 

Kindleberger, Charles P. (1978): Maniacs, Panics, and Crashes. A History of Financial Crisis, 

London et al. 

Kodres, Laura E. und Matthew Pritsker (2002): A Rational Expectations Model of Financial 

Contagion, in: JoF, Vol. 57, S. 769-799. 

Haubrich, Joseph G. (1989): Financial Intermediation, Delegated Monitoring, and Long-Term 

Relationship, in: JBF, Vol. 13, S. 9-20. 

Krümmel, Hans-Jacob: Schutzzweck und Aufsichteingriff. Über den Run auf die 

Bankschalter und seine Verhinderung, in: KuK, 17. Jg. (1984). 

Kupiec, Paul H. und James M. O’Brian (1995): A pre-Commitment Approach to Capital Requirements 

for Market Risk, FEDS working paper No. 95-34, Federal Reserve Board. 

Litan, Robert E. (1987): What Should Banks Do?, Washington D.C. 

Schulte-Mattler, Hermann und Uwe Traber (1995): Marktrisiko und Eigenkapital, Wiesbaden. 

Sechrest, Larry J. (1993): Free Banking. Theory, History, and a Laissez-Faire Model. 

189

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