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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA


par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010
  

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2.8.1 Financial Regulations Methods and Implementations

Basel II financial regulation method is the most commonly used type of financial regulations. Basel II is the second of the Basel Accords which are a set of recommendations on banking and regulators issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations on how much capital banks need to put aside to guard against the different types of financial and operational risks. Supporters of Basel II believe that such an international standard can help to protect the international financial system from the types of problems that might arise if a major bank or series of banks should collapse. Bear in mind that this Basel II accord made sure the issues of risk measurement as well as risk management within financial institutions were tackled.

One of the most difficult aspects of implementing an international agreement such as Basel II
is the need to accommodate different cultures, different structural models and the already
existing regulations. Bear in mind that regulators can't leave capital decisions totally to the

banks because if they do so they will not be doing their jobs and the public's interest will not be served as well. The Basel II framework is intended to promote a more forward-looking approach to capital supervision, that is, one that encourages banks to identify the risks they may face today and in the future and to develop their abilities in managing those risks. As such, Basel II is intended to be more flexible and better able to evolve with advances in markets and risk management practices.

Following Moody's statistics, it was evident that the CDO market in the Europe, Middle East and Africa (EMEA) grew up to 78% in 2006. This growth was driven by banks in a bid in adjusting to the Basel II regulation. This Basel II regulation forced many banks in 2006 to reexamine their risk exposure so as to limit the amount of capital they will be holding against investments, Crompton, 2007. Crompton looked at securitization and CDOs as means of banks moving some of the risks of their balance sheets into investors hands. All of these centre on Basel II because it has focused its attention on economic capital as well as driving the project market into securitization. This is because securitization is assumed to offer easier access to mortgage assets for investors thereby making things difficult for direct holders of home mortgage loans to procure because of the uncertainty existing in the credit quality of the loans and the problems associated with servicing them.

2.8.1.1 The Growth of CDOs

Table 1: Estimated Size of the Global CDO Market by the end of 2006.

Period

Estimated amount in billions of USD

2002

480.0

2003

570.0

2004

1200.0

2005

1510.0

2006

1980.0

Figure 5: Estimated Global CDO Market Size

Source: Thomson Financial

From the graph above, it is clear that between 2002 and 2006, the CDO market size experienced a steady growth increase. The issuance of the CDOs market experienced a significant increase of about 78% in the year 2006. During this period, most of the CDOs tranches obtained the highest level of credit rating which is the triple A (AAA) rating considered to be the safest by the credit rating agencies. The growth in the CDOs market is as a result of innovation such as the creation and implementation of the Basel II regulation. Thanks to this innovation, the CDO market became one of the most profitable markets for investment banking. The CDO market is now moving towards the direction of on demand credit risk whereby an investor can specify a product's risk/return ratio and the bank merely originates and then distorts this risk/return ratio of the portfolio and delivers a new product to its client. The above mentioned points greatly contributed to the growth of the CDO markets between the years 2002 and 2006 and thereby creating some value to its investors, customers as well as the shareholders hence influencing the investment decision-making process.

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