# Risk Regulation and Compliance of UK Banking Essay Sample

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I Introduction

This report is aimed to explore the relationship between the performance of Barclays Bank and the risk regulation. By underlying trend analysis,

correlation analysis, and regression analysis on five important ratios which could represent the performance of Barclays Bank, the report will show if there is any statistical evidence to confirm the hypothesis that a high compliance with regulation is essential for a stable banking system. This report also will provide an overview of the UK banking Regulation and Supervisory Practice and identify the concerns of Barclays Bank. The objective is to provide some useful recommendations for its management with the requirements of the regulatory.

II Findings

2.1 An overview of the UK Financial Regulatory Environment

Banking regulation is designed for the central goal of financial stability. In the UK, HM Treasury, the Bank of England and the Financial Services Authority are responsible for the financial stability as “tripartite authorities”, which show below: 2.1.1 The HM Treasury

The HM Treasury is United Kingdom government department which responsible for “the overall institutional structure of financial regulation and the legislation which governs it (Memorandum of Understanding, 2013).it is include developing and executing the British government’s public finance policy and economic policy. The purpose is to enhance the financial and economic sustainable development and growth, and also to promote economic and create national employment opportunities. 2.1.2 The Bank of England

United Kingdom’s central bank is The Bank of England which executes all the functions of a central band and it is responsible for the stability of the monetary and financial system. On one hand is because monetary policy function of the Bank of England plays an important role in the process of maintaining stability, which means there have a stable price, low inflation and confidence in the currency in United Kingdom. Moreover, the range of its responsibilities also includes supervision the financial system infrastructure particularly payments systems at home and abroad; providing official supports to prevent problems occurring between individual institutions; and improving the efficiency and effectiveness of the financial sector. 2.1.3 Financial Service Authority

Financial Services Authority (FSA) is an independent non-governmental department, responsible for regulatory policy. The Financial Services Authority as micro-prudential that supervision of financial intermediary is responsible for supervision of financial markets, securities listing and clearing and settlements systems.FSA is also responsible for authorization and supervision of many financial institutions, including banks and building societies. 2.1.4 The changes of Financial Services Authority

After the 2007-2008 financial crisis, the new regulatory organizations of UK change to the Financial Policy Committee (FPC), the Prudential Regulation Authority, and the Financial Conduct Authority (FCA)(essentially a new name for the FSA). The PRA will become a subsidiary of the Bank of England. Deposit takers, insurers and a small number of significant investment firms will be goal of supervision. It also will be responsible for supervising both insurance companies and deposit-takers. The role of PRA is maintaining the UK financial system become stability. So the goal is only to improve the safety and robustness of supervision enterprise. The Bank of England concludes the Financial Policy Committee (FPC). The responsibility of FCA is to adjust the behavior in retail and wholesale markets; and it has three main objectives. First is to maintain fair and boost efficient in the UK bank financial services. Secondly, the FCA is helping customers gain a fair deal from financial services. At last, protecting and enhancing the integrity of the UK financial system. 2.1.5 Supervision structures of EU

UK is a member of European Union, thus it should comply with EU supervision arrangement. Under this arrangement, there are 3 parts: the central bank of EU (ECB); the European Systemic Risk Council (ESRC) and the European System of Financial Supervisors (ESFS). The Central Bank of EU core purposes is maintaining monetary stability and financial stability in EU and the European Systemic Risk Council (ESRC) is an independent institution which is in charge of maintaining financial stability in macro-prudential supervision at European level. The main purposes of ESRC are identifying risks to stability and introduce an effective warning system. As a micro-prudential approach, the European System of Financial Supervisors (ESFS) is in order to set up a system which is in line with the objective of a stable and single market for financial services in the European Union. It will also be responsible for linking national supervisors into a strong Community network. (European Commission, 2009) The ESFS form an operational European network. The three Committees of Supervisors are to be replaced by the following authorities, having a legal personality: the European Banking Authority (EBA); the European Insurance and Occupational Pensions Authority (EIOPA); and the European Securities Authority (ESA). 2.2 Date description

In this part, the report will describe the underlying trend in the indicators of Barclays and the overall index of regulation for the period 1996-2010. 2.2.1 Total equity-to-asset ratio

In Figure one, the regulation index (bar chart) for UK was combined with the equity ratio (line chart) of Barclays. The equity ratio is a good indicator that determines the amount of leverage used by companies which measures the total assets are financed by shareholders in Barclays.

It is obvious seen that the changes of regulation index is negative correlation compared with the equity ratio, the regulation index trend to increased and the percentage of equity ratio was decreasing. Furthermore, the regulation index increased to about 80.4 in 2006 and in the opposite side, the equity ratio for Barclays dropped to lowest point (2.31%). 2.2.2 Tier 1 capital ratio

The Tier 1 capital also calls the core capital, it means the equity capital and public reserves which should be the constitute part of bank’s capital. It must occupy 5% of the total capital at least and not be less than the 4% of the total financial assets. The Tier 1 capital ratio which is the Tier 1 capital compare with the risk weighted assets. The “Basle accord” established that bank capital adequacy ratio of signatory must achieve 8% at least and the core capital adequacy ratio reaches at 4%. From the above chart，it can be seen that the Tier 1 capital ratio of Barclays maintain in a average 7.5% and the index of regulation changed slightly. From 2000 to 2002, the capital ratio increased slightly then decreases dramatically until 2005. However, the Tier 1 capital ratio grows rapidly to the top of 14%, in 2010. The overall index regulation increased from 2000 and at the top of 2006. Then drop slightly until 2009 and at 2010 decreased to the bottom in the recent years. So, the index of regulation has no direct relationship with Tier 1 Capital ratio. 2.2.3 Total loans-to-deposits ratio

From figure 3, it is shown that the index of regulation with total loans and deposits ratio from 1996 to 2010. They look like have positive relationship that when regulation index go up, total loans to deposits ratio rise too which implies that the bank was short of deposits when higher regulation index. However, the regulation index was highest in 2006 while Barclays did not borrow the money first from another bank. After 2007, it looks like that to control the high loans they lower the index of regulation. 2.2.4 Cash ratio

The Cash Asset Ratio (CAR) is an approach for measuring the liquidity of a company or a bank by comparing its cash reserves and liabilities. In this graph, it is clearly to see that in 2005, 2009 and 2010 there are great increase in cash asset ratio. And index of regulation goes steadily up before the middle of 2006. After that it decreased rapidly. Firstly, from 1996 to 2004, the financial market of UK is relatedly stable, and Barclays is an advanced financial institution, thus CAR maintain in a lower level. But CAR will have a big change in inflation. As the global financial crisis in 2008, the inflation indicator had a relatively large rise in UK, thus CAR increased very fast from 2008. Also in that global financial crisis, as market failure, the UK government has had to adjust regulations and policies to avoid worsening economic situation. That is why the index of economic freedom would go down.

2.2.5 The ratio of cash balances at the central bank to total deposits The ratio of cash balances at the central bank to total deposits is one of indicators of liquidity asset structure ratio. The purpose of cash balances at the central bank is to ensure that the commercial Bank has quite enough liquidity when there are a lot of withdrawals from bank deposits suddenly. On the other hand, deposit account is an essential part of liquidity management in most Banks. The steady growth of bank deposits is an important factor to strengthen capital and to ensure its liquidity liabilities.

In this chart, it can be clearly found that the ratio remain relatively stable from 1996 to 2003. After that, the figure increases dramatically until 2010. It shows the liquidity asset structure changes dramatically and a cash balance at the central bank becomes important liquidity assets. Whilst, the trend of index of regulation waves. Overall, it seems to have no relationship between index of regulation and the ratio. 2.3 Correlation analysis

In this part, a pairwise correlation analysis of the relationship between the overall index of regulation and selected indicators for 1996-2010 will be conducted. 2.3.1 Total equity-to-asset ratio

From the Excel analysis, the correlation value of the overall regulation index and equity ratio comes up a negative position (-0.577). The negative correlation implies that the relationship between regulation index and the equity ratio in which one variable increase as the other decrease, and vice versa. Then, through analysis of the equity ratio that Barclays could determine the financial health and long-term profitability. If the index of regulation increased, there would be some effect on shareholders’ equity of Barclays and this change must be going to the opposite side (decrease). Thus, the regulation index will have some negative impact to the equity ratio. 2.3.2 Tier 1 capital ratio

According to the correlation calculation of excel, from the above graph, it can see that the correlation result between the overall regulation index and Tier 1 capital ratio is 0.0166.then compare with 1 and 0, it far from 1 and close to 0. So there is no relationship between overall regulation index and Tier 1 Capital Ratio. Only in accidental circumstances the index of overall regulation could be increase together with Tier 1 Capital Ratio or both of them go down in the same time. Furthermore, supervisory has no influence on Barclays’ Tier 1 Capital Ratio. 2.3.3 Total loans-to-deposits ratio

The correlation between the overall index of regulation and total loans to deposits ratio is 0.270941747 which calculated from Excel as shown in the picture above. So, the positive figure means that the changes in two series of indexes tend to move together in the same direction. However, it is only 0.2 far away from 1which implies that the relationship between them is not strong. Thus, we can say that sometimes they may go up and down together but not often, simply because there is little effect from regulation index to total loans to deposits ratio. 2.3.4 Cash ratio

Through excel analysis, we can get correlation between index of regulation and cash asset ratio, it is 0.16501782. It is close to Zero, thus those are small effects for each other. It means almost we cannot base on index of regulation to exactly forecast the trend of cash asset ratio, changes of it or other situations about cash asset ratio, vice versa. 2.3.5 The ratio of cash balances at the central bank to total deposits According to the correlation result (which is 0.069) of relationship between the overall of regulation and the ratio of cash balances at the central bank to total deposits, it also could be concluded that by statistical analysis and calculation the ratio of cash balances at the central bank to total deposits is completely unrelated to the index of regulation. From this perspective, supervision has no effect on Barclays’ ability of liquidity liabilities. The reason may be the risk of commercial environment is low and depositors are confident to the market. 2.4 OLS Regression analysis

2.4.1 Total equity-to-asset ratio

In order to deeply ensure the affecting from changing of regulation on equity ratio, regression could be used to find out the answer. Firstly, the assumption (Appendix 1) is that the variables which measure the ratio of equity(y) depends on only the index of regulation(x).That is: Yt= Intercept+β(Index of regulations). And H0 (null hypothesis) is assumed to be that index regulation is no related to the ratio of equity (H0:β=0,β is slope coefficient). HA (alternative hypothesis) is assumed to be that index regulation is related to the ratio of equity (HA: β≠0).( Miles, J. and Shevlin, M. 2001) Secondly, through the data analysis of regulation index and equity ratio in excel (see Appendix 1), the coefficients is -0.003054801 that measure of the responsiveness of the equity ratio to 0.003054801 percentage point change in the index of

regulation and the P-value is 0.024451, if a significance level of is 5 percent, then the p-value is less than 0.05, so the null hypothesis can be confidently rejected. At last, it can be summarized that regulatory changes has visible impact on the equity ratio in Barclays. 2.4.2 Tier 1 capital ratio

Form the regression test (Appendix 2), it is assumed that the equation of Yt= Intercept+β(Index of regulations) to analyses the relationship between the overall index of regulation and Tier 1 Capital Ratio. The Y is the Tier 1 Capital Ratio depends on the X of the index of regulation. Firstly, it supposes that the null hypothesis is H0: β=0, so when β=0, no matter how the index of regulations change, it has no relationship with Tier 1 Capital Ratio. The alternative hypothesis is HA: β≠0. Then the ratio of Tier 1 Capital will change in terms of the variance of regulation. If a significance level is 5 percent, the P-value(95.31%) is higher than 5%. It recommends that a value equal to or higher than the estimated coefficient will be expected to occur 95.31 percent of the time by random. So, the null hypothesis is accepted and there is no relationship between Tier 1 Capital Ratio and overall index regulation. 2.4.3 Total loans-to-deposits ratio

To analyze the relationship between the overall index regulation (X) and total loans to deposits ratio (Yt), it is assumed that they are related by a linear relationship that: Yt=Intercept+β0(Index of relations). (Appendix 3) From appendix 3, the coefficient is 0.0159744 which implies that one percentage point change in the index of regulation will lead a 0.0159744 change in total loans to deposits ratios. However, the p-value of 0.328691883 also implies that a value equal to or higher than the estimated coefficient will be expected to occur 32.86% of the time by random, thus the null hypothesis (H0:β1=0) is accepted when the sample coefficient is actually equal to zero if the p-value is greater than 0.05. So, it can be concluded that the index of regulation would not affect total loans to deposits ratio very well. 2.4.4 Cash ratio

To analyse the relationship between the index of regulation (X) and cash asset ratio (Yt), it need to consider the following relationship:Yt=Intercept+β0(Index of relations). According to appendix 4, it is obviously to see coefficient of the index of regulation is 0.00374028, it means that one percentage point change in the regulation will cause a 0.00374028 change in cash asset ratio. A p-value of 0.556721173 implies that if the true value of the estimated coefficient is equal to zero, the probability would only be 0.556721173 of observing a sample mean which is equal to or greater than the 0.05. The coefficient is actually equal to zero if the p-value is 0.556721173, it greater than 0.05, null hypothesis would be accepted. To sum up, the index of regulation has not a significant impact in cash asset ratio.

2.4.5 The ratio of cash balances at the central bank to total deposits From the regression perspective, the assumption is that the variables which measure the ratio of cash balances at the central bank to total deposit(y) depends on only the index of regulation(x)( Verbeek, M 2008). That is: Yt= Intercept+β(Index of regulations) (Appendix 5). In addition, the null hypothesis is H0, and it is assumed to be that index regulation is no related to the ratio of cash balances at the central bank to total deposits (H0: β=0, β is slope coefficient). The alternative hypothesis is HA, and it is assumed to be that index regulation is related to the ratio of cash balances at the central bank to total deposits(HA: β≠0). In this test, if a significance level sets as 5 percent, the P-value which is 80.69% is greater than 5%. It suggests that a value equal to the estimated coefficient will be expected to occur 80.69% of the time by random. So, the sample coefficient is actually equal to zero. Thus, the null hypothesis is accepted. (See appendix 5) 2.5 Regulatory concerns

Facing the UK banking industry, the principal regulatory challenges arise from the recent financial crises. The appearance of financial crises seriously affects financial stability. It is evidences that there are a lot of inadequacies of existing regulatory structures. It contains risks within the financial system and macro-prudential issues which need to be refocused regulation. For all banks in UK, due to implementation of Basel Ⅲ, the amount of capital and liquidity resources that a bank is required to hold will dramatically increase. Barclays is no exception. Through new definitions of core tier 1 capital, non-core tier 1 capital and tier 2 capital, the requirement will improve the quality of capital. (Andrea, S & Andrea, R, 2007) In addition, with respect to counterparty credit risk on derivatives, repos and securities financing transactions, more stringent requirements introduced by Basel Ⅲ. It also adopts a leverage ratio and two new liquidity standards (liquidity coverage ratio and net stable funding ratio). For Barclays, those requirements are what the bank concerns about. For instance, the leverage ratio set as a non-risk-based measure to curtail the growth in banks’ balance sheets.

The liquidity coverage ratio is aimed at enabling banks to withstand a short-term liquidity stress and the net stable funding ratio require bank to have a minimum amount of stable funding based on the liquidity characteristics of a bank’s assets and activities over a one-year horizon. After financial crisis from 2007 to 2009, according to the change of FSA (The Turner Review 2009) which set out some new steps that required banks should create a stable and effective system that include banks should increasing the quality and quantity of capital. From this point, the impacts from changing of the measurement of capital and the targets level of capital should be concerned by the Barclays Group. (Barclays Annual Report) Furthermore, at the beginning of 2013 there will be some proposals published to represent the changed definition of regulatory capital by the Basel Committee on Banking Supervision. During this period, there will have a significantly impact on Group’s capital resources and requirements. In order to adapt accordingly, the Group should maintains sufficient Balance Sheet flexibility and enough capital resource. (Barclays Annual Report)

On the other hand, in order to have a more effectively and safety management of liquidity which comply the FSA’s policy about strengthening liquidity standards, Barclays has set up a new comprehensive Liquidity Risk Management Framework to continue to operate in the event that the wholesale funding markets are neither open to Barclays nor to the market as a whole. Moreover, the big banks might improperly set key interest rates. Such key rates have a core role to determine the lending rates that would affect how consumers and companies borrowed money around world. During the period from 2007 to 2009, many troubling actions were occurred, such as traders from other banks seek favourable rates from Barclay’s employees, artificially low interest rate figures to depress Libor for making their financial position look stronger. After the investigation from regulators, Barclays paid $450 million to resolve accusations which describe how they had made false report to manipulate rates to benefit themselves. As part of the settlement, Barclays agreed to adopt the new controls and measures that could reshape how banks reports benchmark rates to prevent a repeat of the regulatory breakdown. (nytimes.com)

III Concluding remarks with policy recommendations

The FSA clarify to banks，When British economy deteriorated, banks can draw on their regulatory capital from the Central Bank, to ensure that banks would be not affected by liquidity problems. It can use to Barclays when they have liquidity problem as well. Moreover, British Central Bank and government announced that offer banks for six months on low interest loan. And if bank could provide more loans to the enterprise, the lower financing can get from Central Bank. So it should be improve the liquidity problems of Barclays. Also, highly liquid assets which Barclays hold can use to ease shock of short-term liquidity problems. All above policies and methods can help Barclays to deal with their existing liquidity problems. In order to achieve new capital requirements, Barclays required retaining a minimum core tier 1 ratio of 4 per cent under the FSA ‘supervisory policy’. Then the post-stress tier 1 ratio of 6 to 7 per cent expected fit to pre-stress tier 1 ratio which is 8 per cent. Barclays needs to maintain an 80 per cent of capital at least under the floor of capital.

Also should base on the Basel 1 regulation which has been expanded. In order to possess enough capital when in bad economic situation, Barclays need to carry out stress test. The FSA decided that all main financial institutions execute annual stress test start from 2010. Reverse stress test is different from general stress test and it influence directly to the capital requirements of Barclays. The test result change according to the environment changing and import a ‘zero-failure’ regime. But if Barclays ‘ reverse stress test has been measure that a business model hole, then the Barclays may be keep a difference amount or quality of capital. It can help Barclays remit pressure from the increase capital and quality of capital. For significant failings in relation to LIBOR and EURIBOR, Barclays fined £ 59.5 million. Therefore, Libor should be reformed, it includes: 1. Banks which make offers should be audited, it is in order to ensure that they did not submit false data to mislead the market to get self-profit; 2. LIBOR reflects the cost of borrowing in inter-bank, it should be based on actual transactions. And external audit agency must to record actual transactions of the bank which makes the Libor quotes, and to manipulate Libor will be subject to criminal sanctions. 3. The rights of Libor’s governance and regulatory should transfer from the BBA to an independent body.

Reference

Andrea Sironi , Andrea Resti (2007),. Risk Management and Shareholders’ Value in Banking: From Risk Measurement Models to Capital Allocation Policies. 1st edition. Publisher: Wiley

Barclays Group Annual Report 1996-2010

Available From: www.heritage.org/index/explore?/view=by-region-country-year

Bank of England. (2012). Financial Stability Report Press Conference. Available From: http://www.bankofengland.co.uk/publications/Documents/fsr/2012/fsrspnote120629.pdf

“Barclays Settles Regulators’ Claims over Manipulation of Key Rates”, (June, 27, 2012), (nytimes.com), AvailableFrom: http://dealbook.nytimes.com/2012/06/27/barclays-said-to-settle-regulatory-claims-over-benchmark-manipulation/

Financial Service Authority. (2012). Pillar 3. Retrieved from http://www.fsa.gov.uk/about/what/international/basel/info/pill3

Leonard Matz and Peter Neu (2006),. Liquidity Risk Measurement and Management: A Practitioner’s Guide to Global Best Practices, 1st edition. Publisher: Wiley

Miles, J. and Shevlin, M. (2001). Applying regression and correlation: a guide for students and researchers. London: SAGE Publications.

Sylvester Eijffinger (2012),. Handbook of Central Banking, Financial Regulation and Supervision. Publisher: Edward Elgar Pub