Principles of Banking

Module code: EC7093

The latest global financial crisis caught many economists and regulators by surprise. Indeed, the crisis has revealed an inadequate appreciation of banking risks not only by the industry itself but also by central bank economists and other regulators.

Understanding the economic principles that govern the functioning of modern banks and banking systems is necessary in order to prevent financial crises from occurring. It is also vital in order to better appreciate the important role and limitations of financial regulation. To this end, it is important to develop a good understanding of key banking concepts such as liquidity, solvency and capital adequacy, and how they are managed in the context of imperfect information. A deeper understanding of banking can also be gained by studying various economic models of banking, while recognising model limitations.

Capital requirements remain the main tool in regulating banks, although their complexity has increased since 1988 when the Basel Accord first required internationally active banks to hold capital equal to 8% of their risk-weighted assets. More than 100 countries have so far adopted the Basel Accord; however, its crude risk weighting has, if anything, provided incentives for banks to engage in regulatory arbitrage by moving into riskier assets within the same risk category. In 2004, Basel II attempted to address the weaknesses in Basel I by allowing banks to use their own risk models, failing nonetheless to prevent the sub-prime crisis. Basel III, which is the latest international agreement on capital standards, attempts to take on board the lessons learned from the crisis by attaching more emphasis to systemic banking risks, externalities and macro-prudential measures.

Topics covered

  • Liquidity and solvency analysis using bank balance sheets and income statements
  • Banking risks and their management
  • Prudential regulation and Basel I, II, and III
  • Economic models of bank behaviour
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