Banking Regulations for Quants: A Primer

Amit Kumar Jha, UBS

Contents
1 Introduction to Banking Regulations 1
1.1 Why Regulations are Necessary . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 The Evolution of Banking Regulations . . . . . . . . . . . . . . . . . . . 2
1.3 Types of Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4 Regulatory Bodies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 Basel Accords 3
2.1 Purpose of the Accords . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1.1 Basel I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1.2 Basel II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1.3 Basel III . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1.4 Basel IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.2 Conclusion on the Basel Accords . . . . . . . . . . . . . . . . . . . . . . 5

3 Different Regulatory Compliances 5

3.0.1 CCAR (Comprehensive Capital Analysis and Review) . . . . . . . 5
3.0.2 DFAST (Dodd-Frank Act Stress Tests) . . . . . . . . . . . . . . . . 5
3.0.3 PRA (Prudential Regulation Authority) . . . . . . . . . . . . . . . 6
3.0.4 FINMA (Swiss Financial Market Supervisory Authority) . . . . . . 6
3.0.5 ECB (European Central Bank) . . . . . . . . . . . . . . . . . . . . 7
3.0.6 ICAAP (Internal Capital Adequacy Assessment Process) . . . . . . 8

4 Conclusion on Banking Regulations 8

1 Introduction to Banking Regulations

Banking regulations are the rules and guidelines that banks must follow to ensure the
stability and security of the financial system. Think of them as the rules in a game: they
make sure all players play fairly and know what to expect.

1.1 Why Regulations are Necessary

Just like traffic rules prevent accidents on the road, banking regulations prevent finan-
cial crises and protect consumers. Without these rules, banks might take excessive risks,
which could lead to bank failures, economic downturns, or loss of people’s savings.

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 Analogy: Consider a soccer match without any rules. Players might tackle danger-
ously, leading to injuries, or use their hands, making the game chaotic. Just as soccer
rules ensure a fair and safe match, banking regulations ensure a stable and trustworthy
financial environment.

1.2 The Evolution of Banking Regulations

Over time, as the financial system has evolved and become more complex, so have the
regulations. This evolution is often in response to financial crises or the emergence of
new financial products and technologies.
Analogy: Think of how cars have evolved. Early cars didn’t have seatbelts or
airbags. But as we understood the risks better and technology advanced, we intro-
duced these safety features. Similarly, as we learn from financial mishaps and as the
banking sector evolves, regulations are updated to keep the system safe.

1.3 Types of Regulations

Banking regulations cover various aspects:

• Capital Requirements: Banks are required to hold a certain amount of capital to

cover potential losses. This ensures that they remain solvent even if some loans
go bad.
Analogy: Imagine a ship designed to stay afloat even if one of its compartments
is flooded. The ship’s multiple compartments are like the capital banks must hold,
ensuring they don’t sink under adverse conditions.

• Operational Standards: These rules govern how banks operate, including their
internal controls, risk management procedures, and corporate governance.
Analogy: Consider a restaurant’s operating procedures, from hygiene standards
to customer service protocols. These procedures ensure the restaurant runs smoothly
and customers have a good experience.

• Consumer Protection: Regulations ensure that banks treat customers fairly, pro-
vide transparent information, and don’t engage in deceptive practices.
Analogy: Think of safety standards for children’s toys. These standards ensure
that toys don’t have sharp edges or small parts that could be swallowed, protect-
ing children from harm.

1.4 Regulatory Bodies

Just as referees ensure that players follow the rules in sports, regulatory bodies ensure
that banks adhere to banking regulations. These bodies supervise, inspect, and, if
necessary, penalize banks that don’t comply with the rules.
Analogy: Picture a lifeguard at a beach. The lifeguard watches over swimmers,
ensures they stay within safe zones, and intervenes if someone is in trouble. Simi-
larly, regulatory bodies oversee banks, ensuring they operate within set guidelines and
stepping in if there’s a problem.

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1.5 Conclusion
Banking regulations, while intricate, play a pivotal role in maintaining the health and
trustworthiness of the financial system. As the world of banking evolves, so too will
these rules, ensuring that the ”game” of banking remains fair, safe, and beneficial for
all participants.

2 Basel Accords
The Basel Accords are a series of international standards for banking regulations, de-
veloped by the Basel Committee on Banking Supervision. These accords can be likened
to the different versions of a software update, each addressing previous vulnerabilities
and enhancing overall performance.

2.1 Purpose of the Accords

The primary goal of the Basel Accords is to ensure that banks across the globe have
adequate capital to safeguard against potential losses from their risk exposures, thereby
preserving the stability of the global financial system.
Analogy: Think of a dam built to contain water. If there’s a risk of overflow, the
dam’s walls need to be fortified. Similarly, the Basel Accords ensure banks have strong
”walls” (capital) to prevent ”overflows” (financial crises).

2.1.1 Basel I
Introduced in 1988, Basel I set the stage by establishing a minimum capital standard.
Banks were required to maintain capital equal to 8% of their risk-weighted assets.
Key Metric: Risk-weighted assets, where different assets were assigned different
risk weights.
Analogy: It’s like packing a suitcase with items of different fragility. Glass items
(high-risk assets) need more protective padding (capital) than clothes (low-risk assets).

2.1.2 Basel II
Coming into effect in 2004, Basel II took a more detailed approach. It introduced three
pillars: minimum capital requirements, supervisory review, and market discipline. The
emphasis was on banks assessing their risks more effectively. The same 8% capital
requirement was maintained, but the way risks were assessed was refined.
Analogy: Moving from a manual car (Basel I) to an automatic one (Basel II). While
the fundamental driving principle (capital requirement) remains the same, the new
model offers a more sophisticated driving experience (risk assessment).

2.1.3 Basel III

In the aftermath of the 2008 financial crisis, Basel III was introduced in 2010 to
strengthen the banking system’s defenses against potential future economic shocks.
A key element of Basel III was the emphasis on Common Equity Tier 1 (CET1) capital.

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 What is CET1? CET1 is, in essence, the core capital of a bank. It consists of common
shares and retained earnings, which represent the bank’s primary source of funds. This
capital is vital because it can absorb losses, helping a bank weather financial difficulties.
Analogy: Think of CET1 as the foundation of a house. Just as a strong founda-
tion ensures the house remains upright and stable even during storms or earthquakes,
CET1 ensures that a bank remains solid during economic downturns. The thicker the
foundation (higher CET1), the sturdier the house (bank).
In Basel III, banks were required to have CET1 capital amounting to at least 4.5%
of their risk-weighted assets. This was like setting a minimum thickness for the founda-
tion of a house. On top of this, an additional ”capital conservation buffer” was added,
increasing the total CET1 requirement to 7%. This buffer is like adding extra reinforce-
ment to the foundation, ensuring even greater stability.
Key Metric: Liquidity Coverage Ratio (LCR) – ensuring banks held high-quality
liquid assets that could cover net cash outflows over a stressed 30-day period.
Analogy: If banks were vehicles, Basel III ensured they had both a strong engine
(more capital) and enough fuel (liquidity) to run efficiently, even in challenging terrains
(economic stress).

2.1.4 Basel IV
Often referred to as the next phase after Basel III, Basel IV, set to commence from
2025, was born out of the need to address inconsistencies in how banks computed
risk-weighted assets.
Key Changes in Basel IV:
Internal Risk Models: A major concern was the over-reliance on advanced internal
risk models by banks, which often resulted in a significantly reduced perceived credit
risk compared to regulator models. Basel IV restricts the use of these sophisticated
internal models, especially for large corporates with turnovers exceeding 500 million
EUR. Analogy: Think of each bank as a student in a class. Previously, students could
use their own methods to solve a math problem. With Basel IV, while they can still use
their methods, there are stricter guidelines to ensure everyone’s approach is somewhat
aligned. Output Floor: The reforms introduce an output floor, ensuring that a bank’s
internally determined risk exposure doesn’t fall below 72.5Analogy: Imagine a music
tuning app that allows musicians to fine-tune their instruments. No matter how the
musician perceives the tune, the app ensures they don’t deviate too far from the stan-
dard tune. Leverage Ratio Modification: Changes have been made to the definition of
a bank’s total exposure in the leverage ratio. Analogy: It’s like updating the rules of a
board game. While the essence of the game remains, some actions or strategies are now
redefined to ensure a fair and balanced gameplay. Adjustments to CVA and Operational
Risk Frameworks: Basel IV brings changes to both credit valuation adjustment (CVA)
and the frameworks for managing operational risks.
Impact on Banks: While Basel IV’s intent is to standardize risk calculations across
banks and not necessarily to raise global capital levels, its implications will vary re-
gionally. Particularly, European and Nordic banks, which traditionally rely more on
internal risk models, will face more significant impacts. Estimates suggest European
banks might need to bolster their Tier 1 capital buffer by 19%, while Swedish banks
could require an increase of 28%. In contrast, US banks might only need an additional
2%. This translates to the European banking system potentially needing to source an

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additional 52 billion EUR of capital based on current lending volumes.

2.2 Conclusion on the Basel Accords

From Basel I to Basel IV, the journey of the Basel Accords has been about refining the
global banking system’s defenses against economic downturns. Like upgrading safety
features in vehicles over the years, these accords ensure that the global financial system
remains robust, resilient, and capable of weathering various challenges.

3 Different Regulatory Compliances

3.0.1 CCAR (Comprehensive Capital Analysis and Review)
CCAR, introduced by the Federal Reserve in the U.S., is a rigorous assessment of whether
the largest U.S. banks have sufficient capital to continue operations throughout times of
economic and financial stress. It evaluates how these banks would fare under adverse
economic scenarios, such as a severe recession.
Components of CCAR:
Capital Planning: Banks need to demonstrate they have effective capital planning
processes that consider their unique risks. This is like a company having a sound busi-
ness plan before venturing into a new market.
Stress Testing: Banks undergo stress tests to simulate how they would perform under
various adverse economic conditions. Think of this as a fire drill, where everyone
practices what to do in case of an actual emergency.
Qualitative Assessment: The Federal Reserve evaluates the internal processes and
decision-making frameworks of banks. This is akin to assessing the management quality
of a sports team, ensuring they have effective strategies in place.
Outcome: If a bank fails CCAR, it might be restricted from making capital distribu-
tions, like paying dividends to shareholders or buying back shares. This is similar to an
athlete being advised not to participate in a marathon if they fail a health check-up, as
it could be risky.
Analogy: Think of CCAR as a rigorous training camp for athletes. It tests their
endurance, strategy, and overall health, ensuring they’re fit and prepared for the main
event or competition. Just as athletes need to be in top shape to handle the challenges
of their sport, banks need to be financially robust to handle economic downturns and
crises.

3.0.2 DFAST (Dodd-Frank Act Stress Tests)

DFAST, mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act
in the U.S., is a complementary framework to CCAR. Its primary focus is to gauge
how banks would fare under unfavorable economic conditions by simulating potential
financial shocks or downturns.
Components of DFAST:
Scenarios: The Federal Reserve provides specific economic scenarios each year.
These scenarios range from baseline (most likely outcomes) to adverse and severely
adverse scenarios. It’s similar to weather forecasts, from sunny days to extreme storm
conditions.

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 Quantitative Projections: Banks are required to project potential losses, revenues,
and capital levels over a nine-quarter planning horizon under these scenarios. Imagine
a ship’s captain predicting how much fuel they’ll need for different voyage lengths and
conditions.
Transparency: DFAST results are made public, providing valuable information to
market participants about the condition and resilience of the banks. It’s akin to athletes
publishing their fitness metrics, giving insights into their performance capabilities.
Outcome: While CCAR has both qualitative and quantitative assessments, DFAST is
primarily quantitative. The test results help regulators identify which banks might be
vulnerable in a downturn. If a bank doesn’t fare well in the DFAST, it’s a signal that they
might need to strengthen their capital position or risk management practices. Think of
it as a coach identifying weak points in an athlete’s performance and working on those
areas to improve.
Analogy: Imagine DFAST as a simulation game where architects test their building
designs against various natural disasters. Just as these simulations help refine and
fortify structures against potential calamities, DFAST ensures banks are prepared to
weather economic storms.

3.0.3 PRA (Prudential Regulation Authority)

Established in 2013 as a part of the Bank of England, the PRA plays a crucial role in
the UK’s financial system. Its primary responsibility is to promote the stability of the
UK’s financial system by ensuring that financial institutions, like banks and insurance
companies, are well-managed and adequately capitalized.
Key Responsibilities of PRA:
Supervision: The PRA actively supervises financial institutions to ensure they adhere
to regulatory standards. This is similar to a school board regularly reviewing schools to
ensure they maintain quality education and infrastructure.
Setting Standards: The PRA establishes regulations and standards that financial in-
stitutions must follow. This includes requirements for capital, liquidity, and risk man-
agement. Imagine a board of education defining curriculum standards for schools.
Enforcement: If institutions fail to comply with PRA’s regulations, the authority has
the power to impose sanctions or even revoke licenses. This is akin to a school inspector
having the authority to penalize or shut down schools that don’t meet the required
standards.
Objective: The main goal of the PRA is to prevent scenarios where problems within
financial institutions harm the broader economy or result in the need for taxpayer-
funded bailouts. Think of it as a proactive approach, similar to ensuring schools have
evacuation plans and fire safety measures in place long before any emergency arises.
Analogy: The PRA is like the quality control department in a manufacturing unit.
Just as quality control ensures every product meets the required standards and is safe
for consumers, the PRA ensures that financial institutions operate safely and don’t pose
risks to the broader economy.

3.0.4 FINMA (Swiss Financial Market Supervisory Authority)

Established in 2009, FINMA is the independent supervisory authority for Switzerland’s
financial markets. It supervises banks, insurance companies, stock exchanges, and

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other financial intermediaries in Switzerland to ensure the stability, transparency, and
integrity of the country’s financial system.
Key Responsibilities of FINMA:
Regulation: While FINMA does not create laws, it is responsible for implementing
and interpreting financial market legislation. Imagine a referee clarifying how specific
game rules should be applied during a match.
Supervision: FINMA monitors financial institutions to ensure they adhere to Swiss
regulations and maintain the required standards. It’s akin to a referee closely watching
players during a game to spot any fouls or violations.
Enforcement: If financial institutions breach regulations, FINMA can impose mea-
sures ranging from warnings to revoking licenses. This is similar to a referee handing
out penalties or even red cards for serious infractions.
Objective: FINMA’s main goal is to protect financial market participants, including
creditors, investors, and policyholders. It ensures that Switzerland’s financial market
functions properly, which in turn boosts confidence in the Swiss financial system. Think
of it as ensuring a sports match is played fairly, which then enhances the reputation of
the entire tournament.
Analogy: FINMA is like the umpire in a tennis match. The umpire ensures that both
players adhere to the rules, makes judgment calls when there are disputes, and ensures
the overall fairness and integrity of the match. Similarly, FINMA ensures that finan-
cial institutions play by the rules and maintains the integrity of Switzerland’s financial
market. .

3.0.5 ECB (European Central Bank)

Founded in 1998, the ECB is the central bank for the Euro and is responsible for mone-
tary policy within the Eurozone, which consists of the 19 European Union (EU) member
states that have adopted the Euro as their official currency. One of its significant roles,
especially post the financial crisis, is to supervise significant banks within the Eurozone
to ensure financial stability.
Key Responsibilities of the ECB:
Monetary Policy: The ECB sets the key interest rates for the Eurozone and manages
the Euro’s money supply. This is akin to a coach deciding the strategy for a game,
determining the pace and style of play.
Banking Supervision: Through the Single Supervisory Mechanism (SSM), the ECB
directly supervises the significant banks in the Eurozone. It’s like a coach closely moni-
toring key players, ensuring they’re performing optimally and not making mistakes.
Financial Stability: The ECB works to maintain the stability of the financial system
in the Eurozone. When banks face issues, the ECB can intervene to prevent wider
economic problems. This is similar to a coach stepping in during a game when things
aren’t going well, making changes to turn the situation around.
Objective: The ECB aims to maintain price stability within the Eurozone, targeting
inflation rates below, but close to, 2% over the medium term. By supervising banks, it
also ensures that they operate safely and soundly, protecting the savings of European
citizens. Think of it as a coach ensuring the team is well-prepared, not just for one
game, but for the entire season.
Analogy: The ECB is like the head coach of a major sports league. While each team
(bank) has its own strategies and managers, the head coach (ECB) ensures that the

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entire league operates under a set of guidelines, maintains a certain standard of play,
and that the games (financial transactions) are conducted fairly.

3.0.6 ICAAP (Internal Capital Adequacy Assessment Process)

ICAAP is a comprehensive framework that requires banks to assess and ensure they
hold adequate capital relative to their risk profile. It’s an integral part of the supervisory
review process in the European banking system, emphasizing the relationship between
risk and capital.
Key Responsibilities under ICAAP:
Risk Identification: Banks need to identify and evaluate all material risks they might
face. This is akin to a sports team analyzing the strengths and weaknesses of an oppo-
nent before a game.
Capital Assessment: Based on the identified risks, banks must determine the amount
of capital they need to hold. Think of this as a team strategizing how much energy to
reserve for the final quarter of a game.
Stress Testing: Banks have to test their resilience against adverse economic scenarios
to ensure they remain adequately capitalized even in downturns. This is similar to ath-
letes undergoing rigorous training to perform well even under challenging conditions.
Objective: The main goal of ICAAP is to ensure that banks have a proactive ap-
proach to managing their capital in relation to their risk profile. It emphasizes that
banks should not just meet regulatory capital minimums but should have a buffer based
on their internal risk assessments. Imagine a coach advising a team to not just aim for
a narrow win, but to dominate the game, ensuring victory.
Analogy: ICAAP is like the training and strategy sessions a sports team undertakes
before a big tournament. The team (bank) reviews potential challenges (risks), plans
its moves (allocates capital), and prepares for unexpected scenarios (stress tests). This
ensures they’re not caught off-guard and can handle whatever the competition throws
at them.

4 Conclusion on Banking Regulations

Just as traffic rules keep the roads safe for all users, banking regulations ensure the
stability and safety of the financial system. These rules and standards, continuously re-
fined over the years, ensure that banks operate fairly, transparently, and can withstand
economic shocks. As the financial world evolves, so do these regulations, adapting to
new challenges and ensuring the system remains robust for all its participants.

Thank You