Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

17.1 Introduction

Since the global financial crisis, regulation has been heavily in the spotlight, as rules need to be improved, and new ones introduced, to prevent a repeat of the almost Armageddon scenario where financial institutions collapsed and had to be bailed out by governments and (effectively) the taxpayer. It is not, therefore, surprising that new regulation has been put together very quickly with the Dodd–Frank act, for example, being signed into law in July 2010, and totalling almost one thousand pages of rules governing financial institutions. In addition, Basel III guidelines for regulatory capital have been developed quickly (compared with, for example, the previous Basel II framework).

A key form of regulation is determining the minimum amount of capital that a given bank must hold. Capital acts as a buffer to absorb losses during turbulent periods and, therefore, contributes significantly to defining creditworthiness. Ultimately, regulatory capital requirements partially determine the leverage under which a bank can operate. The danger of overly optimistic capital requirements has been highlighted during the recent period, with losses not just exceeding, but dwarfing, the capital set aside against them. Banks continually strive for ever-greater profits to be shared by employees (via bonuses) and shareholders (via dividend payments and capital gains). Banks will therefore naturally wish to hold the minimum amount of capital possible in order to maximise the amount ...