Handbook of Market Risk

Chapter Thirteen

Banks and Basel II/III

Banks play a special role of intermediation, by facilitating payment flows across customers, and maintain markets for financial instrument. The purposes of banks can make their failures much more disruptive for the economy than the failure of other businesses. The threat here of a failure of a bank is that of a systemic risk.

Systemic risk can be defined as the risk of a sudden shock, which would damage the financial system to such an extent that economic activity would suffer. Systemic risk involves contagious transmission of the shock due to actual or suspected exposure to a failing bank. This is usually accompanied by a flight-to-quality, which reflects an increased demand for government securities, pushing up the relative cost of capital to the corporate sector.

Failures in the banking system have been particularly damaging, as we have been witnessing since the bankruptcy of Lehman, which plunged the world economy into recession, with several domestic banking systems being rescued by their respective governments.

In order to avoid systemic risk, regulators around the world worked together along with local governments and supra-national agencies to develop a set of tools and regulations to keep banks regulated. Systemic risk can come from two sources:

• Panicky behavior of depositors or investors, which would lead to a bank run in most cases
• Interruption in the payment system.

In this chapter, first we will provide a brief historical perspective ...