Since the 2007â09 crisis, increasing attention has been devoted to capital adequacy and balance sheet integrity. Banks have been required to improve the quality of their own funds, strengthen their liquidity structure, and enforce their risk management processes. As a starting point, this chapter outlines the regulatory response to the recent financial crunch. On this subject, stress tests and risk integration are useful tools to enhance bank resilience against adverse conditions. Then, Bank Alphaâs illustrative example is introduced to show how an international bank runs its business. It serves to outline throughout the book all complex challenges one needs to face when modeling risks. As in an executive summary, this introductory chapter shows some of Bank Alphaâs main stress testing and risk integration results. Finally, a practical guide to explore the text is provided. It serves as a map for the reader looking for orientation during the deep-dive journey.
1.1 Antidote to the Crisis
A series of failures recently sharpened the question about the role of banks in a modern economic system. On this subject, two ways may be followed to connect savings and investments. Firstly, fund suppliers may directly meet the financial demand by acquiring equity positions or debt instruments. However, the wide range of costs associated with direct finance justifies a second way to link money supply and demand. Financial intermediaries screen, monitor, and diversify risks by providing credit to those needing resources.
It is worth noting that, in the recent past, banks progressively moved from their traditional institutional background to a more marked economic value creation perspective. This evolution raised a possible conflict with their social role by highlighting the potential for systemic breakdown. In this regard, given the nature of their operations, banks never hold sufficient capital to guarantee full deposit withdrawals. Additionally, the opaque nature of financial investments does not allow analysts to distinguish the problems specific to one intermediary from those affecting the industry as a whole. As a result, the distress of one entity may lead to runs on others as well. These are the reasons why laws and regulations govern financial intermediation, as detailed in the following sections.
1.1.1 What Went Wrong
Many economic crises in history originated as failures of financial intermediaries. A few banks became bankrupt during the 2007â09 crisis, and many more had impaired operations. Nevertheless, major disruptions occurred among new segments of financial intermediation. A run on asset-backed commercial paper (ABCP) liabilities was one of the main issues experienced during the recent crisis. These short-term funding instruments were used to finance asset portfolios with long-term maturities. ABCP issuers (conduits) performed a typical financial intermediation function but they were not banks. In many instances, banks were the driving force behind ABCP funding growth. They sponsored these activities and provided the required liquidity. However, this new structure shifted a component of financial intermediation away from it...