Bank business models, capital rules and structural separation policies

Abstract

Purpose – The study examines the roles of capital rules, macro variables and bank business models in determining the safety of banks as measured by the “distance-to-default” (DTD) with the purpose of drawing implications for regulation of bank capital and business models. Design/methodology/approach – A panel regression study using pre- and post-crisis data for 108 US and European banks is used to explore the issue empirically. A new technique is also used to back out the amount of capital banks would have needed during the crisis to keep the “DTD” in the very safe zone. Findings – The simple leverage ratio has a strong relationship with “DTD”, while the Basel ratio does not. The most important business model features are derivatives and wholesale funding, which have a strong negative relationship with “DTD”. Trading and available-for-sale securities have a positive influence. Calculations show that it is not possible for any reasonable capital rule to compensate for the risks created by business model features encompassing large derivative-based activities. Bank separation policies are essential. Originality/value – The micro evidence-based analysis as an approach to bank regulation and business model requirements stands in contrast to the ad hoc way policy has been constructed before and after the crisis. The empirical evidence supports separation based on the balance sheet size of derivatives and a leverage ratio instead of the complex Basel risk-weighted capital approach. The current approaches to structural separation are criticised constructively, and some evidence-based suggestions for improving bank business models to reduce systemic risk are made.