Bank Capital Requirements Research Articles

Downturn Credit Portfolio Risk, Regulatory Capital and Prudential Incentives*

ABSTRACTThis paper analyzes the level and cyclicality of bank capital requirement in relation to (i) the model methodologies through‐the‐cycle and point‐in‐time, (ii) four distinct downturn loss rate given default concepts, and (iii) US corporate and mortgage loans. The major finding is that less accurate models may lead to a lower bank capital requirement for real estate loans. In other words, the current capital regulations may not support the development of credit portfolio risk measurement models as these would lead to higher capital requirements and hence lower lending volumes. The finding explains why risk measurement techniques in real estate lending may be less developed than in other credit risk instruments. In addition, various policy recommendations for prudential regulators are made.

Subordinated Debt in Bank Funding and Financial Market Stability

In the emerging consensus view on reforming bank capital requirements, the need for increased regulatory capital and some form of crisis insurance are beyond doubt, as has been established in Caballero (2009). The present paper contributes to the ongoing debate concerning the proper composition of capital buffers, in which banks favor sub-ordinate debt over equity. Subordinated debt recommends itself based on its ability to enhance market discipline in interbank funding markets. We find that this measure also helps towards resolving perverse incentives in the risk management framework based on VaR, since the reliance on subordinated debt helps in putting a cap on loss given default of senior claims of failing banks, hence emulating simultaneously the theoretically sound risk measure of expected shortfall and a version of a joint stress test and scenario analysis. To arrive at a benchmark to compare the viability of capital buffers, we propose to use a financier of last resort in a dual manner: as a theoretical entity to arrive at an archimedean point on which comparisons concerning capital adequacy can be based, and in practice in a certain weakened form of a market maker of last resort, extending the function of exchanges and of central clearing of derivatives. Based on these constructions and arguments, we demonstrate that it is optimal to increase capital requirements mainly based on sub-ordinate bank debt against the alternative of purely increasing equity buffers and staying within the VaR risk paradigm. We provide further support for this conclusion by showing its compatibility with the basic outcomes of economic capital models capable of capturing counterparty risk and contagion, leading to phase transitions and bimodal loss distributions.

Basel II Modified in Response to Market Crisis

The Basel Committee on Banking Supervision has adopted amendments to the Basel II Capital Accord in response to the financial-markets crisis. The amendments deal with risk-based capital requirements for banking book exposures and the trading book framework. The changes to the banking book rules relate solely to securitization exposures, which are subject to a framework separate from those that apply to retail, wholesale, or equity exposures. Some of the most important changes relate to “resecuritization exposures,” a concept that is new to the Basel II framework and is meant to capture collateralized debt obligations (CDOs) of asset-backed securities (ABS) and other structures with similarly elevated correlation risks, but may also cover some exposures to asset-backed commercial paper (ABCP) conduits and other less risky structures. Other changes the Basel Committee has made to the banking book securitization framework include denying effect to self guaranties, changes to both the standardized and the internal risk-based (IRB) approach to ABCP liquidity facilities, elimination of special treatment for general market disruption liquidity facilities, and additional operational requirements banks must satisfy to use the securitization framework. In addition to addressing minimum quantitative capital requirements (Pillar 1), the Basel Committee provides supplemental guidance for the two “qualitative pillars,” the supervisory review process (Pillar 2) and market discipline (Pillar 3). Finally, believing that the current capital framework for market risk fails to capture some key risks, the Basel Committee now requires a stressed value at risk (VaR) measure as an add-on to the general market risk capital component. These changes are part of a continuing trend by the Basel Committee and national regulators to tighten bank capital requirements, especially for structured finance. <b>TOPICS:</b>CLOs, CDOs, and other structured credit, asset-backed securities (ABS)

The Basel II reform and the provision of finance for R &amp; D activities in SMEs: An analysis of a sample of Italian companies

In this article, we investigate the issue of the financing of R &amp; D investments in SMEs in Italy with respect to the changes in the banking system, which are driven by the adoption of the new version of the Basel Capital Accord. Results from an instrumental variable (IV) probit model show a significant and large marginal effect of both indicators of R &amp; D activity and R &amp; D intensity on the probability that firms report unsatisfied credit needs. We find that the introduction of the new rules is likely to have a moderate impact on the capital requirements of banks when considering the possibility for a bank to pool together all the companies in its portfolio. However, we obtain an increase in capital requirements when we focus on the sub-sample of firms performing product innovation. In particular, the analysis suggests that the new rules on regulatory capital requirements might have a negative impact on lending conditions for those SMEs that are relatively younger, smaller and showing positive R &amp; D expenditures.

Bank Capital, Liquidity Creation and Deposit Insurance

This paper examines how the introduction of deposit insurance influences the relationship between bank cap-ital and liquidity creation. As discussed by Berger and Bouwman (2009), there are two competing hypothes-es on this relationship which can be influenced by the presence of deposit insurance. The introduction of a deposit insurance scheme in an emerging market, Russia, provides a natural experiment to investigate this issue. We study three alternative measures of bank liquidity creation and perform estimations on a large set of Russian banks. Our findings suggest that the introduction of the deposit insurance scheme exerts a limited impact on the relationship between bank capital and liquidity creation and does not change the negative sign of the relationship. The implication is that better capitalized banks tend to create less liquidity, which sup-ports the fragility/crowding-out hypothesis. This conclusion has important policy implications for emerging countries as it suggests that bank capital requirements implemented to support financial stability may harm liquidity creation. JEL classification: G21; G28; G38; P30; P50 Keywords: Bank capital, liquidity creation, deposit insurance, Russia

The crash sonata in D major

The current US-made financial crisis has been exacerbated by the mark-to-market rule, by pro-cyclical bank capital requirements, by fragility in the originate-to-distribute system, and by the volume of fraudulent mortgages in the USA, which have distorted profit and loss distributions and confounded all prediction models. The monetary value of such frauds in 2006–07 is estimated to reach $100–120bn. Like most crises since the 1980s, the present one is also due to regulatory mistakes, excessive leverage and concentration in real estate investments. While previous crises tended to be localised, the most recent turmoil has unfortunately had a global impact.

Financial globalization, financial crises and contagion

Two observations suggest that financial globalization played an important role in the recent financial crisis. First, more than half of the rise in net borrowing of the U.S. non-financial sectors since the mid-1980s has been financed by foreign lending. Second, the collapse of the U.S. housing and mortgage-backed-securities markets had worldwide effects on financial institutions and asset markets. Using an open-economy model where financial intermediaries play a central role, we show that financial integration leads to a sharp rise in net credit in the most financially developed country and to large asset price spillovers of country-specific shocks to bank capital. The impacts of these shocks on asset prices are amplified by bank capital requirements based on mark-to-market.

BANK CAPITAL REQUIREMENTS, BUSINESS CYCLE FLUCTUATIONS AND THE BASEL ACCORDS: A SYNTHESIS

Abstract In order to survey the mechanisms through which the introduction of Basel II bank capital requirements is likely to accentuate the procyclical tendencies of banking, this paper brings together the theoretical literature on the bank capital channel of propagation of exogenous shocks and the literature on the regulatory framework of capital requirements under the Basel Accords. We conclude that the theoretical models that revisit the bank capital channel under the new accord generally support the Basel II procyclicality hypothesis and that the magnitude of the procyclical effects essentially depends on (i) the composition of banks' asset portfolios, (ii) the approach adopted by banks to compute their minimum capital requirements, (iii) the nature of the rating system used by banks, (iv) the view adopted concerning how credit risk evolves through time, (v) the capital buffers over the regulatory minimum held by the banking institutions, (vi) the improvements in credit risk management and (vii) the supervisor and market intervention under Basel II. The recent events and instability in financial markets all over the world have led the procyclicality issue to enter the agendas of several political international fora and some measures to mitigate procyclicality are being put forward. The bank capital channel literature should now play an important role in evaluating their effectiveness.

Time-Varying Capital Requirements in a General Equilibrium Model of Liquidity Dependence

This paper attempts to quantify business cycle effects of bank capital requirements. The authors use a general equilibrium model in which financing of capital goods production is subject to an agency problem. At the center of this problem is the interaction between entrepreneurs' moral hazard and liquidity provision by banks as analyzed by Holmstrom and Tirole (1998). They impose capital requirements on banks and calibrate the regulation using the Basel II risk-weight formula. Comparing business cycle properties of the model under this procyclical regulation with those under hypothetical countercyclical regulation, the authors find that output volatility is about 25 percent larger under procyclical regulation and that this volatility difference implies a 1.7 percent reduction of the household's welfare. Even with more conservative parameter choices, the volatility and welfare differences under the two regimes remain nonnegligible.

The Credit Rating Crisis

Since June 2007, the creditworthiness of structured finance products has deteriorated rapidly. The number of downgrades in November 2007 alone exceeded 2,000 and many downgrades were severe, with 500 tranches downgraded more than 10 notches. Massive downgrades continued in 2008. More than 11,000 of the downgrades affected securities that were rated AAA. This paper studies the credit rating crisis of 2007-2008 and in particular describes the collapse of the credit ratings of ABS CDOs. Using data on ABS CDOs we provide suggestive evidence that ratings shopping may have played a role in the current crisis. We find that tranches rated solely by one agency, and by S&P in particular, were more likely to be downgraded by January 2008. Further, tranches rated solely by one agency are more likely to suffer more severe downgrades.(This abstract was borrowed from another version of this item.)

On the Real Effects of Bank Bailouts: Micro Evidence from Japan

Exploiting the Japanese banking crisis of the 1990s as a laboratory, we investigate the effects of bank bailouts on the supply of credit and the performance of banks' clients. Our findings indicate that the size of capital injections relative to the initial financial condition of banks is crucial for the success of bank bailouts. Capital injections that are large enough to reestablish bank capital requirements increase the supply of credit and spur investment. In contrast, not only do capital injections that are too small fail to increase the supply of credit, but they also encourage the evergreening of nonperforming loans. (JEL E44, G21, G28, G32, G34)

Correlated Leverage and Its Ramifications

This paper develops a theory in which housing prices, the capital structures of banks that make mortgage loans and the capital structures of borrowers who take these loans are all endogenously determined in equilibrium. There are four main results. First, leverage is a "positively correlated" phenomenon in that high leverage among borrowers is positively correlated with high leverage among banks. Both borrower and bank leverage are higher when house prices are higher. First-time homebuyers with fixed wealth endowments must borrow more to buy more expensive homes, whereas higher current house prices rationally imply higher expected future house prices and therefore higher collateral values, inducing banks to be more highly levered. Second, higher bank leverage leads to greater volatility of house prices in response to shocks to fundamental house values. Third, a bank's exposure to credit risk depends not only on its own leverage but also on the leverage decisions of other banks. Fourth, positive fundamental shocks to house prices dilute financial intermediation by reducing banks' pre-lending screening, and this reduction in bank screening further increases house prices. Empirical and policy implications of the analysis are drawn out, and empirical evidence is provided for the first two predictions. The key policy implications are that greater geographic diversification by banks, tying mortgage tax exemptions to the duration of home ownership, and increasing bank capital requirements when borrower leverage is high can help reduce house price volatility.

Government Guarantees: Why the Genie Needs to Be Put Back in the Bottle

Viral Acharya and Matthew Richardson point out that bank capital requirements and deposit insurance premia need to be based on the bank's systemic risk rather than its individual risk.

CAUSE AND EFFECT: GOVERNMENT POLICIES AND THE FINANCIAL CRISIS

ABSTRACT The underlying cause of the financial meltdown was much more mundane than a “crisis of capitalism”: The real origins lay in mostly obscure housing, tax, and regulatory policies of the U.S. government. The Community Reinvestment Act, the affordable‐housing “mission” of Fannie Mae and Freddie Mac, penalty‐free refinancing of home loans, penalty‐free defaults on home loans, tax preferences for home‐equity borrowing, and reduced capital requirements for banks that held mortgages and mortgage‐backed securities combined with each other to create the incentives for both subprime lending and the housing bubble that eventually led to the financial collapse.

International initiatives in market regulation: the storm before the calm?

PurposeThe purpose of this paper is to analyze causes and regulators' responses to the current international financial market crisis.Design/methodology/approachThe paper discusses warning signs of the crisis in world financial services markets, principal underlying problems that have been identified, steps the financial services industry and its regulators are taking to address those problems, and the likely direction of future regulation.FindingsMore resource was put into structuring investment portfolios than in managing the risk positions those vehicles created. The problem with credit ratings was less in the actual ratings than in the meaning attached to them. Regulators were focusing mainly on credit and discovered they should have been worrying about access to liquidity; however, liquidity is difficult to regulate. The Financial Stability Forum has highlighted shortcomings in the way regulators cooperate across borders. The industry will not be allowed to sort this out by itself. Increased bank capital requirements and tightening of regulations on structured or off‐balance‐sheet vehicles are likely.Originality/valueThe paper is an overview and insight from experienced financial services lawyers.

Bâle II, réallocation des portefeuilles de crédits et incitation à la prise de risque

Résumé Nous analysons l’impact de l’approche par les notations internes du nouvel accord de Bâle (ci-après Bâle II version irb ) sur les portefeuilles de crédits des banques et sur leur incitation à la prise de risque. Les exigences en capital réglementaire de Bâle II sont basées sur le taux de défaut de chaque crédit financé par les banques. Ce taux de défaut est établi en prenant en compte le risque idiosyncrasique du crédit (sa propre probabilité de défaut) et sa sensibilité au facteur de risque systématique. La relation entre ces deux facteurs de risque est supposée décroissante de la probabilité de défaut du crédit dans Bâle II. Cette hypothèse implique que la charge marginale en capital pour une banque finançant un crédit plus risqué est décroissante. Cette charge marginale décroissante doit être comparée au gain croissant lié au financement de crédits plus risqués, mesuré par le spread de crédit sur l’actif sans risque. Nous montrons alors que, pour des banques initialement risquées, il existe un biais incitatif au financement de crédits davantage risqués lors du passage de Bâle I à l’approche irb de Bâle II. Ce biais incitatif est en contradiction avec l’objectif principal de Bâle II de réduire le risque global encouru par les banques.

The regulatory use of credit ratings in bank capital requirement regulations

The paper addresses recent developments in international bank capital requirement regulations. A major change over the last decade has been the involvement of credit rating agencies in the measurement of bank capital requirements in the Basel II Accord. The proposed way of proceeding is expected to incentivise banks to improve their risk management practices. The authors argue, however, that the ratings-based regulation has negative effects on the financial markets. The paper analyses its effects on the credit rating industry as well as on the banking business. It is recommended that regulators reconsider the use of credit ratings in financial market regulation.

DO CAPITAL ADEQUACY REQUIREMENTS MATTER FOR MONETARY POLICY?

Central bankers and financial supervisors can have conflicting goals. While monetary policymakers work to ensure sufficient lending activities as a foundation for high and stable economic growth, supervisors may limit banks’ lending capacities in order to prevent excessive risk taking. We show that, in theory, central bankers can avoid this potential conflict by adopting an interest rate strategy that takes accounts of capital adequacy requirements. Empirical evidence suggests that while policymakers at the Federal Reserve have adjusted their interest rate to neutralizing the procyclical impact of bank capital requirements, those in Germany and Japan have not. (JEL E52, E58, G21)

PERSYARATAN KECUKUPAN MODAL MINIMUM DAN PERILAKU BANK DI INDONESIA

This study aims to analyze the impact of bank capital requirements in Indonesia where credit and capital crunch. In investigating the impact of bank capital requirements, we set up a simple model of the banking firm as well as having possible effects on the economy. In this study, change of deposits and change of loan were included as the dependent variable and capital requirements as the independent variable while logarithm of total assets, Certificates of Bank Indonesia (SBI) and growth of GDP as the control variable. In estimation, we use annually panel data of all the banks conventional period 2002-2206 while number of samples was 372 banksyears. Based on our econometric tests, we choose the Fixed Effect panel regression model because the bank specific characteristics are found to be different. The results of this study indicated that regulatory capital takes part in the change of Indonesia banks behaviour. The main finding of this study, firstly from the liabilities side of banks is that there was a strong positive relationship between bank capital and growth rate of deposits, where the impact of change in capital is smaller for well-capitalised banks than for poor-capitalised banks. Secondly, with regards to bank lending, it was shown that credit crunch was less apparent in the aftermath of change in capital regulatory in Indonesia. Thus, this study supported of capital crunch. Keywords: Capital Adequacy Ratio, Deposits, Loans, Capital Crunch

The welfare cost of bank capital requirements

Capital requirements are the cornerstone of modern bank regulation, yet little is known about their welfare cost. This paper measures this cost and finds that it is surprisingly large. I present a simple framework, which embeds the role of liquidity creating banks in an otherwise standard general equilibrium growth model. A capital requirement limits the moral hazard on the part of banks that arises due to deposit insurance. However, this capital requirement is also costly because it reduces the ability of banks to create liquidity. The key insight is that equilibrium asset returns reveal the strength of households’ preferences for liquidity and this allows for the derivation of a simple formula for the welfare cost of capital requirements that is a function of observable variables only. Using US data, the welfare cost of current capital adequacy regulation is found to be equivalent to a permanent loss in consumption of between 0.1% and 1%.