Basel Capital Requirements Research Articles

Basel II and the Capital Requirements Directive: Responding to the 2008/09 Financial Crisis

This paper addresses factors which have prompted the need for further revision of banking regulation, with particular reference to the Capital Requirements Directive. The Capital Requirements Directive (CRD), which comprises the 2006/48/EC Directive on the taking up and pursuit of the business of credit institutions and the 2006/49/EC Directive on the capital adequacy of investment firms and credit institutions, implemented the revised framework for the International Convergence of Capital Measurement and Capital Standards (Basel II) within EU member states. Pro cyclicality has attracted a lot of attention – particularly with regards to the recent financial crisis, owing to concerns arising from increased sensitivity to credit risk under Basel II. This paper not only considers whether such concerns are well-founded, but also the beneficial and not so beneficial consequences emanating from Basel II’s increased sensitivity to credit risk (as illustrated by the Internal Ratings Based approaches). In so doing it considers the effects of Pillar 2 of Basel II, namely, supervisory review, with particular reference to buffer levels, and whether banks’ actual capital ratios can be expected to correspond with Basel capital requirements given the fact that they are expected to hold certain capital buffers under Pillar 2. Furthermore, it considers how regulators can respond to prevent systemic risks to the financial system during periods when firms which are highly leveraged become reluctant to lend. In deciding to cut back on lending activities, are the decisions of such firms justified in situations where such firms’ credit risk models are extremely and unduly sensitive - hence the level of capital being retained is actually much higher than minimum regulatory Basel capital requirements ?

Bank risk and performance in the MENA region: The importance of capital requirements

This paper benefits from various risk- and non-risk-based regulatory capital ratios and examines their impact on bank risk and performance in the Middle East and North Africa (MENA) region. Our findings suggest that compliance with the Basel capital requirements enhances bank protection against risk, and improves efficiency and profitability. The impact of capital requirements on bank performance is more pronounced for too-big-to-fail banks, banks in periods of crisis and banks in countries with good governance. The results are also robust when controlling for the Arab Spring transition period. Finally, endogeneity checks, alternative risk and performance measures, a principal component analysis and other estimation techniques confirm our findings.

Probability of Default Uncertainty in the Vasicek Credit Risk Framework

After the recent financial crisis (2007-2010), many doubts on the reliability of the mathematical models to measure the financial risks have arisen. As a consequence, model risk has been a source of concern for financial regulators. This risk includes, among others, incorrect mathematical modelling, inaccurate model inputs calibration or inappropriate model application. In this paper we explore the possible effects of the uncertainty in the calibrated probability of default (PD) on the Basel capital requirements. We also propose two approximated formulas to account for the effect of this uncertainty on, respectively, single and multiple correlated portfolios. Using S&P data and a portfolio of European sovereign bonds, our main empirical conclusion is that the PD uncertainty has not a relevant impact on the risk measurement.

Causes and Remedies of the Japan's Long‐lasting Recession: Lessons for China

AbstractJapan has suffered from sluggish economic growth and recession since the early 1990s. In this paper, we analyze the causes of the prolonged slowdown of the Japanese economy (the lost decade). Economics Nobel laureate Paul Krugman has argued that Japan's lost decade is an example of a liquidity trap. However, our empirical analysis shows that stagnation of the Japanese economy comes from its vertical IS curve rather than a horizontal LM curve, so the Japanese economy has been facing structural problems rather than a temporary downturn. The vertical IS curve is caused by an insensitivity of investment to a lower interest rate partly because of the decline of sales due to the aging population and firms not wanting to invest. The structural problems come from the aging demographic, which is often neglected by scholars and policy‐makers, and also from the allocation of transfers from the central government to local governments, and the unwillingness of Japanese banks to lend money to startup businesses and small and medium enterprises (SMEs), mainly because of Basel capital requirements. Many countries, like China, are expected to face similar issues, particularly given the aging population. The present paper will address why the Japanese economy has been trapped in a prolonged slowdown and provide some remedies for revitalizing the economy.

Causes and Remedies for Japan's Long-Lasting Recession: Lessons for the People's Republic of China

Japan has suffered from sluggish economic growth and recession since the early 1990s. In this paper, we analyze the causes of the prolonged slowdown of the Japanese economy (the lost decade). Economics Nobel laureate Paul Krugman has argued that Japan’s lost decade is an example of a liquidity trap. However, our empirical analysis shows that stagnation of the Japanese economy comes from its vertical IS curve rather than a horizontal LM curve, so the Japanese economy faces structural problems rather than a temporary downturn. The structural problems mainly come from the aging demographic, which is often neglected in other studies, and also from the allocation of transfers from the central government to local governments, and the unwillingness of Japanese banks to lend money to startup businesses and SMEs, mainly because of Basel capital requirements. Many countries, like the People’s Republic of China, are expected to face similar issues, particularly the aging population, and so are very much concerned about the long-term recession that Japan has experienced. This paper will address why the Japanese economy has been trapped in a prolonged slowdown and will provide some remedies for revitalizing the economy.

Effective regulatory regimes: a comparative analysis of GCC financial regulators

Purpose– The purpose of this study is to investigate the effects of the global financial crisis on Gulf Cooperation Council (GCC) bank regulation and the impact on the region and the policies adopted by the regulators to avoid financial panic and contagion.Design/methodology/approach– The author examines GCC countries’ financial soundness indicators in terms of capital adequacy, non-performing loans and provisioning rates, including central bank liquidity support, deposit guarantees, capital injections and monetary easing and policies to mitigate risk assessment, and the monitoring and elimination of practices promoting excessive risk. GCC compliance regimes through multinational organizations and the exposure of the region to cross-border financial linkages to test for financial soundness are assessed.Findings– Overall, results indicate that comprehensive regulatory oversight exists in the GCC in conformity with international standards, and Basel capital adequacy requirements, and that the GCC regulators have acted prudently to establish high coverage in all measures but that gaps exit concerning cross-border surveillance and a need for imposition of capital surcharges on banks deemed high systemic risk. The supervision of Islamic financial institutions and a lack of inter-GCC liquidity support mechanism for this segment are highlighted.Practical implications– The paper shows that the GCC regulators need to address cross-border surveillance, as local banks branch internationally and foreign banks operate in the region.Originality/value– The author is not aware of any similar work that compares the regulatory policies of the GCC.

Exploring the use of the Kelly criterion for Basel capital requirement: An optimal and countercyclical approach

The Basel capital is a ‘margin’ requirement imposed by regulators to cushion banks against extreme losses, and is a function of value-at-risk. The way banks adjust their balance sheets to maintain the requirement is equivalent to leverage targeting that has been shown to cause procyclical risk. The 2008 crisis revealed that Basel 2 capital was insufficient but the industry believes the current Basel III requirements are too high for sustainable business. Is there an optimal capital? Balance sheet rebalancing with a target leverage can be described by a multiplicative game/process. Most players will lose even if the game has a positive expectation because excessive leverage brings the majority to ruin over time and the system achieves a ‘winner takes all’ effect. Fortunately, the Kelly criterion provides an optimal leverage that prevents this. Using empirical data for simulation, we show that the Kelly criterion gives an optimal capital vis-à-vis Basel 2, Basel 2.5 and expected shortfall. This framework provides the best survival strategy over the economic cycle. The article suggests how this can be applied for an actual bank. Moreover, a Kelly-based capital is potentially countercyclical, which addresses procyclical risks and could also reinforce the central bank's monetary policy transmission mechanism.

The pricing of deposit insurance in the presence of systematic risk

Based on the Merton (1977) put option framework, we develop a deposit insurance pricing model that incorporates asset correlations, a measurement for the systematic risk of a bank, to account for the risk of joint bank failures. Estimates from our model suggest that actuarially fair risk-based deposit insurance that considers only individual bank failure risk is underpriced, leaving insurance providers exposed to net losses. Our estimates also capture the size premium where big banks are priced with higher deposit insurance than small banks. This result is particularly relevant to the current regulatory concerns on big banks that are too-big-to-fail. Above all, our approach provides a unifying framework for integrating risk-based deposit insurance with risk-based Basel capital requirements.

Bank Loan Pricing in an Imperfectly Competitive Bank Market

This paper presents a theoretical model of bank loan pricing in an imperfectly competitive interbank market under Basel capital requirements. It is based on the relevant work by Ruthenberg and Landskroner (2008) who develop a model along the same lines, although our model incorporates more realistic assumptions such as a non-zero Recovery Rate on loans and a securities portfolio to match capital and reserves. Under the loan-pricing equation suggested, quoted loan rates depend on monopoly power, elasticity of demand for loans, risk premiums (in the interbank market and for individual borrowers) and the market required Return-On-Equity weighted by Basel risk-weighted capital ratios. The borrower’s Probability of Survival enters as a compounding factor for the whole loan rate.

Downside risk and portfolio diversification in the euro-zone equity markets with special consideration of the crisis period

This study examines the Value-at-Risk for ten euro-zone equity markets individually and also divided into two groups: PIIGS (Portugal, Italy, Ireland, Greece and Spain) and the Core (Austria, Finland, France, Germany and the Netherlands), employing four VaR estimation and evaluation methods considered over the full period and the pre- and post-global crisis subperiods 1 and 2. The backtesting results are also evaluated according to the Basel capital requirements. The results demonstrate that the CEVT methods meet all the statistical criteria the best for most individual equity indices over the full period, but these results over the two subperiods for those two methods are mixed, compared to those the DPOT methods. Moreover, the two optimal group portfolios of the PIIGS and the Core as well as the grand portfolio that combines the ten indices do not show much diversification benefits. The PIIGS portfolio selects Spain's IBEX only, while that of the Core opts for Austria's ATX only in the full period and subperiod 1. However, Germany's DAX overwhelmingly dominates both the Core and the Grand portfolios in subperiod 2.

Concentration risk model for Greek bank's credit portfolio

Purpose – The IRB capital requirements of Basel II define the minimum level of capital that the bank has to retain to cover the current risks of its portfolio. The major risk that many banks are facing is credit risk and Basel II provides an approach to calculate its capital requirement. It is well known that Pillar I Basel II approach for credit risk capital requirements does not include concentration risk. The paper aims to propose a model modifying Basel II methodology (IRB) to include name concentration risk. Design/methodology/approach – The model is developed on data based on a portfolio of Greek companies that are financed by Greek commercial banks. Based on the initial portfolio, new portfolios were simulated having a range of different credit risk parameters. Subsequently, the credit VaR of various portfolios was regressed against the credit risk indicators such as Basel II capital requirements, modified Herfindahl Index and a non-linear model was developed. This model modifies the Pillar I IRB capital requirements model of Basel II to include name concentration risk. Findings – As the Pillar I IRB capital requirements model of Basel II does not include concentration risk, the credit VaR calculations performed in the present work appeared to have gaps with the Basel II capital requirements. These gaps were more apparent when there was high concentration risk in the credit portfolios. The new model bridges this gap providing with a correction coefficient. Practical implications – The credit VaR of a loan portfolio could be calculated from the bank easily, without the use of additional complicated algorithms and systems. Originality/value – The model is constructed in such a way as to provide an approximation of credit VaR satisfactory for business loan portfolios whose risk parameters lie within the range of those in a realistic bank credit portfolio and without the application of Monte Carlo simulations.

Structural Credit Loss Distributionsunder Non-Normality

In the context of Merton [1974] and Vasicek [1987, 2002] Gaussian single-factor credit risk models, the authors examine the impact of neglected non-normality of the underlying asset return process on the shape of the derived credit loss distribution and the resulting Basel capital requirements. They relax the Gaussian assumption and specify skew-normal and skew-student <i>t</i> densities to model the underlying asset return process, thus generalizing the credit loss distribution, and develop a maximum-likelihood estimator for the structural parameters. They apply their approach to aggregate charge-off rates published by the Federal Reserve Board for 10 U.S. sectors. The authors show that the non-gaussian modeling of the common factor provides a better characterization of data than its Gaussian counterpart and that it has a significant impact on the capital requirements, depending on the sign and magnitude of the skew-related coefficient. On the other hand, the non-gaussian modeling of the idiosyncratic factor does not provide a significantly better characterization than the Gaussian base case. The latter could stem from the fact that the sector portfolios are large, so the idiosyncratic component has been diversified away. <b>TOPICS:</b>Analysis of individual factors/risk premia, quantitative methods

Book‐to‐Market Equity, Asset Correlations and the Basel Capital Requirement

AbstractThis paper examines the effect of book‐to‐market equity (BE/ME) on asset correlations under the Basel capital requirement. We find that BE/ME captures variations in asset correlations after controlling for firm size, default probability and industry effects from 1987 to 2011. Obligors with higher BE/ME exhibit lower asset correlations compared to those with lower BE/ME. Decomposing BE/ME into assets‐in‐place and growth options based on the asset pricing literature shows that obligors with more assets‐in‐place or more fixed assets have higher BE/ME and lower asset correlations than those with more growth options. Overall, our findings suggest that BE/ME is an additional important factor that may improve the estimates of asset correlations and thereby banks’ capital adequacy.

Basel Capital Requirements and Credit Crunch in the MENA Region

The 1988 Basel I Accord set the common requirements of bank capital to promote the soundness and stability of the international banking system. The agreement required banks to hold capital in proportion to their perceived credit risks, and this requirement may have caused a “credit crunch,” a significant reduction in the supply of credit. We investigate the direct link between the implementation of the Basel I Accord and lending activities, using a data set spanning annual observations covering 1989–2004 for banks in Egypt, Jordan, Lebanon, Morocco, and Tunisia. The results provide clear support for a significant increase in credit growth following the implementation of capital regulations, in general. Despite higher capital adequacy ratios, banks expanded credit and asset growth. Credit growth appears to be driven by demand fluctuations attributed to real growth, cost of borrowing, and exchange rate risk. Overall, the effects of macroeconomic variables, in contrast to capital adequacy, appear to be more dominant in determining credit growth, regardless of the capital adequacy ratio, and regardless of variation across banks by nationality, ownership, and listing.

Has the Basel Capital Requirement Caused Credit Crunch in the Mena Region?

The 1988 Basel I Accord set the common requirements of bank capital to promote the soundness and stability of the international banking system. The agreement required banks to hold capital in proportion to their perceived credit risks, and this requirement may have caused a “credit crunch,” a significant reduction in the supply of credit. We investigate the direct link between the implementation of the Basel I Accord and lending activities, using a data set spanning annual observations covering 1989–2004 for banks in Egypt, Jordan, Lebanon, Morocco, and Tunisia. The results provide clear support for a significant increase in credit growth following the implementation of capital regulations, in general. Despite higher capital adequacy ratios, banks expanded credit and asset growth. Credit gTowth appears to be driven by demand fluctuations attributed to real growth, cost of borrowing, and exchange rate risk. Overall, the effects of macroeconomic variables, in contrast to capital adequacy, appear to be more dominant in determining credit growth, regardless of the capital adequacy ratio, and regardless of variation across banks by nationality, ownership, and listing.

Market crises and Basel capital requirements: Could Basel III have been different? Evidence from Portugal, Ireland, Greece and Spain (PIGS)

Basel III represents a crucial step in strengthening the capital rules underlying banking operations, aimed at reducing the probability and severity of a systemic crisis. Alongside two supplementary capital buffers, the Basel Committee of Banking Supervision imposed severe pressure on the Value-at-Risk based Internal Models Approach in order to increase. This is to increase the capital base by adding the stressed Value-at-Risk component in an effort to reduce reliance on internal models while keeping the Standardized Approach avenue open. However, even though those measures might appear theoretically correct, evidence gathered for long and short exposures in Portugal, Italy, Greece and Spain highlights several defects in Basel III. We emphasize that leptokurtic models, primarily those derived from Extreme Value Theory, should be enforced in the regulations given their superior performance in market crises, and that Basel II could have shielded against 2008 mayhem provided that heavy-tailed techniques had been employed.

Book-to-market equity, operating risk, and asset correlations: Implications for Basel capital requirement

We examine the effect of book-to-market equity (BE/ME) on asset correlations in the asymptotic single risk factor (ASRF) framework under the Basel II Accord on regulatory capital requirement. Over a sample period from 1988 to 2007, we find that BE/ME is negatively related to asset correlations after controlling for firm size, default probability, and industry effects. Decomposing BE/ME into risks of operating leverage and financial leverage according to Penman et al. (2007) reveals that higher (lower) operating risk are related to lower (higher) asset correlations. Our findings suggest that incorporating risk of operating leverage into the estimation of asset correlations may improve the measurement of a bank's regulatory capital requirement and potentially reduce regulatory capital arbitrage.

Pro-cyclicality of the Basel Capital Requirement Ratio and Its Impact on Banks

This paper proposes replacing the present Basel capital requirement with a new counter-cyclical measure. Optimally, (i) the Basel capital requirement ratio should depend on various economic factors such as the cyclical stage of GDP, credit growth, stock prices, interest rates, and land prices—hence, avoiding the expansion of bank loans during a boom period and a credit crunch during a sluggish period; (ii) the Basel minimum capital requirement rule should be different from country to country since the economic structures and the behavior of banks are different; and (iii) cross-border bank operation should follow the minimum capital requirement ratio where bank lending activities occur rather than the origin of the source of funds.

Summary of General Discussion on “Pro-cyclicality of the Basel Capital Requirement Ratio and Its Impact on Banks”

Summary of General Discussion on “Pro-cyclicality of the Basel Capital Requirement Ratio and Its Impact on Banks”

The Impact of Pillar 3 Disclosure Requirements on Bank Safety

We consider the impact of a mandatory information disclosure on bank safety in a spatial model of banking competition, in which a bank’s probability of success depends on the quality of its risk measurement and management systems. Under Basel capital requirements, this quality is at least partially disclosed to market participants by the Pillar 3 disclosures. We show that the regulator can improve the safety of the banking system by tightening the disclosure requirements. Furthermore, the stricter the disclosure requirements are the bigger is a positive impact of an increase in capital requirements on bank safety.