Basel Framework Research Articles

Dynamic Interaction of Bank Risk Exposures: An Empirical Study for the Indian Banking Industry

Banks are exposed to different types of risks in the process of financial intermediation and maturity transformation. The experience of the extant global financial crisis provided ample evidence of interaction among bank risks and perils of ignoring interactions in the changing economic, technological and regulatory environment. In this study, we assess the dynamic interaction among bank risks for the entire banking sector and bank groups based on various bank-specific characteristics in a vector autoregression framework, including variance decomposition and impulse response function analysis. We estimate the market measures of different risks using a multivariate GARCH (1, 1) in mean model. The study uses weekly bank level data from 23 October 2004 to 1 August 2014 for 40 listed Indian banks. The findings suggest that there is a positive interaction between equity risk and all other risks. Credit risk and exchange rate risk have a reciprocal relationship. It has also been observed that equity risk impacts credit risk positively. Interest rate risk seems to be affected by its lagged values and does not appear to be affected by other risks. The study highlights the role of liquidity in reducing bank risk exposures and supports new liquidity standards introduced in Basel III. The results improve the understanding of the interaction among risk exposures, which may enhance the supervisory process in the Basel framework. The risk interactions must be kept in mind for making capital provisioning, and an integrated approach to risk management by banks is more desirable.

Financing as a supply chain: The capital structure of banks and borrowers

We develop a model of the joint capital structure decisions of banks and their borrowers. Bank leverage of 85% or higher emerges because bank seniority both dramatically reduces bank asset volatility and incentivizes risk-taking by producing a skewed return distribution. Nonfinancial firms choose low leverage to protect their banks, presenting a partial resolution to the low-leverage puzzle. Our setup naturally extends to include government actions as we model bank assets using a modified Basel framework. Deposit insurance and bailout expectations lead banks and borrowers to take on more risk. Capital regulation lowers bank leverage but can increase bank risk due to a compensating increase in borrower leverage. Despite this, doubling current capital requirements reduces bank default risk by up to 90%, with only a small increase in loan interest rates.

Market Reaction to Bank Liquidity Regulation

We measure market reactions to announcements concerning liquidity regulation, a key innovation in the Basel framework. Our initial results show that liquidity regulation attracts negative abnormal returns. However, the price responses are less pronounced when coinciding announcements concerning capital regulation are backed out, suggesting that markets do not consider liquidity regulation to be binding. Bank- and country-specific characteristics also matter. Liquid balance sheets and high charter values increase abnormal returns whereas smaller long-term funding mismatches reduce abnormal returns. Banks located in countries with large government debt and tight interbank conditions or with prior domestic liquidity regulation display lower abnormal returns.

Modeling the Dependence between PD and LGD

In the current Basel framework, the A-IRB formula, used by banks or other financial institutions to compute their Regulatory Capital to hedge Credit Risk, completely neglects any possible dependence between Probability of Default and Loss Given Default. This happens since it uses a stressed version of the first parameter only, which is computed according to a mathematical model (ASRF), while for the latter is simply requested a parameter which can\properly describe a downturn period. Therefore the main goal of this thesis is to investigate a possible correlation between these two parameters and, eventually, propose a new formula to compute the Regulatory Capital which could incorporate this potential relationship. Hence, in order to achieve this goal, we first estimate both parameters, developing a well known statistical tool (Survival Analysis) and confirming (or even improving) the results of some previous studies which claim that this approach is actually suitable for the modelling of both quantities, clearly with a different meaning of the results which have to be properly interpreted. In a second phase we study the common behavior of these two risk parameters and present a completely new application in Credit Risk of a Bivariate Non Central Beta distribution, starting from empirical evidences of positive correlation. This approach is not only absolutely new in this field, but it also suggests a new methodology to stress both the parameters and to compute the Unexpected Losses. Consequently, it allows to obtain a new model for the Regulatory Capital of a bank and any other financial institutions, which actually takes into account any possible dependence between Probability of Default and Loss Given Default. The empirical analysis to test the proposed model is performed on public data coming from the US mortgage market, published by Freddie Mac. We obviously acknowledge that our solution is only a small step towards a long and hard path, therefore we encourage and recommend further research in this direction, since we believe that this could really lead to a more conscientious modelling of the Regulatory Capital for Credit Risk and, hence, to safer markets.

Bank Runs, Prudential Tools and Social Welfare in a Global Game General Equilibrium Model

The regulatory framework of Basel III features joint requirements on bank capital and liquidity. I study such requirements by developing a general equilibrium model with bank runs in a global game framework. The model highlights the role of noisy information for studying liquidity and shows that bank runs are inevitable. Risk shifting induces excessive leverage and insufficient liquidity, causing an inefficiently high crisis probability. Imposing one requirement only causes risk migration: banks respond by taking more risk in another area, which warrants joint requirements. The design of the optimal joint requirements depends crucially on the model's general equilibrium effect.

The Golden Rule of Banking: Funding Cost Risks of Bank Business Models

The liquidity regulation of banks in Pillar 1 of the Basel framework does not consider funding cost risks of different bank business models. Therefore, we assemble a data set of balance sheet positions including maturities and use the method of Value-Liquidity-at-Risk to explore 118 European retail, wholesale, and trading banks. When examining liquidity-induced equity risks, triggered by exemplary rating shifts, we find that retail banks bear significantly lower funding cost risks than wholesale and trading banks. Consequently, a prudential regulation, which simultaneously considers the funding cost risk and the diversification of the banking system is recommended.

Ranking of EU national banking systems using multi-criteria analysis in the light of Brexit

In order to define and implement the most effective measures to overcome the difficulties of the post-crisis period, the policy-makers of ECB must identify not just main weaknesses of each banking system, but their strong points also. This requires the application of multi-criteria analysis, considering that policy-makers need to take into account a number of different aspects that, on the whole, indicate the quality of the banking system. Our aim is a comparative analysis of European banking systems right after the Brexit moment and within the framework of the tight new Basel III regulations. In this paper, we have ranked the banking systems of the 28 EU member states using multi-criteria analysis, specifically the PROMETHEE II method. The use of the PROMETHEE II method in combination with the entropy method offers a comprehensive insight into the banking system of each member state, given that the observed countries are ranked according to 9 conflicting criteria that are mostly used in banking system analysis. Our analysis shows that the banking systems in Central and Eastern Europe are the best performers, while the EMU’s developed banking systems such as the German, Italian, British, and French one are positioned among the last ranked. The Portuguese and Greek banking systems are, as expected, ranked in the last positions in our list. The obtained results also pointed out that the ECB should change its approach to the management and further development of a European Banking Union.

The Agency of CoCo: Why Do Banks Issue Contingent Convertible Bonds?

Most regulators grant contingent convertible bonds (CoCos) the status of equity. The theory, however, suggests that these securities can distort incentives via inducing debt overhang and risk shifting. In this paper, we therefore theoretically model how the degree of this distortion varies with bank risk. Our model predicts that riskier banks face higher debt overhang from CoCos. Next, analyzing a comprehensive database of CoCo issuance in Europe, we empirically test the predictions of our model. We find that banks with lower risk are more likely to issue CoCos than their riskier counterparts. Since in the current regulatory framework of Basel III banks are expected to raise equity prior to CoCo conversion, future debt overhang makes CoCos an expensive source of capital. Thus, riskier banks will opt for equity issuance over CoCos.

Bank Risk Factors and Changing Risk Exposures in the Pre- and Post-financial Crisis Periods: An Empirical Study for India

In this study, we measure and analyse the time-varying nature of risk exposures for the Indian banking industry using weekly bank-level data from 23 October 2004 to 1 August 2014. We extend the literature by studying credit, equity, interest rate and exchange rate risks following a more comprehensive framework. The study finds evidence that the risk exposures are time varying in nature and differ across banks with different characteristics. Equity risk and credit risk increase post the global financial crisis (GFC) while interest rate and exchange rate risk gets reduced. The capital market has a favourable view of small-sized, well-capitalized, well-diversified private sector banks. Furthermore, the results also show that asset size and ownership structure offer relevant information for differentiating banks regarding their riskiness. Large banks have more equity risk exposure; public sector banks have higher credit risks while private sector banks have greater interest rates and exchange rate risk exposure. The study offers valuable insights for the regulators, supervisors, policymakers, banking industry, bank managers, investors and academia. The main contribution is a better understanding of sources of banks’ risks and needs to enhance the supervisory process in the Basel framework.

A Revised Basel Framework for Coop Banking Institutions Operating in North America

In this research report, we examine the impact of the economic inefficiencies imposed on Credit union through the Basel III accord Credit Unions play a crucial role in the economy as financial intermediaries, more importantly. The Basel committee on banking supervision published the Basel Accords to provide a framework --consistent and appropriate regulation of capital adequacy, liquidity and risk management in financial institutions. The Basel Accords are major steps forward towards more resilient banking operations, however, there are a number of significant problems and challenges for experienced by coop banks and credit unions in North America. The development of a revised Basel framework for Coop Banking institutions and credit unions could pave the way to a more effective and efficient banking environment for credit unions and Coop members, which could lead to the improvement of financial stability and economic growth.

The Adequate Verification on Implication of the Asset Correlation of Commercial Bank Retail Portfolio using BIS II and CreditMetrics Method of OFM

The Adequate Verification on Implication of the Asset Correlation of Commercial Bank Retail Portfolio using BIS II and CreditMetrics Method of OFM

Integrating Stress Tests within the Basel III Capital Framework: A Macroprudentially Coherent Approach

In the post-crisis era banksi?½ capital adequacy is established by the Basel III capital standards and, in many jurisdictions, also by supervisory stress tests. In this paper we first describe the ways in which supervisory stress tests can supplement the risk-based capital framework of Basel III and how this could be codified with a stress test buffer. We then argue that in order to ensure coherence with the macroprudential objectives of Basel III, the severity of supervisory stress tests should be procyclical. In addition, to increase the transparency and predictability of the overall capital framework, severity choices should follow a constrained discretion approach based on a simple rule. Finally, we analyze supervisory stress testing practices across some jurisdictions and find that while the United States and the UK frameworks are in line with some of the elements of our proposal, including most notably the need for procyclical severity, this is not the case in the euro area.

On the Dynamic Measurement of Capital Adequacy and Leverage for Basel III

The Basel Committee has made it a goal to create a regulatory framework that is simple, comparable and risk sensitive for the measurement of insolvency risk and the determination of capital adequacy. To this end, our contribution in this paper is to propose a novel dynamic geometrical methodology that addresses these criteria. We show that the key to Basel framework is proportional scaling, scale invariance to firm size and time, total boundedness, time consistency and time dynamism. We propose a new risk measure; the Capital Leverage Index that combines the capital adequacy and leverage ratio into a single dynamic and consistent risk index that is simple to apply, comparable across all firms and multiple time periods and is risk sensitive. We illustrate the usefulness of our new risk measures with data from Goldman Sachs by comparing it to Value-at-Risk (VaR) figures and show how it is responding to a post crisis environment of higher capital. We find that the new index is able to sensitively detect risk shifting even when VaR figures are constant or decreasing. This calls into question of the continued use of VaR as a risk and capital metric.

Securitisation, Bank Capital and Financial Regulation: Evidence from European Banks

The paper analyses how banks manage their capital position when they securitise, by focusing on the issuances sponsored by European banks before and after the financial crisis. Stylised facts suggest that, at the time of the crisis, European banks continued to issue structured products, but by retaining them on balance sheet for collateral purposes. Based on a new dataset combining tranche-level information for structured products with bank balance sheet data for the corresponding originators, I investigate the changes in the riskbased capital ratios and in the leverage ratios of securitiser banks, for different classes of products. In the pre-crisis period, banks observed an increase in their risk-based capital ratios particularly from the transfer of risky assets. In the crisis time, securitiser banks improved their risk-weighted solvency ratios but without reducing their actual leverage: across products, this increase in the risk-based prudential ratios was larger for the issuances of asset-backed securities eligible as collateral for monetary policy, which banks could retain and pledge in central bank liquidity operations. Also, across banks, institutions in weaker liquidity conditions exploited the regulatory arbitrage opportunities of the securitisation framework to obtain larger increases in their prudential solvency ratios. The paper provides some policy implications, both for the collateral framework of monetary policy, and for the reforms of prudential regulation, such as the introduction of the new leverage ratio in the Basel framework. JEL Classifications: G21, G23, G28, E58 Key-words: Securitisation, Risk-weighted Capital Ratio, Leverage Ratio, Bank Liquidity, Collateral Eligibility, Prudential Requirements ___________________________ * University of Warwick and University of Reggio Calabria. Corresponding Address: University of Warwick, Department of Economics, Social Studies Building, CV4 7AL Coventry (UK). Email: A.D.Scopelliti@warwick.ac.uk # I thank Mark P. Taylor and Michael McMahon for their precious guidance and support. I am grateful to Eleftherios Angelopoulos, Urs Birchler, Robert DeYoung, Juan Carlos Gozzi, Jordi Gual, Andreas Jobst, John Kiff, Nataliya Klimenko, Jan Pieter Krahnen, David Llewellyn, Andre Lucas, Angela Maddaloni, David Marques, JeanStephane Mesonnier, Steven Ongena, George Pennacchi, Jose-Luis Peydro, Fatima Pires, Alberto Pozzolo, Marco Protopapa, Marc Quintyn, Massimiliano Rimarchi, Jean-Charles Rochet and Carmelo Salleo, for insightful discussions and helpful suggestions at various stages of this work. I gratefully acknowledge the support of the managers and of the staff of the Financial Regulation Division at the ECB, and the kind hospitality of the Department of Banking and Finance at the University of Zurich. This paper benefited also from useful comments and feedback from the participants of the 4 EBA Research Workshop (London), the 14 CREDIT Conference (Venice), the SUERF-FinLawMetrics Conference (Milan), the 29th EEA Conference (Toulouse), the 6th IFABS Conference (Lisbon), the 4th FEBS Conference (Surrey), the MFS Symposium (Cyprus), the Research Seminar on Banking (Zurich), the Barcelona GSE Banking Summer School (UPF), the Macro Workshop (Warwick). Some of the results have been summarised in a nontechnical policy study on “Securitisation and Risk Retention in European Banking: The Impact of Collateral and Prudential Rules”, published as a chapter in the SUERF Study 2014/4 on “Money, Regulation and Growth: Financing New Growth in Europe”. I am deeply indebted to the organisers of the SUERF – Finlawmetrics 2014 Conference for being awarded the 2014 SUERF Marjolin Prize. All the errors are mine.

Integrating Stress Tests within the Basel III Capital Framework: A Macroprudentially Coherent Approach

In the post-crisis era banks’ capital adequacy is established by the Basel III capital standards and, in many jurisdictions, also by supervisory stress tests. In this paper we first describe the ways in which supervisory stress tests can supplement the risk-based capital framework of Basel III and how this could be codified with a stress test buffer. We then argue that in order to ensure coherence with the macroprudential objectives of Basel III, the severity of supervisory stress tests should be procyclical. In addition, to increase the transparency and predictability of the overall capital framework, severity choices should follow a constrained discretion approach based on a simple rule. Finally, we analyze supervisory stress testing practices across some jurisdictions and find that while the United States and the UK frameworks are in line with some of the elements of our proposal, including most notably the need for procyclical severity, this is not the case in the euro area.

The EU Framework for Bank Capital Regulation and Repo Collateral

This paper traces the roots of collateral flow and its potential vulnerabilities in the shadow banking system to their regulatory capital treatment in the banking sector. As part of assessing the interaction of banking regulation and the shadow banking sector, it investigates the impact of bank regulatory capital reforms on the repo markets, and specifically the regulatory treatment of certain types of collateral widely used to secure repo transactions in Europe. As sovereign bonds constitute 80% of the financial collateral used in the European repo transactions, this paper details the preferential regulatory capital treatment of such assets within the Basel framework as well as the EU regime for bank regulatory capital, i.e., the CRD IV package comprising the CRD IV & CRR. The paper argues that the effects of capital reforms percolate to collateral used in repo transactions, which constitute a large part of the shadow banking operations and is the major source of short-term funding for banks and other financial institutions. It highlights the favorable regulatory risk-weights assigned to sovereign debt the exposure to which requires lower levels of capital or bears no capital at all. In addition, the regulation-induced perceived riskless nature of sovereign bonds leads to lower collateral haircuts for government collateral in the repo markets, which again boosts the demand for such collateral. The main finding of the paper is that there is a positive correlation between the preferential regulatory treatment of certain exposures for regulatory capital purposes and the surge of interest in such exposures (collateral) to be used in repo transactions. The preferential treatments of certain repo collateral (domestic government bonds) in terms of capital requirements and repo haircuts can also partly explain the home bias and bank-sovereign loop in the European banking and financial markets. This paper concludes that the preferential regulatory capital treatment of sovereign bonds, which drives a wedge between their real or fundamental riskiness and perceived riskiness, should be removed, as they tend to increase the distortions in risk pricing and are likely to contribute to systemic risk, the consequences of which can by far offset the potential benefits of such a preferential regulatory treatment.

How Do Banks Adapt Their Asset Holdings to Binding Leverage Ratio and Liquidity Requirements under Basel III?

Over the last years, the capital regulation of banks under the Basel framework has undergone a fundamental review. In parallel to the implementation of Basel III, a non-risk-sensitive leverage ratio and new liquidity standards are introduced. I study the combined impact of the new regime on the behaviour of banks and find that a binding leverage ratio requirement prompts banks to rearrange the asset side of their balance sheets, by shifting from assets with low risk weights into assets with high risk weights. If the loan demand is elastic, this implies a reduction in volumes for low risk loans, and a concurrent increase in volumes for high risk loans. Further, a binding leverage ratio requirement encourages banks to reduce their voluntary liquidity reserves, or in combination with a binding liquidity coverage ratio requirement, to shrink the overall size of their balance sheets. Arguably, these effects where not intended by policy makers.

Effect of the Basel Accord capital requirements on the loan-loss provisioning practices of Australian banks

There are two distinct regimes for bank provisioning in Australia: a forward-looking model for regulatory purposes and an incurred loss model for financial reporting. This study examines the former using a unique but confidential database. We find evidence that: (i) banks increase provisions in anticipation of future lending growth, (ii) banks allocate part of surplus capital above regulatory requirements to pre-fund future credit losses through provisions, and (iii) banks allocate part of higher earnings for the same purpose. These results suggest that bank managers use their discretion in setting provisions to dampen the impact of fluctuations in credit market conditions on their lending activities. For internal ratings-based banks, results suggest that the revised Basel framework allowing these banks to estimate expected losses using their own credit risk models may come at a cost of reduced general provisions.

Measuring Concentration Risk - A Partial Portfolio Approach

Concentration risk is an important feature of many banking sectors, especially in emerging and small economies. Under the Basel Framework, Pillar 1 capital requirements for credit risk do not cover concentration risk, and those calculated under the Internal Ratings Based (IRB) approach explicitly exclude it. Banks are expected to compensate for this by autonomously estimating and setting aside appropriate capital buffers, which supervisors are required to assess and possibly challenge within the Pillar 2 process. Inadequate reflection of this risk can lead to insufficient capital levels even when the capital ratios seem high. We propose a flexible technique, based on a combination of “full” credit portfolio modeling and asymptotic results, to calculate capital requirements for name and sector concentration risk in banks’ portfolios. The proposed approach lends itself to be used in bilateral surveillance, as a potential area for technical assistance on banking supervision, and as a policy tool to gauge the degree of concentration risk in different banking systems.

Measuring Concentration Risk - A Partial Portfolio Approach

Concentration risk is an important feature of many banking sectors, especially in emerging and small economies. Under the Basel Framework, Pillar 1 capital requirements for credit risk do not cover concentration risk, and those calculated under the Internal Ratings Based (IRB) approach explicitly exclude it. Banks are expected to compensate for this by autonomously estimating and setting aside appropriate capital buffers, which supervisors are required to assess and possibly challenge within the Pillar 2 process. Inadequate reflection of this risk can lead to insufficient capital levels even when the capital ratios seem high. We propose a flexible technique, based on a combination of 'full' credit portfolio modeling and asymptotic results, to calculate capital requirements for name and sector concentration risk in banks' portfolios. The proposed approach lends itself to be used in bilateral surveillance, as a potential area for technical assistance on banking supervision, and as a policy tool to gauge the degree of concentration risk in different banking systems.