Capital Adequacy Regulation Research Articles

Accounting Window Dressing and Template Regulation: A Case Study of the Australian Credit Union Industry

This article documents the response of cooperative institutions that were required to adhere to new capital adequacy regulations traditionally geared for profit-maximising organisations. Using data from the Australian credit union industry, we demonstrate that the cooperative philosophy and internal corporate governance structure of cooperatives will lead management to increase capital adequacy ratios through the application of accounting window dressing techniques. This is opposite to the intended purpose of template regulation aimed at efficiently increasing operating margins and lowering risk. Our results raise several debatable issues regarding the ethics of accounting management and the imposition of one-shoe-fits-all external regulation.

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%.

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 U.S. 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 percent.

Basel 2: the implementation in the UK of its capital requirements for banks

Banks that are regulated in the UK have lived with regulatory capital adequacy requirements since 1988 when the original Basel Capital Accord came into effect. Basel 2 effected a substantial revision to the old regime. The capital requirements of the Basel 2 Capital Accord were intended to become effective from the beginning of 2007 and, in pursuance of EC legislation, have now been implemented in the UK. This article describes the more important features of the application of the Basel 2 capital requirements in the UK, including a comparison with the position that applied previously, as well as the related subjects of large exposures and liquidity requirements.

Operational risk management in financial institutions: Process assessment in concordance with Basel II

AbstractThe improvement of banks' operational risk management frameworks concerns new requirements addressed in the Basel II Framework, a new capital adequacy regulation proposed by the Basel Committee on Banking Supervision (BCBS). Basel II will apply to internationally active banks and to all banks and investment firms in the EU via transposition of a new Directive into national regulations.By doing so, the national financial supervisory authority, Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg, and a public research centre, Centre de Recherche Public Henri Tudor (CRPHT), have engaged in a joint research project that investigates solutions conformant to ISO/IEC 15504 for assessing operational risk management frameworks implemented in banks.The ISO/IEC 15504 requirements can meet the CSSF's expectation on consistent, transparent and sound risk assessments, as well as the expectation on promoting enhancements in institutions' risk management practices without dictating the form or operational detail of their policies and practices.Moreover, although the domain is largely outside the scope of software and systems engineering, the ISO/IEC 15504 process assessment standard provides for an adequate solution to the so‐called supervisory review process. This adequacy is validated through the structure of Basel II and financial domain requirements. Last but not least, we will show that ISO/IEC 15504 provides an adequate approach to assessing institutions in two sub‐domains, namely, the domain of credit operational risk management and the domain of IT risk management (including IT security risks management). Copyright © 2007 John Wiley & Sons, Ltd.

The soft budget constraint of banks

Since the source of funds for banks is mainly deposits, banks have difficulty raising funds to refinance their balance sheets when a substantial portion of their loan portfolio is in default. Intrinsically, banks face hard budget constraints and are subject to market discipline. However, governments with both the resources and the incentives to bail out failing banks may lead to soft budget constraints for banks. Consequently, banking regulation, especially bank capital adequacy regulation, becomes an important institutional solution to the resulting instabilities. Our theory predicts that countries having a larger fiscal capacity are more prone to applying soft budget constraints to failing banks; thus, these governments impose tighter bank capital adequacy regulations to minimize the adverse impact of moral hazard arising from the soft budget constraint on banks. We provide cross-country empirical evidence to support this prediction. Journal of Comparative Economics 35 (1) (2007) 108–135.

Capital Adequacy Regulation and Financial Conglomerates

A topical concern in public-policy debate is that the current capital adequacy regulation designed for stand-alone financial institutions exhibits several weaknesses due to the emergence of large financial institutions combining several activities under common control. This paper addresses these concerns using a theoretical framework derived from the economic literature. I will first describe the possible causes of the emergence of financial conglomerates, proceed to consider the theoretical background for the regulation of financial institutions, especially insurance and banking companies, and, finally, examine the limitations of the current regulatory framework in controlling the risks in financial conglomerates. My conclusions provide little support for the view that the regulatory approach should be modified towards a more consolidated one (i.e., harmonization).

Deteriorating Bank Health and Lending in Japan: Evidence from Unlisted Companies under Financial Distress

When a borrower faces a hold-up problem, deteriorating bank health might reduce a borrower's credit availability. However, a bank with an impaired balance-sheet might attempt to ‘gamble for resurrection’ and hence might increase risky lending to zombie firms. The purpose of this paper is to investigate what impacts weakened financial conditions of banks had on loans outstanding to medium size firms in Japan. Estimating lending functions, we examine the determinants of lending to unlisted Japanese companies in the late 1990s and the early 2000s. We find that two alternative measures of the bank health, regulatory capital adequacy ratios and ratios of non-performing loans (NPLs), had opposite impacts on lending. In the case of regulatory capital adequacy ratios, its deterioration had a perverse impact on the bank's lending. The deteriorating NPL ratios, however, increased lending to troubled firms to keep otherwise economically bankrupt firms alive.

Capital adequacy regulation and bank asset quality: the Nigerian empirical evidence

Capital adequacy regulation and bank asset quality: the Nigerian empirical evidence

Explaining cosmetic compliance with international regulatory regimes: The implementation of the Basle Accord in Japan, 1998–2003

A central theme of much recent international political economy (IPE) scholarship has been the question of what determines compliance with international regulatory regimes.1 The contemporary debate ...

A dynamic analysis of an economy with banking optimization and capital adequacy regulations

In this paper, we investigate the short-run and long-run macroeconomic effects of bank net worth and capital adequacy regulations. In general, capital adequacy regulations work as a stabilizer in the sense that they reduce the macroeconomic effects of negative productivity shocks. In addition, strengthening of the regulations increases the long-run capital stock, although it may lead the economy to a recession in the short run. However, the timing of the introduction of tight regulations is important. If the regulations become tighter when a negative productivity shock occurs, the economy falls into a long and severe slump. This is consistent with what the Japanese economy has experienced after the bubble economy.

Bank Capital, Liquidity, and Systemic Risk

We analyze the impact of capital adequacy regulation on bank insolvency and aggregate investment. We develop a model of the banking system that is characterized by the interaction of many heterogeneous banks with the real sector, interbank credit relations as a consequence of bank liquidity management and an insolvency mechanism. This allows us to study the impact of capital adequacy regulation on systemic risk. In particular we can analyze the impact of regulation on contagious defaults arising from mutual credit relations. We show that the impact of capital adequacy on systemic stability is ambiguous and that systemic risk might actually increase as a consequence of imposing capital constraints on banks. Furthermore we analyze the indirect consequences of capital adequacy regulation that are transmitted to the real economy by their impact on equilibrium interbank rates and thus the opportunity costs of liquidity within the banking system.

Bank Capital, Liquidity, and Systemic Risk

We analyze the impact of capital adequacy regulation on bank insolvency and aggregate investment. We develop a model of the banking system that is characterized by the interaction of many heterogeneous banks with the real sector, interbank credit relations as a consequence of bank liquidity management and an insolvency mechanism. This allows us to study the impact of capital adequacy regulation on systemic risk. In particular we can analyze the impact of regulation on contagious defaults arising from mutual credit relations. We show that the impact of capital adequacy on systemic stability is ambiguous and that systemic risk might actually increase as a consequence of imposing capital constraints on banks. Furthermore we analyze the indirect consequences of capital adequacy regulation that are transmitted to the real economy by their impact on equilibrium interbank rates and thus the opportunity costs of liquidity within the banking system.

Capital Adequacy beyond Basel: Banking, Securities, and Insurance

This book is timely since the Basel Committee on Banking Supervision at the Bank for International Settlements is in the process of making major changes in the capital rules for banks. It is important that capital adequacy regulation helps to achieve financial stability in the most efficient way. Capital adequacy rules have become a key tool to protect financial institutions. The research contained within the book covers some key issues at stake in the capital requirements for insurance and securities firms. The contributors are among the leading scholars in financial economics and law. Their contributions analyze the use of subordinated debt, internal models, and rating agencies in addition to examining the effect on capital of reinsurance, securitization, credit derivatives, and similar instruments.

The Welfare Cost of Bank Capital Requirements

Abstract 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%.

Capital adequacy regulation and financial conglomerates

A topical concern in public policy debate is that the current capital adequacy regulation designed for stand-alone financial institutions exhibits several weaknesses due to the emergence of large financial institutions combining several activities under common control. This paper will address these concerns in the framework for capital regulation of financial institutions proposed in the economic literature. It will first describe the potential reasons that led to the emergence of financial conglomerates. Secondly, it will consider the theoretical background for the regulation of financial institutions, especially insurance and banking companies. Finally, it will use this framework to examine the limitations of the current regulatory framework in controlling the risks in financial conglomerates. The conclusions of the paper give little support for the view that regulatory approach should be modified toward harmonisation.

The role of non-financial factors in internal credit ratings

Internal credit ratings are expected to gain in importance because of their potential use for determining regulatory capital adequacy and banks' increasing focus on the risk–return profile in commercial lending. Whereas the eligibility of financial factors as inputs for internal credit ratings is widely accepted, the role of non-financial factors remains ambiguous. Analyzing credit file data from four major German banks, we find evidence that the combined use of financial and non-financial factors leads to a more accurate prediction of future default events than the single use of each of these factors.

A capital adequacy framework for Islamic banks: the need to reconcile depositors’ risk aversion with managers’ risk taking

Conceptually, an Islamic bank has an equity-based capital structure, dominated by shareholders’ equity and investment deposits based on profit and loss sharing (PLS). There is no need for capital adequacy regulations if the Islamic banks are structured as pure PLS-based organizations. However, because of informational asymmetry and risk aversion by investors, there currently exist fixed claim liabilities on the Islamic banking balance sheets. This necessitates the imposition of capital adequacy requirements, which aim at maintaining systemic stability by achieving two fundamental objectives. First, capital regulations should protect risk-averse (assumed unsophisticated) depositors. This requires a minimum equity capital cushion and an optimal assets–liabilities composition. Second, capital regulations should give the right incentives to shareholders to promote prudent behaviour by the banks. This requires analysis of the effect of financial participation by shareholders on Pareto optimality, and analysis ...

Banks’ buffer capital: how important is risk

Most banks hold a capital to asset ratio well above the required minimum defined by the present capital adequacy regulation (Basel I). Using bank-level panel data from Norway, important hypotheses concerning the determination of this buffer capital are analyzed. Focus is on the importance of: (i) risk, (ii) the buffer as an insurance, (iii) the competition effect, (iv) supervisory discipline, and (v) economic growth. A negative or non-significant risk effect is found, which suggests that introducing a more risk-sensitive capital regulation (Basel II) is likely to affect Norwegian banks. Support is found for the hypothesis that buffer capital serves as an insurance against failure to meet the capital requirements.

The Foundations of Banks' Risk Regulation: A Review of the Literature

The stability of the banking industry around the world has been observed as periodical since the Great Depression. Financial markets have changed dramatically over the last twenty-five years, introducing more competition for and from banks. Banks are the financial institutions responsible for providing liquidity to the economy. This responsibility is, however, the main cause of their fragility. Deposit insurance is the most efficient instrument for protecting depositors and for preventing bank runs. Pricing deposit insurance according to the individual bank’s risk seems to be the most appropriate strategy but it does not seem to be sufficient in the sense that it seems to remain residual information problems in the market, although there is no appropriate statistical analysis on this issue. In 1988, the G10 modified banking regulation significantly by setting capital standards for international banks. These standards have now been adopted by more than one hundred countries as part of their national regulation of banks’ risk. Current regulation of bank capital adequacy has its critics because it imposes the same rules on all banks. This seems particularly unsuitable when applied to credit risk which is the major source of a bank’s risk (about 70%). Moreover, diversification of a bank’s credit-risk portfolio is not taken into account in the computation of capital ratios. These shortcomings seem to have distorted the behaviour of banks and this makes it much more complicated to monitor them. In fact, it is not even clear that the higher capital ratios observed since the introduction of this new form of capital regulation necessarily lower risks. Additional reform is expected in 2004, but there is as yet no consensus on the form it will take nor on whether it will suitably regulate banks in individual countries. Consequently, it might be appropriate to continue developing national regulation based on optimal deposit insurance (with individual insurance pricing and continuous auditing on individual risk) and to keep searching for other optimal complementary instruments for use against systemic risk, instruments suitably designed to fit the banking industry’s peculiar structure. Other market discipline (such as subordinated debt) and governance instruments may be more efficient than the current capital requirement scheme for the banks’ commitment problem associated to deposit insurance. The central bank should be responsible for aggregate liquidity. Confidence in the financial sector is a public good that must be ensured by the government. Who should be in charge: the central bank or a regulatory agency? The revised literature seems to say that this role should be taken by a regulatory agency independent from the central bank and independent from the political power.