Common Equity Tier Research Articles

The Impact of Basel III Capital Regulation on Credit Risk: A Hybrid Model

This research examined the impact of Basel III capital regulation (BCR) on credit risk (CR) using a sample of 25 commercial banks in Lebanon over the period 2012–2017. BCR is measured using the capital adequacy ratio (CAR) and the common equity tier one ratio (CET1 ratio), CR is measured using net provision for credit losses /total assets. To analyze the data, we constructed a hybrid model based on 3 statistical approaches. First, we modelled the dual impact of BCR and CR using probabilistic inference in the framework of Bayesian Belief Network formalism (BBN). Second, to highlight more about the correlation between BCR and CR, we used Spearman correlation test as a nonparametric approach. Third to study the simultaneous effect of CAR and CET1 ratio on CR we applied multivariate regression analysis. By analyzing the probabilistic inference for the first approach we concluded that there is an effect of BCR on CR especially for the high level of CET1 ratio, but when we investigated more if this effect is significant using the Spearman correlation test and the multivariate regression analysis, we concluded that there is no effect statistically significant of Basel III capital regulation (BCR) on credit risk (CR).

Are CoCo Bonds Suitable as Core Capital Instruments?

Basel III introduced significant innovations in bank regulation. One of them is the minimum required leverage ratio. To help banks implementing the new measure , Basel III created two different core capital measures: Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1). Since raising capital for CET1 is expensive, other instruments are used to build up AT1 in case of need, like for example Contingent Convertible (CoCo), which can convert to equity or written-down when a bank is under stress. In this paper we show that CoCos are not suitable as regulatory core capital instruments. Problems of timing, incentives, systemic risk, regulatory discretion and regulatory capture make CoCos unreliable as core capital instruments, and regulators should not treat them as such.

The Impact of Basel III Capital Regulation on Profitability: A Hybrid Model

This research examined the impact of Basel III capital regulation (BCR) on profitability (P) using a sample of 25 commercial banks in Lebanon over the period 2012–2017. BCR is measured using the capital adequacy ratio (CAR) and the common equity tier one ratio (CET1 ratio), P is measured using two ratios: ROAA and ROAE. To analyze the data, we constructed a hybrid model based on three statistical approaches. First, we modelled the dual impact of BCR and P using probabilistic inference in the framework of Bayesian Belief Network formalism (BBN). Second, to highlight more about the correlation between BCR and P, we used the Spearman correlation test as a nonparametric approach. Third, to study the simultaneous effect of the BCR ratio on Profitability we apply multivariate regression analysis. By analyzing the probabilistic inference for the first approach, we concluded that there is an effect from BCR on P. When we investigated more if this effect is significance using the Spearman correlation test and the multivariate regression analysis, we concluded that that the impact of BCR on P is only found between CAR and ROAA and this regression relationship is weak because only 24.3% of the changes in ROAA variance is explained by CAR.

Executive Stock Options and Systemic Risk

Employing a novel control function regression method that accounts for the endogenous matching of banks and executives, we find that equity portfolio vega, the sensitivity of executives' equity portfolio value to their firms' stock return volatility, leads to systemic risk that manifests during subsequent economic contractions, but not expansions. We further find that vega encourages systemically risky policies, including maintaining lower common equity Tier 1 capital ratios, relying on more run-prone debt financing, and making more procyclical investments. Collectively, our evidence suggests that executives' incentive-compensation contracts promote systemic risk-taking through banks' lending, investing, and financing practices.

The Costs and Benefits of Bank Capital—A Review of the Literature

In 2010, the Basel Committee on Banking Supervision published an assessment of the long-term economic impact (LEI) of stronger capital and liquidity requirements. This paper considers this assessment in light of estimates from later studies of the macroeconomic benefits and costs of higher capital requirements. Consistent with the Basel Committee’s original assessment, this paper finds that the net macroeconomic benefits of capital requirements are positive over a wide range of capital levels. Under certain assumptions, the literature finds that the net benefits of higher capital requirements may have been understated in the original committee assessment. Put differently, the range of estimates for the theoretically optimal level of capital requirements—where marginal benefits equal marginal costs—is likely either similar to, or higher than was originally estimated by the Basel Committee. The above conclusion is however subject to a number of important considerations. First, estimates of optimal capital are sensitive to a number of assumptions and design choices. For example, the literature differs in judgments made about the permanence of crisis effects as well as assumptions about the efficacy of post crisis reforms, such as liquidity regulations and bank resolution regimes, in reducing the probability and costs of future banking crisis. In some cases, these judgements can offset the upward tendency in the range of optimal capital. Second, differences in (net) benefit estimates can reflect different conditioning assumptions such as starting levels of capital or default thresholds (the capital ratio at which firms are assumed to fail) when estimating the impact of capital in reducing crisis probabilities. Finally, the estimates are based on capital ratios that are measured in different units. For example, some studies provide optimal capital estimates in risk-weighted ratios, others in leverage ratios. And, across the risk-weighted ratio estimates, the definition of capital and risk-weighted assets (RWAs) can also differ (e.g., tangible common equity (TCE) or Tier 1 or common equity tier 1 (CET1) capital; Basel II RWAs vs. Basel III measures of RWAs). A full standardisation of the different estimates across studies to allow for all of these considerations is not possible on the basis of the information available and lies beyond the scope of this paper. This paper also suggests a set of issues which warrant further monitoring and research. This includes the link between capital and the cost and probability of crises, accounting for the effects of liquidity regulations, resolution regimes and counter-cyclical capital buffers, and the impact of regulation on loan quantities.

Application of the Merton model to estimate the probability of breaching the capital requirements under Basel III rules

In this paper, we estimate the probability of a financial institution breaching the Common Equity Tier 1 capital under Basel III rules. We do so by applying the Merton model, where balance sheet data and market data are used to match the probability of default implied by the model with the probability of default implied by market quotations for credit default swaps. We provide an empirical analysis for several banks classified by the Financial Stability Board and the Basel Committee on Banking Supervision as Global Systemically Important Financial Institutions, evaluating how the probability of breaching the Common Equity Tier 1 Capital evolved from 2005 to 2015. We find that higher Common Equity Tier 1 Capital ratios do not necessarily imply lower probabilities of breaching capital requirements and vice versa. We also focus on the asset volatility calibrated according to our model and we find that it appears to be a good proxy for the risk-weighted asset density.

Corporate Social Responsibility Reports of European Banks – An Empirical Analysis of the Disclosure Quality and its Determinants

Banks are crucial enablers of financial and economic development. They have an immense corporate social responsibility (CSR) towards society. Bank´s CSR activities are considered increasingly vital for their own success and sustainable growth, especially as they operate in a business environment with multiple stakeholder demands and an increasing awareness of CSR. In 2014, an CSR-Directive was established. The ultimate aim of the Directive is to encourage a more sustainable economy by strengthening both the comparability and relevance of non-financial information disclosure across the European Union (EU). The Directive was required to be adopted by banks and other companies for financial year 2017. This study analyses the quality of the CSR information discloses by 76 banks in the European Monetary Union (EM) in the years 2017 and 2018. To assess the quality of the reported information a disclosure index study was conducted. Furthermore, an OLS regression was performed to test seven hypotheses concerning the relationship between the extend of the banks´ CSR reporting and size, profitability, common equity tier 1 (CET1) ratio, number of pages containing CSR information, ownership type, availability of an external audit, and communication channel used. In addition, the banks´ reported commitments to the Sustainable Development Goals (SGDs) are presented, and the disclosed information on the extent to which climate-change related risks are integrated in the banks´ risk management framework for lending activities are addressed.

I requisiti degli strumenti di capitale primario di classe 1 Appunti per uno studio del capitale delle banche

The need for stability in the financial and economic system arising from the outcome of the most significant of the recent financial crises was the premise for the regulation of banking capital developed by the Basel Committee. In a short time, to respond to similar needs, the European legislator has profoundly renewed the European banking regulation with the result of creating the Single Rulebook. A significant part of this harmonization tool is entrusted to Regulation 575/2013 on prudential requirements (Capital Requirement Regulation, CRR). The CRR identifies capital requirements of banks by determining the rules for the formation of bank capital and the balance ratios between the various elements of bank financing based on the riskiness of the assets. Common equity tier 1 (CET1) is one of the fundamental components of bank capital. The study sets out the structural elements of bank capital and the requisites that the capital instruments must possess in order to be classified as CET1. Furthermore, the essay highlights those profiles in which the prudential discipline overlaps the corporate one and notes those issues on which further analysis of the relationship between the disciplines could be focused.

Effects of Basel III Higher Capital and Liquidity Requirements on Banking Sectors across the Main South East Asian Nations

This paper analyzes the cost impact of the Basel III higher capital and liquidity requirements on bank capital, lending spreads, and steady state output across the main Southeast Asian nations (ASEAN-5). We also investigate potential long-run economic benefit expressed as a gain in steady state output (GDP). By emphasizing the use of dynamic stochastic general equilibrium and vector error correction models, we find that ASEAN-5 banking sectors are comfortably capitalized and need no recapitalization by January 1st 2019 deadline when Basel III is fully enforced. The new Basel III rules are assumed to force ASEAN-5 banks to increase lending spreads to pass down a portion of increasing funding costs to bank customers. The impact of 1 percentage point rise in common equity Tier 1 ratio on lending spreads is analyzed; to meet the regulatory capital minima of 7% as of 2015, ASEAN-5 banks will have to increase lending spreads by 30 basis points on average; to meet 10.5% fully effective by January 2019, ASEAN-5 banks will have to increase average lending spreads by 68 basis points. In terms of economic benefits, the estimates of this study indicate that the projected economic benefits across ASEAN-5 outweigh the economic costs in the long-run.

The value relevance of the fair value hierarchy. Empirical evidence from the European Union

This paper investigates the value relevance of the fair value hierarchy disclosed for financial instruments through a sample of 97 financial entities listed over the period 2011-2016 in the stock markets of 23 European countries. Its main objectives are threefold. First, by analysing the European setting, the paper means to study the value relevance of the fair value hierarchy to judge the choice of the International Accounting Standard Board (IASB) to extend the disclosure of the hierarchy to all the assets and liabilities. Second, the paper aims to evaluate the choice of abandoning management intent as a criterion for the classification and measurement of financial instruments investigating the effect that such an intent has on the value relevance of the fair value hierarchy. Finally, by studying the effect that exposure to risks has on the value relevance of the fair value hierarchical levels, the paper plans to investigate the implications that the disclosure of the hierarchy could have on the rules of Basel 3 capital adequacy. Formulating three different research hypotheses, the findings validate them providing evidence that the value relevance of fair value measurement depends on the source of inputs used to estimate fair value and that both management intent and the risk intensity of the asset book only affect the value relevance of the less reliable fair value estimates. These results are useful for standard setters and regulators. Actually, for the investors decisions, they suggest the importance of disclosing the fair value hierarchy for all the assets and liabilities as required by IFRS 13, as well as the advantage of replacing in IFRS 9 the management intent criterion with the business model test and the characteristics of the instruments for the classification and measurement of financial assets. For the future, the findings suggest the opportunity to introduce filters within the common equity tier 1 for the less reliable fair value estimates. This paper's current and future implications for standard setters and regulators are to avoid earnings management and capital management behaviour possibly affecting the quality of financial reporting.

EXPECTED CREDIT LOSS MODEL BY IFRS 9 AND ITS POSSIBLE EARLY IMPACTS ON EUROPEAN AND TURKISH BANKING SECTOR

ABSTRACT IFRS 9 – ²Financial Instruments², the replacement of IAS 39 – ²Financial Instruments: Recognition and Measurement² was issued by International Accounting Standards Board in July, 2014 and became mandatory on January 1, 2018. The significant change implemented in the new standard is about the “impairment” phase which is based on "Expected Credit Losses" (ECL) rather than "Incurred Credit Losses". In this study, the measurement and recognition of allowances for impairment are explained and then the expected possible qualitative and quantitative effects of this transition primarily in the European Banking Industry are analyzed and compared with Turkish Banking Industry. It is expected that, ECL application by European banks would result in on average 13%-18% increase in loss provisions and Common Equity Tier 1 (CET1) and total capital ratio decrease by on average 45-75 basis points (bps) and 35-50 bps, respectively whereas the total amount of provisions will be diminishing by 4.1% and will have 33 bps and 21 bps positive impacts on CET1 and total capital adequacy ratio on average, respectively for Turkish banks.

Contingent convertible bonds with the default risk premium

Contingent convertible bonds (CoCos) are hybrid instruments characterized by both debt and equity. CoCos are automatically converted into equity or written down when a predefined trigger event occurs. The present study quantifies the issuing bank's default risk that only manifests in the post-conversion period for pricing CoCos depending on a loss-absorbing method. This work aims to reflect the distinct features of equity-conversion CoCos - in contrast to a write-down CoCos - in a valuation framework. Accordingly, we propose a model to compute the ratio of common equity Tier 1 (CET1), which is composed of core capital and risky assets, by employing a geometric Brownian motion and a random variable. Then, we formulate the post-conversion risk premium by measuring the probability with which the bank's CET1 ratio breaches a regulatory default threshold after conversion. Finally, we empirically examine a positive value of the post-conversion risk premium embedded in the market prices of equity-conversion CoCos.

Risk Management of Full-Fledged Islamic Banks versus Islamic Subsidiaries of Conventional Banks in Malaysia : The Sustainable Growth within Restricted Minimum Requirements

This paper aims to analyze the risk management practices of full-fledged Islamic banks versus Islamic subsidiaries of conventional banks in Malaysia and thesustainable rate of growth within restricted minimum requirements of capital adequacy, leverage and liquidity. In achieving these objectives, the paper assessesthe risk management practices of full-fledged Islamic banks, i.e. Bank Islam Malaysia Berhad and Bank Muamalat Malaysia Berhad and Islamic subsidiaries ofconventional banks, i.e. Maybank Islamic Berhad and CIMB Islamic Berhad. This paper uses annual reports and focus group interview to obtain the data. Theresults of the analysis show that the Leverage Ratio, Liquidity Coverage Ratio (LCR) and capital requirement ratios, such as Common Equity Tier 1 capital Ratio, Core Capital Ratio (CCR) and Risk Weighted Capital Ratio (RWCR) have exceeded the minimum requirement by Basel Accord. The result of the focus group interview shows that full-fledged Islamic banks and Islamic subsidiaries of conventional banks conformed and implemented the risk management framework imposed by the regulatory agency. However, the growth rate in total asset, loan, Return On Assets (ROA) and net income margin has mixed growth except for loan to total asset which increase over the year, albeit of the minimum risk management requirement. These empirical and focus group results suggest an important policy on issues pertaining to how Islamic banks have to adjust the changes in the banking environment in terms of growth and its comparative advantages specifically on management efficiency.

CoCo bonds and implied CET1 volatility

s at AFMathConf 2016 CoCo Bonds and Implied CET1 Volatility Ine Marquet KU Leuven Dep. of Mathematics, Celestijnenlaan 200B, 3001 Heverlee Belgium ine.marquet@wis.kuleuven.be Joint work with: J. De Spiegeleer, W. Schoutens In this talk we introduce the notion of implied Common Equity Tier 1 volatility and the concept of a risk-adjusted distance to trigger. Using a derivatives-based valuation approach, we are able to derive the implied CET1 volatility from the market price of a CoCo bond in a Black-Scholes setting. The numerical results show how different contingent convertibles issued by the same bank and sharing a similar contractual CET1 trigger, have almost identical implied CET1 volatility levels. The same results confirm the difference in market risk between Tier 2 and Additional Tier 1 CoCo bonds. The ability to obtain an implied level for the CET1 volatility offers other interesting results. We are able to determine the implied CET1 level corresponding to a coupon cancellation. It further allowed us for example to look at the severity of one of the stress tests imposed by the ECB on European banks in November 2014. In that perspective we were also able to derive implied PONV CET1 levels.

Position of Low-Cost Banks on the Financial Market in the Czech Republic

1. Introduction In addition to insurance companies, pension funds, cooperative banks, investment companies, investment and share funds, and leasing companies, banks represent the most important segment of the financial sector with a stake of nearly 80% of total assets. The balance sum of the banking sector of the Czech amounted to 5, 476 billion CZK as of 1.3.2015. The balance sheet shows that main assets are represented by loans provided to residents (3,235 billion CZK) and main liabilities are represented by deposits made by residents of the banking sector (3,513 billion CZK) (Czech Association, 2014). in the Czech is an integral part of the financial market of the European Union, and just like anywhere else in Europe, there are multinational players here (Unicredit, KBC, Erste Bank, Societe Generale and Raiffeisenbank International) that define the product and pricing policies on the banking market. Innovative (and often low-cost) players have become the latest trend on the market, presenting an alternative to traditional banking. Small, low-cost banks can be classed as a type competition; the business model of low-cost retail banking is based on an internet platform. This model focuses on young and innovative clients who want from their bank low costs and a change. Compared to abroad, the Czech banking system is stable, profitable and well capitalised. Czech banks have been showing a very good liquidity position for a long time since the volume covering all their clients' deposits with fast liquid assets exceeds 45%. From the point of view of capital adequacy, the Czech banking sector is well equipped. In 2013, capital adequacy ratio Tier 1 (CAR Tier 1) grew by 16.9 % and all banks reached the minimum value of 8% CAR Tier 1 which, for the Czech banking sector, is nearly identical with the newly required Common Equity Tier 1. The banking sector complies with the new capital rules under CRD IV/CRR with sufficient reserves, which is supported by the fact that as of the end of 2013, banks representing more than 83% of assets of the sector had a capital adequacy ratio Tier 1 higher than 15%. (Czech National Bank 1, 2015). 2. Literature Review Only a few authors in the Czech focus on the issue of financial markets and service marketing at a general level in the Czech Republic, apart from the coauthor of this paper [e.g., Jilkova, P., 2015, Retail Banks in the Czech Republic (VSERS, Ceske Budejovice) or Jilkova, P. and R. Riha, 2014, Communication Strategy And Product Policy for New Retail Banks in the Czech Republic (Kremenchuk Mykhailo Ostrohradskyi National University, Kremenchuk)]. We can mention, for example, doc. Ing. Heskova Marie, CSc. and her paper in Foret, M., 2013, Marketing (Mendelov University, Brno) or a publication by Vastikova, M., 2014, Efficient and Modern Service Marketing (Grada, Praha). A theory of financial markets is discussed by prof. Mejstnk, M., Pecena, M. and P. Teply, 2014, in their publication Banking in Theory and Practice (Karolinum, Praha). To name some foreign publications, we can mention a Slovak publication, Lakowski, S., 2012, Disruptive Innovation in Banking. A Business Case in Low Cost Finance. How to Win Against the Leaders by Creating Competitive Advantage and Real Value for Customer (Wydawnictwo Studio Emka, Warszawa, Poland), which discuss the issues of low-cost banking. The role of the rating companies describes an article by Thalassinos el a I. (2014). 3. Material and Methods The professional objective of the paper is to focus on the collation, processing and interpreting of secondary data concerning the position of low-cost banks on the financial market in the Czech in terms of their pricing policies. The research focused on relatively new and innovative small banks on the Czech financial market, such as Bank a.s. (hereinafter Air Bank), Equa bank a. …

Determinants Of European Banks' Capital Adequacy

This paper examines the factors affecting the Common Equity Tier 1 Ratio (CET1), which is a measure of the relationship between core capital and the risk-weighted assets of banks. The research is based on a randomly selected sample from the group of banks examined by the European Central Bank authorities. The ECB conducted stress tests assessing the CET1 Ratio with respect to the Basel III regulations. The findings confirm the hypothesis about the impact of bank size and the risk indicators (risk-weight assets to total assets ratio and the share of loans in total assets) on banks’ capital adequacy. They also confirm strong effect of competitive pressure and the negative correlation between the CET1 Ratio and the share of deposits in non-equity liabilities, which may be explained by the existence of the deposit insurance system. Finally the paper presents the limitations of the study and conclusions regarding possible further research in this subject area.

European Banking Union D: Cross-Border Resolution Dexia Group

In September 2008, Dexia Group, SA, the world’s largest provider of public finance, experienced a sudden liquidity crisis. In response, the governments of Belgium, France, and Luxembourg provided the company a capital infusion and credit support. In February 2010, the company adopted a European Union (EU)-approved restructuring plan that required it to scale back its businesses and cease proprietary trading. In June 2011, Dexia withdrew from the government-sponsored credit support program before its expiration date, and in July, the company announced that it had passed an EU stress test. However, just three months later, Dexia wrote down its substantial position in Greek debt and posted its largest loss ever. The company’s shares plummeted, and its Common Equity Tier 1 capital became negative. To avoid a disorderly resolution, the governments of Belgium, France, and Luxembourg nationalized Dexia’s assets. This case examines the attempted rescue of Dexia, provides an analysis of the successes and failures of that cross-border effort, and discusses the impact that Dexia’s holdings of sovereign debt had on the company’s viability and on the ability of its host countries to rescue it.

Accounting for OTC Derivatives: Funding Adjustments and the Re-Hypothecation Option

Banks hold and routinely exercise the option of freely re-hypothecating variation margin across counterparties and trades. However, the emerging FCA/FBA standards for funding cost accounting are mostly formulated in terms of netting set specific metrics that fail to properly account for re-hypothecation benefits to Common Equity Tier 1 Equity Capital (CET1). Additionally, the FCA/FBA standard introduces a double-counting issue between funding benefits and DVA which ultimately leads to a violation of the fundamental accounting tenet of asset-liability symmetry. In this paper, we propose an alternative accounting framework meant to rectify some of the problems in existing standards. The new accounting method, denoted FVA/FDA, explicitly incorporates the re-hypothecation option into its definition of funding costs, and maintains consistency with the Modigliani-Miller Theorem, with fair-value asset-liability symmetry and with Basel III rules for DVA and equity capital. We argue that derivative pricing necessitates an incremental assessment of the capital structure impact of new trades and propose that entry prices should be struck at the indifference level for CET1. Unlike the FCA/FBA method, FVA/FDA accounting does not result in outright net income write-offs due to funding costs. FCA/FBA accounting and FVA/FDA accounting lead to very similar and quantitatively close conclusions in the particular case of a portfolio consisting of a single netting set and a single trade. However, material differences arise in the case of large portfolios. We discuss a case study with a representative portfolio whereby CET1 adjustments for funding are three times as large as the ones required in FVA/FDA accounting. In case portfolio effects are accounted for, incremental entry prices for individual trades differ materially between the FCA/FBA and the FVA/FDA methods, with FCA/FBA accounting often displaying sizable and risky pricing biases between derivative payables and receivables.

Integrated Stress Testing: Impact on Liquidity and Solvency

The global financial crisis has reminded us that effective stress tests should not only be probabilistic, but also consider risk interdependence. In this paper, we combine two hypothetical shocks, of varying degrees, with more than fifteen years of fortnightly data on deposits, borrowings and assets for the Indian banking sector. Our objective is to estimate the impact of stressed outflows on liquidity and solvency positions. We find that large shocks worsen existing short-term liquidity deficits. Moreover, the associated fall in book value of assets is more than the aggregate Common Equity Tier 1 Capital.

Quantitative evaluation of contingent capital and its applications

A new type of bank regulatory capital, known as contingent capital, has emerged in tandem with discussions on the BASEL III regulatory framework but there is a lack of consensus on a standard valuation approach among those proposed so far. We think that the practical solution is to be able to price these instruments seamlessly and consistently with other existing derivatives. We propose a novel and practical ⿿convertible bond approach⿿ which is theoretically consistent with existing frameworks such as Black⿿Scholes and is conceptually and technically similar to the pricing models already being used in practice for convertible bonds and hybrid securities. Such a model is reasonable as all of these asset classes are hybrid equity-credit instruments and share many characteristics. Also, contingent capital through its unique mechanisms such as principal loss absorption, presents interesting risk scenarios which may not be readily apparent or may appear counterintuitive. Contingent capital may thus, at first sight, appear to carry obscure risks but, we show that by taking a careful quantitative approach, we can understand the characteristics of such instruments in a concise manner. Further, for discussing the pricing in terms of characteristics of the issuer, one in turn, needs a concise framework to describe those characteristics in terms of Common Equity Tier 1 (CET1) ratio risk. Our framework describes CET1 ratio risk via three intuitive issuer parameters: target, volatility, and resilience. In spite of the exotic risks, an investment decision in contingent capital can be justified if a sufficient return is expected in compensation. In this paper, we present a valuation method based on hurdle Sharpe ratios that has direct implications for investment decision making in the context of expansion of investor's efficient frontier. We also demonstrate the usefulness of our framework as a daily pricing tool for market participants using empirical market data.We appreciate helpful comments from an anonymous referee and the editors of North American Journal of Economics and Finance. The view expressed are those of the authors and do not necessarily reflect views and policies of Nomura Securities.