Higher Capital Requirements Research Articles

Do Basel Accords influence competition in the banking industry? A comparative analysis of Germany and the UK

This paper compares the impact of Basel Accords on the degree of competition in the German and UK banking industries. The banking sector is heavily regulated in terms of capital requirements, and the Basel Accords regard both the optimal level of capital that banks have to hold (Pillar I), and the complementary supervisory review of the banks’ compliance to the capital requirement rules (Pillar II), and the market discipline via disclosure, where the aim is enhancing banking transparency (Pillar III). We argue that if regulation raises the cost of entry into the banking industry and that of staying in the sector, there is no need for the existing banks to dissipate their profits in order to maintain the dominant position they eventually have. On the one hand, the regulation impacts profits in the short run by imposing higher capital requirements that are tighter for smaller banks; on the other hand regulation reduces the threat by potential entrants at no extra cost for the existing banks. The likely outcome of these incentives is that profit-oriented systems invest rents in new technology, able to escape the regulation that, in turn, prevents new entrants from entering into the field.

The Dark Side of the Implementation of Basel Capital Requirements: Theory, Evidence and Policy

Most financial systems around the world have imposed new capital requirements for banks in the past years. This policy seems to be justified on two powerful economic grounds. First, better capitalized banks promote financial stability by reducing banks’ incentives to take risks and increasing banks’ buffers against losses. Second, lack of compliance with a set of rules established by the Basel Committee may harm confidence on a country´s financial system. While acknowledging these potential benefits, this paper makes the often overlooked point that the full implementation of Basel capital requirements may be socially undesirable for poorer countries seeking to develop their economies. On the one hand, higher capital requirements may reduce people´s access to finance, which can be particularly problematic in emerging countries with less developed capital markets and greater problems of financial exclusion. On the other hand, the one-size-fits-all model incentivized by the Basel Committee does not take into account many emerging countries’ social and economic markets, infrastructures and priorities. In our opinion, the presence and power of certain countries in the Basel Committee makes Basel recommendations partially biased toward those problems existing in these jurisdictions. Based on the aforementioned problems, this paper suggests some policy recommendations to promote a more resilient financial system without hampering financial inclusion and economic growth.

Dynamic Market Participation and Endogenous Information Aggregation

This paper studies information aggregation in financial markets with recurrent investor exit and entry. I consider a dynamic general equilibrium model of asset trading with private information and collateral constraints. Investors differ in their aversion to Knightian uncertainty: When uncertainty is high, some investors exit the market. Since exiting investors' information is not fully revealed by prices, conditional return volatility and risk premia both increase. I use data on institutional investors' holdings of individual stocks to show that investor exits indeed move negatively with price informativeness. The model also implies that exit is more likely when wealth is more concentrated in the hands of less uncertainty-averse investors. The model thus predicts less informative prices toward the end of a long boom, as seen in the data. Moreover, economies with looser collateral constraints should see more volatility due to exit and partial revelation. Higher capital requirements can improve welfare by inducing more information revelation by prices.

GCD Shipping Finance LGD Study 2017

The shipping industry is the backbone of global trade as most exported goods are transported by ship. More than almost any other sector, it benefits from globalization and economic upturn. This also makes the industry vulnerable to economic downturns. The world of shipping banks has radically changed in recent years. After a decade of boom, the industry was hit very hard by the global economic crisis after 2008. GCD loss data confirms this general observation, showing few defaults in the early 2000’s but high default levels starting in 2009. Upcoming regulatory changes put more pressure on the financing banks, who face the possibility of much higher capital requirements currently under discussion by the Basel Committee, especially for Specialised Lending exposures. Other requirements like IFRS9/CECL or stress testing/CCAR create the need for more detailed default and loss modelling, especially in respect of term structure and macroeconomic dependency. The long timespan of the GCD database and the detailed cash flow data allow for dedicated LGD time series analysis. This report shows an excerpt of the work performed on the shipping finance loss data provided by members to the GCD LGD/EAD loss database. Following our motto “by banks for banks” more detailed analytics as well as the raw data set are available to GCD member banks. In particular, this report provides insights regarding four major questions: Does the data tell the story of why selling the ship is the option of last resort? Different workout scenarios such as cures, rescheduling or sale of collateral can be analysed with the GCD data set, indicating that selling the ship leads on average to higher loss and is therefore not the preferred or indeed usual course of action taken by banks. What is the impact of collaterization on LGD? The loan to value ratio (LTV) is one of the main drivers for LGD modelling. The GCD data confirms a strong positive correlation between LTV and LGD. Can you link macroeconomic developments to the LGD curve over time? The impact of the macroeconomic downturn after the financial crisis is clearly visible in the GCD database, explaining both banks’ recovery strategies as well as external economic developments. Is specialised lending actually riskier than corporate finance? No evidence can be found in the data for a significant difference between the average outcome of Large Corporate Defaults and Specialised Lending defaults, after controlling for similar collateralization.

New Product Development in the Pharmaceutical Industry: Evidence from Iran

In today’s competitive world, there are several strategies to deal with the fast changing environment, among which New product development (NPD) is a common strategy. However, almost half of the resources that companies devote to NPD are spent on products that may fail. This issue is particularly highlighted in the pharmaceutical industry mainly because of a long development-time, low success rate, high capital requirement, and market uncertainty in. This study identifies critical success factors of NPD based on the relevant literatures and expert opinions in Iranian pharmaceutical industry, then prioritizes them using the methodology of multiple criteria decision making (MCDM) through analyzing 50 filled questionnaires which is structured based on the AHP (Analytical Hierarchy Process) approach. Although the NPD success factors seem same in both generic and bio-generic pharmaceutical industries, the underlying factors and related sub-factors show the different importance in these two industries. However, this study reveal that, the company capabilities is the most important factor affecting new product development success in both pharmaceutical generic and bio-generic industry. The results of this study contribute to create baseline information for pharmaceutical industry especially Iranian pharmaceutical companies to be more effective in budget allocation on improving NPD success factors so that they can boost the success rate of NPD more effectively.

Value-Based Pharmaceutical Pricing From the Patient Perspective Could Incentivize Innovation

The pharmaceutical industry is characterized by high risk, high capital investment requirements, and comparatively low marginal costs of production. While drug patents incentivize innovation by granting producers of new drugs monopoly pricing power, social expectations pressure manufacturers to keep prices low. This tension leaves the question of how drug development should be financed, and how to address the needs of special subpopulations, unresolved. This paper proposes a new approach that shifts the focus of the debate from producer costs to patient value, based on treatment outcomes. The principal consequence of this patient-centric view is that variability in patient outcomes and circumstances would result in individualized drug prices—a practice known as price discrimination that has already taken hold in other high capital investment industries such as airlines and software. In this model, fixed costs are typically borne by market segments that reap the greatest economic value, while other segments pay lower prices set relative to marginal production costs. Given the high uncertainty and variability characteristic typical of patient populations, several obstacles must be overcome before this strategy can be made practical for pharmaceuticals. Chief among these is determining broad economic measures of treatment benefits that include health-related quality of life outcomes from the patient perspective.

Applying insights from the pharma innovation model to battery commercialization—pros, cons, and pitfalls

ABSTRACTLessons from the pharmaceutical industry’s commercialization successes can be identified and applied to the U.S. battery industry to potentially improve its discouragingly low startup success rates.A carbon-neutral and sustainable society of the future necessitates the widespread use of battery technologies that are efficient, effective, and economical. Lower-cost and more energy-dense battery technology can help solve many of our energy challenges, such as balancing the intermittency problems of renewables and making possible electric transportation fleets. New advanced materials are crucial to such battery advances. However, bringing advanced energy materials to market in the United States remains a formidable challenge. Hurdles include high upfront capital requirements, long timelines to success, and few opportunities for technology risk-reduction. Such challenges impede startups from developing financially viable technologies. Consequently, recent advances in battery performance have come from incremental changes implemented by large companies. By contrast, the pharmaceutical industry has many similar technical challenges, yet has an established pipeline of U.S. startup successes. We review and compare the current market structures of battery and pharma innovation. We propose an updated model of U.S. battery commercialization, informed by the pharma model’s successes. The new approach’s benefits and potential pitfalls are discussed. We provide recommendations for entrepreneurs, investors, manufacturers, and policy makers to improve the battery innovation ecosystem. We hope that these ideas spur the battery community to more successfully commercialize and deploy transformative technologies.

Capital requirement, bank competition and stability in Africa

Monetary authorities around the world are implementing enhanced banking capital adequacy requirements under Basel III meant to improve financial stability. Critics however argue that increased capital requirements concentrate the banking industry reducing competition while not guaranteeing financial sector stability. Using data from 167 banks in 37 African countries, we find that increased capital beef-up significantly increases financial instability in Africa (except in big banks) implying that higher capital requirements did not make African banks safer. We also find that increased regulatory capital improves competitive pricing for foreign banks while it makes domestic banks less competitive mainly attributed to the high cost of sourcing and holding extra capital for domestic banks compared to foreign banks who can source cheaper capital from parent companies. The results put to question the effectiveness of enhanced regulatory capital on stability and competitiveness of the African financial system.

Systemic Risk Measurement: Bucketing G-SIBs Between Literature and Supervisory View

The general consensus on the need to enhance the resilience of the financial system has led to the imposition of higher capital requirements for certain institutions, supposedly based on their contribution to systemic risk. Global Systemically Important Banks (G-SIBs) are divided into buckets based on their required additional capital buffers ranging from 1% to 3.5%. We measure the marginal contribution to systemic risk of 26 G-SIBs using the Distressed Insurance Premium methodology proposed by Huang et al. (2009) and examine ranking consistency with that using the SRISK of Acharya et al. (2012). We then compare bucketing using the two academic approaches and supervisory buckets. Because it leads to capital surcharges, bucketing should be consistent, irrespective of methodology. Instead, discrepancies in the allocation between buckets emerge and this suggests the complementary use of other methodologies.

Politics, Credit Allocation and Bank Capital Requirements

I develop a theory of political influence on bank lending and capital structure. The idea is that legislators may want to direct bank credit to politically-favored loans that reduce bank shareholder wealth, but generate social and/or political benefits. The regulator, who implements the laws passed by legislators, uses both asset-choice regulation and capital requirements to induce this lending. There are four main results. First, the enacting of credit-allocation regulation should be accompanied by higher capital requirements. Second, when credit-allocation regulation is adopted, political or regulatory hubris in misestimating the bank’s valuation of its lending alternatives can generate “hidden” banking fragility. Third, when politics weighs more heavily in bank regulation, the result is a larger (and more competitive) banking sector with higher capital requirements. Fourth, political influence on bank credit allocation is likely to be stronger when banks are more profitable.

Optimal Dynamic Capital Requirements

We characterize welfare maximizing capital requirement policies in a quantitative macro-banking model with household, firm and bank defaults calibrated to Euro Area data. We optimize on the level of the capital requirements applied to each loan class and their sensitivity to changes in default risk. We find that getting the level right (so that bank failure risk remains contained) is of foremost importance, while the optimal sensitivity to default risk is positive but typically smaller than under Basel IRB formulas. Starting from low levels, savers and borrowers benefit from higher capital requirements. At higher levels, only savers prefer tighter requirements.

Banks' Adjustment to Basel III Reform: A Bank-Level Perspective for Emerging Europe

The paper seeks to identify strategies of commercial banks in response to higher capital requirements of Basel III reform and its phase-in. It focuses on a sample of nine EU emerging market countries and picks up 5 largest banks in each country assessing their response. The paper finds that all banking sectors raised CAR ratios mainly through retained earnings. In countries where the banking sector struggled with profitability, banks have resorted to issuance of new equity or shrunk the size of their balance sheets to meet the higher capital-adequacy requirements. Worries echoed at the early stage of Basel III compilation, namely that commercial banks would shrink their balance sheet by reducing their lending to meet stricter capital requirements, did materialize only in banks struggling with profitability.

Agency Conflicts, Bank Capital Regulation and Accounting Measurement

We develop a model to show how shareholder-creditor agency conflicts interact with accounting measurement rules to influence the design of bank capital regulation. Relative to a benchmark autarkic regime, higher capital requirements mitigate inefficient asset substitution, but exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances the distortions created by underinvestment and asset substitution, while also incorporating the excess cost of equity relative to debt financing for banks. The optimal regulatory policy can be implemented using historical cost accounting for low values of the excess cost of equity. For intermediate levels of the excess cost of equity, fair value accounting is necessary for regulation to optimally respond to interim performance signals by imposing higher capital requirements that mitigate asset substitution. If the excess cost of equity is sufficiently high, however, the optimal regulatory policy features forbearance by permitting asset substitution to mitigate underinvestment. Overall, our results highlight the importance of accounting measurement in influencing the design of bank regulation through the implementation of capital requirements.

Parameter risk in time-series mortality forecasts

The projection of mortality rates is an essential part of valuing liabilities in life insurance portfolios and pension schemes. An important tool for risk management and solvency purposes is a stochastic projection model. We show that ARIMA models can be better representations of mortality time-series than simple random-walk models. We also consider the issue of parameter risk in time-series models from the point of view of an insurer using them for regulatory risk reporting – formulae are given for decomposing overall risk into undiversifiable trend risk (parameter uncertainty) and diversifiable volatility. Particular attention is given to the contrasts in how academic researchers might view these models and how insurance regulators and practitioners in life offices might use them. Using a bootstrap method we find that, while certain kinds of parameter risk are negligible, others are too material to ignore. We also find that an objective model selection criterion, such as goodness of fit to past data, can result in the selection of a model with unstable parameter values. While this aspect of the model is superficially undesirable, it also leads to slightly higher capital requirements and thus makes the model of keen interest to regulators. Our conclusions have relevance to insurers using value-at-risk capital assessments in the European Union under Solvency II, but also territories using conditional tail expectations such as Australia, Canada and Switzerland.

On the non-neutrality of the financing policy and the capital regulation of banking firms

Purpose The paper aims to investigate whether the value of banks is affected by their financing policies. Higher capital requirements have been invoked by exploiting a renewed edition of the Modigliani–Miller (M&M) theorem. This paper shows the limits of this claim by highlighting that the general statement that “bank equity is not expensive” can be misleading. The authors argue that market prices should play an important role in bank supervision. Expectations of future profits in prices supply timely information on the viability of a bank. Design/methodology/approach The authors use the Merton model to show the inapplicability of M&M theorem to banks. The long-run viability of a bank is analyzed with a dividend discount model which allows to compare a bank’s long-term profitability with its overall cost of capital implicit in market prices. Findings The authors show that the M&M framework cannot be applied to banks neither ex-ante nor ex-post. Ex-ante the authors focus on government guarantees, ex-post they emphasize the risk-shifting phenomena that may increase the overall risk of the bank. The authors show that a bank’s stability cannot be achieved if the market expectations of its future profits stay below the cost of funding. Research limitations/implications The authors use simple analytical models. In a future study, some key peculiarities of banks, such as the monetary nature of deposits, should be analytically modelled. Practical implications The paper contributes to the debate on capital regulation on the level of capital requirements and the instruments to assess the viability/stability of banks. Originality/value This paper uses simple models to assess analytically the key issues in the debate on banks’ capital regulation.

Bank Capital Regulation and Dividend Policy

We examine whether bank capital requirements are relevant to bank dividend payout policies. On the basis of an unbalanced panel analysis of 9,127 observations in 83 countries over the period of 1999 to 2012, we find that higher capital requirement regulation stringency is negatively associated with bank dividend payouts. In addition, we also find that capital regulatory pressure clearly explains dividend payouts during the 2007 to 2009 financial crisis. However, capital regulatory pressure is effective only in limiting dividend payouts by undercapitalized banks in developing countries.

Liquidity Creation and Bank Capital in the Eurozone

This article empirically analyzes the relationship between liquidity creation (or, alternatively, illiquidity) and bank capital in the Eurozone by considering an indicator related to the new liquidity requirements established in Basel III: the inverse of the net stable funding ratio (NSFR). Our sample consists of an unbalanced panel data set of 7,275 observations from 1999 to 2013, which allows us to consider the impact of the recent financial and economic crisis on the Eurozone banking system. We find that, although the establishment of the new liquidity requirements in Basel III (and the subsequent EU regulation) could strengthen bank solvency, the higher capital requirements together with the need to comply with the new liquidity ratios may weaken economic recovery in the Eurozone. Therefore, liquidity ratios and capital ratios should be jointly determined, looking for a trade-off between the benefits of greater financial stability and those of higher liquidity creation.

Macroprudential Regulation and Misallocation

In this paper, we study the macroeconomic effects of banking capital requirements. We provide a theoretical explanation for why decreasing capital requirements may lead to lower average leverage ratio among banks. This counterintuitive result is an outcome of the general equilibrium effects on interest rates, which affects capital allocation across different types of banks. Additionally, we find that the optimal policy for capital requirements depends on the available equity in the banking sector. Countries with a relatively undeveloped financial sector should have a higher capital requirement. For countries in the middle the optimal policy is a relaxed capital requirement. Finally, countries with a large amount of domestic capital are unaffected by capital requirements.

Macroprudential regulation and macroeconomic activity

I develop a dynamic stochastic general equilibrium model to examine the impact of macroprudential regulation on banks’ financial decisions and the implications for the real sector. I model an occasionally binding capital requirement constraint and analyze its costs and benefits. This friction means that the banks refrain from valuable lending. At the same time, capital requirements provide structural stability to the financial system. I show that higher capital requirements can dampen the business cycle fluctuations and raise welfare. I also show that switching to a countercyclical capital requirement regime can help reduce volatility and raise welfare. Finally, by means of the welfare analysis, I also obtain the optimal level of capital requirement.

Participating Life Insurance Products with Alternative Guarantees: Reconciling Policyholders’ and Insurers’ Interests

Traditional participating life insurance contracts with year-to-year (cliquet-style) guarantees have come under pressure in the current situation of low interest rates and volatile capital markets, in particular when priced in a market-consistent valuation framework. In addition, such guarantees lead to rather high capital requirements under risk-based solvency frameworks such as Solvency II or the Swiss Solvency Test (SST). Therefore, insurers in several countries have developed new forms of participating products with alternative (typically weaker and/or lower) guarantees that are less risky for the insurer. In a previous paper, it has been shown that such alternative product designs can lead to higher capital efficiency, i.e., higher and more stable profits and reduced capital requirements. As a result, the financial risk for the insurer is significantly reduced while the main guarantee features perceived and requested by the policyholder are preserved. Based on these findings, this paper now combines the insurer’s and the policyholder’s perspective by analyzing product versions that compensate policyholders for the less valuable guarantees. We particularly identify combinations of asset allocation and profit participation rate for the different product designs that lead to an identical expected profit for the insurer (and identical risk-neutral value for the policyholder), but differ with respect to the insurer’s risk and solvency capital requirements as well as with respect to the real-world return distribution for the policyholder. We show that alternative products can be designed in a way that the insurer’s expected profitability remains unchanged, the insurer’s risk and hence capital requirement is substantially reduced and the policyholder’s expected return is increased. This illustrates that such products might be able to reconcile insurers’ and policyholders’ interests and serve as an alternative to the rather risky cliquet-style products.