Lower Risk Weights Research Articles

The Effect of Retail Loans on Bank Profitability: A Comparative Empirical Analysis

Retail loans became an important instrument of banking during 1960s. The effect of retail loans, in which mortgage and consumer loans have a great share, in the profitability of banks has not been analyzed in detail so far. The main items of retail loans, like mortgage and consumer loans, contribute greatly to the risk management of banks with their characteristics like having regular cash flow in banks. Due to the structure of the guarantee and mortgage loans, which provides low risk weight, it is important to determine the capital needs of banks. However, due to relatively long maturity structure, mortgage loans also feed the maturity mismatch risk, which is the basic problem of banking system. Such loans, with which low costs are provided in favor of the clients, play a considerable role in the profitability of banks. Consumer loans, on the other hand, are provided to the clients in shorter maturity periods and with costs that are more in favor of banks. In the scope of this study, the effects of retail loans on conventional banks and participation banks, which are active in Turkey, have been investigated for mortgage and consumer loans. The findings of the study show that retail loan types have strong negative effects on Net Interest Margin (NIM), which has been selected as the profitability indicator for conventional banks in the scope of the study. For Participation Banks, on the other hand, unlike conventional banks, retail loan types have stronger and more positive influences on Net Profit Share Margin (NPSM). The findings of the present study are important for further studies that will be conducted on retail banking and for comparative studies on performance assessment.

Evaluating the Shariah-compliance of equity portfolios: The weighting method matters

The choice of weighting method in constructing an equity portfolio affects not only the financial performance, but also its Shariah-compliance. We show how the implicit bets in market capitalization, fundamental value, equal and low risk weights can affect the individual's perception of Shariah compliance of the financial portfolio. For the universe of Shariah-compliant S&P 500 stocks over the period 1986–2014, we find that the risk-adjusted performance is improved when using the alternative weighting methods compared with the traditional use of market capitalization weighting. The choice of weighting method matters for the Shariah-compliant equity investor, both in terms of compliance with the primary objectives of Shariah investing and in terms of the secondary objective of optimizing the financial performance of the portfolio.

Time-Varying Capital Requirements and Disclosure Rules: Effects on Capitalization and Lending Decisions

This paper investigates how banks’ capital and lending decisions respond to changes in bank-specific capital and disclosure requirements using proprietary regulatory data from the Danish FSA on the full population of banks in Denmark. We find that banks adjust their capital ratio via different channels, depending on the sign of the change in the capital ratio a bank is required to fulfill. An increase in the required capital ratio results in an increase in a bank’s capital ratio, brought about via a decrease in asset risk. Given that total lending as well as equity are not affected this indicates a reshuffling of loans towards those with lower risk weights. Additionally, the buffer banks choose to hold over and above the required capital ratio decreases. A decrease in the required capital ratio implies more lending to firms and a higher buffer between actual and required capital but also a decrease in Tier 1 capital and higher bank leverage. These effects are most pronounced in a regime when the required capital ratio is a “hard” requirement, meaning that the supervisor withdraws the banking license when it is breached. In contrast to the intention in Basel III, we do not observe differences between confidential and public disclosure of banks’ regulatory capital ratio requirement. Our results empirically illustrate a tradeoff between bank resilience and a fostering of the economy through more bank lending using banks’ capital ratio as policy instrument.

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.

The Real Impact of Basel Ratings-Based Capital Rules on the Finance-Growth Nexus

We investigate whether ratings-based banking regulation introduced under the Basel capital framework has had any impact on the finance-growth nexus via the foreign credit channel. Using data on GDP growth per capita and cross-border bank lending to 77 countries between 1999 to 2013 we find that since the implementation of Basel 2 capital rules, risk weight changes mapped to sovereign credit rating revisions have exerted a more significant effect on economic growth in both recipient and lender countries. We also find direct evidence to indicate that the practice of global banks in increasing their foreign lending to investment grade sovereigns given their lower risk-weights has contributed to lower economic growth in these recipient countries. However, the adverse effects of the Basel capital rules are ameliorated in the presence of more open financial markets with better developed banking systems.

The Credibility of European Bankss Risk-Weighted Capital: Structural Differences or National Segmentations?

Supranational institutions, academics and market analysts have increasingly questioned the reliability of bank risk-weighted assets (RWAs), a cornerstone of the system of minimum capital ratios designed by the Basel Committee on Banking Supervision. In fact, significant differences can be found in the banks’ average risk weights, both over time and across countries. Such differences can be explained by several factors, some of which may reflect the actual risk content of bank’s assets, while others may conceal distortions due to “RWA tweaking” and supervisory segmentations. We analyze a sample of 50 large European banks between 2008 and 2012 and document several meaningful findings. First, risk weights are affected by the banks’ size, business model and asset mix. Second, the adoption of internal ratings based (IRB) approaches is (as expected) a powerful driver of bank risk-weighted assets. Third, lower risk weights are positively linked to the banks’ capital cushion. Fourth, IRB adoption is more widespread in countries where supervisory capture is potentially stronger, due to a banking industry that is both larger (compared to GDP) and concentrated. Fifth, regulatory risk weights are not disconnected from market-based measures of bank risk.

How Does Post-Crisis Bank Capital Adequacy Affect Firm Investment?

We examine the effect of bank capital levels on firm investment drawing on a sample of 11,106 non-financial firms from 2007 to 2013 in 16 advanced economies. We examine two measures of bank capital adequacy, the Tier 1 ratio and a simple leverage ratio, and find that firms with larger external financial needs invest relatively more when domestic financial systems have relatively high leverage ratios. This pattern is more pronounced for those firms that have sound fundamentals, suggesting that bank balance sheets and their willingness to extend credit can be an important factor in determining aggregate investment and growth outcomes. The empirical findings are robust to a range of specifications. Bank Tier 1 capital ratio does not appear to have a significant effect on corporate investment, possibly because a higher Tier 1 ratio also captures a high share of assets with low risk weights.

How Does Post-Crisis Bank Capital Adequacy Affect Firm Investment?

We examine the effect of bank capital levels on firm investment drawing on a sample of 11,106 non-financial firms from 2007 to 2013 in 16 advanced economies. We examine two measures of bank capital adequacy, the Tier 1 ratio and a simple leverage ratio, and find that firms with larger external financial needs invest relatively more when domestic financial systems have relatively high leverage ratios. This pattern is more pronounced for those firms that have sound fundamentals, suggesting that bank balance sheets and their willingness to extend credit can be an important factor in determining aggregate investment and growth outcomes. The empirical findings are robust to a range of specifications. Bank Tier 1 capital ratio does not appear to have a significant effect on corporate investment, possibly because a higher Tier 1 ratio also captures a high share of assets with low risk weights.

Rational Blinders: Strategic Selection of Risk Models and Bank Capital Regulation

The regulatory use of banks' internal models aims at making capital requirements more accurate and reducing regulatory arbitrage, but may also give banks incentives to choose their risk models strategically. Current policy answers to this problem include the use of risk-weight floors and leverage ratios. I show that banks for which those are binding reduce their credit supply, which drives interest rates up, invites other banks to adopt optimistic models and possibly increases aggregate risk in the banking sector. Instead, the strategic use of risk models can be avoided by imposing penalties on banks with low risk-weights when they suffer abnormal losses or bailing out defaulting banks that truthfully reported high risk measures. If such selective bail-outs are not desirable, second-best capital requirements still rely on internal models, but less than in the first-best.

Security Holdings, Capital Regulation, and Risk Exposure of Japanese Banks

This paper empirically investigates how risk exposure of security holdings affected the optimal choice of total risk weighted asset under Basel II regulation. With costly recapitalization cost, banks optimally choose buffer regulatory capital above the minimum standard. Therefore, security holdings ratio with low risk weight under current regulation increases the optimal risk exposure because marginal cost of recapitalization decreases. This paper provides empirical results consistent with this prediction and demonstrates the simulated negative effect of higher risk weight on the security holdings.

Rational Blinders: Is it Possible to Regulate Banks Using Their Internal Risk Models?

Using banks' internal models for regulatory purposes, while aimed at making capital requirements more accurate, invites regulatory arbitrage. I show how the strategic use of risk models can be avoided by penalizing banks with low risk-weights when they suffer abnormal losses. As defaulting banks cannot be penalized, under tail risk uncertainty it is optimal to reward banks that truthfully reveal high risk measures by a commitment to bailing them out in case of default. Recent regulatory reforms that use floors on risk weights instead can be counter-productive when the issue is a hidden problem and not model risk.

When is a Supervisory Recognized External Rating Worthwhile for a Medium-Sized Enterprise and its Bank? – An Empirical Analysis Against the Background of Basel III

In Germany, more than 95% of the credit institutions report their regulatory capital requirements for counterparty risk by means of the credit risk standardized approach (CRSA) instead of the more sophisticated internal rating based approach (IRBA). Though the CRSA allows a partially risk sensitive calculation of the banks’ regulatory capital German CRSA-banks cannot benefit from this provision as only around 100 non-financial companies have the required published agency rating on hand. We examine, whether the upcoming re-regulation of the banking business Basel III is a driver for both CRSA-banks and their preponderantly medium-sized corporate borrowers to push the use of external corporate ratings. Evaluating a unique sample of 26,025 data sets of German medium-sized companies, we find that under the provisions of Basel III CRSA-banks may experience only minor savings of about 0.5 billion euros in their regulatory capital if their corporate customers had a supervisory recognized rating available. Projected to the total population of German corporates, the exposures of around 9,000 of them potentially qualify for lower risk weights within the CRSA, while estimated 200 are eligible for financial benefits that match or even overcompensate the incurred costs of an external rating. Respectively, for the majority of German companies the benefits of such ratings rather reflect improvements in strategic management issues than lower financing costs.

Basel II and securitising bank holdings of foreign currency government debt

The Basel II Accord on capital standard, which will take effect in 2007 in many countries, requires banks to hold a larger amount of capital than was specified in Basel I against their holdings of certain categories of assets, one of which is foreign currency government debt. The Accord impacts many countries but mostly has major capital implications for around 110 countries with export credit arrangement risk scores of category seven and category four to six, which are the highest risk scores applicable to nations in the Basel agreement. This paper examines one aspect of the balance-sheet implications of the Basel II Accord concerning capital held by commercial banks against their holdings of foreign currency government debt (Eurobonds) issued by their own governments. Basel II attaches 150 per cent risk weight to this asset for countries with classification risk of seven and 100 per cent for countries with classification risk of four to six. Using a simplified numerical model applied on two countries' representatives of the two classification groups, the analysis shows a major necessary increase in capital to meet the requirements specified in Basel II. This necessitates a bank balance sheet reshuffling away from this asset into assets with lower risk weights. Banks, however, have to continuously subscribe to this asset due to the large amounts of dollarised debt in highly dollarised countries, the reduced ability of many countries to market debt internationally and for other relevant reasons. Therefore, we present analysis that relies on the securitisation process to suggest a new proposal that has not been applied or practised yet, in which banks may not have to raise a large amount of additional capital for debt they subscribe to by securitising some of the foreign currency government bonds held on their balance sheets.

CBLO and its Impact on Other Money Market Segments

Collateralized Borrowing and Lending Obligations, more popularly known as CBLO, has been taking the center stage in financial markets in recent months. CBLO has been a innovative product that provides tremendous flexibility to the user which a Repo does not provide. During the initial period of its launching, the volume in CBLO market was negligible as it was a new product. Any new product takes time to integrate with comparable products in the market. However as the time progressed, market participants realized the utility of the product and the restrictions imposed in call market for non-bank participants helped this market to grow. The CBLO, an infant in the financial world, stands on its own in this market, and the statistics display a calibrated integration of CBLO market with other markets due to its advantages like CRR exemption, SLR status for the securities remaining unencumbered in the gilt accounts of the bank maintained with the CCIL under the Constituents' Subsidiary General Ledger (CSGL) facility, lower risk weight etc. The statistical results presented in the paper have shown that introduction of CBLO is a significant event in Indian financial market and it has a clear relationship with other forms of the short term market. It has absorbed the liquidity mismatch arisen out of call market restrictions imposed by RBI.

Profits and Balance Sheet Developments at U.S. Commercial Banks in 2001

Despite the economic slowdown, the profitability of the U.S. commercial banking industry remained high in 2001. Although the weak economy contributed to a sharp rise in provisions for loan and lease losses, those losses were offset in large part by an advance in realized gains on investment account securities as banks' portfolios benefited from declining short- and intermediate-term market interest rates. Profits were also supported by reductions in noninterest expense, as large merger-related charges in 2000 were not repeated last year. Lower short-term interest rates also spurred a rapid increase in core deposits, which provided banks with plentiful, low-interest-rate funding. The expansion of bank balance sheets was slower in 2001 than in the preceding year, as weaker economic activity held down growth in loans to businesses. Loans to households advanced relatively rapidly, though at a somewhat slower pace than in 2000. An increase in the share of banks' portfolios consisting of mortgage-backed securities issued by government agencies, which have lower risk weights than loans, together with continued strong earnings, contributed to an increase in risk-based capital ratios.

Bank Capital and the Credit Crunch: The Roles of Risk‐Weighted and Unweighted Capital Regulations

We investigated whether in recent years banks have increased their holdings of securities at the expense of their holdings of business loans in response to shortfalls of their capital relative to risk‐weighted capital standards and relative to a capital standard that made no explicit allowance for credit risk. We estimated that bank credit fell by about $4.50 for each $1 that a bank's capital fell short of the unweighted capital standard. Banks that had less capital than required by the risk‐weighted standard appear to have shifted away from assets with low risk weights (securities and single‐family mortgages) and to have shifted toward assets with higher risk weights (commercial real estate and commercial and industrial loans). When we included both shortfall variables in a regression, shortfalls relative to the unweighted capital standard significantly affected bank credit, while shortfalls of capital relative to the risk‐weighted standard did not. We found no significant effects of capital shortfalls at other, local‐competitor banks on bank portfolios. Delinquencies in a given category of a bank's loans generally had significantly negative effects on that bank's holdings of loans in that category. In contrast, banks tended to increase holdings of loans in categories in which local‐competitor banks were experiencing higher delinquency rates.