Microprudential Regulation Research Articles

It Takes More than Two to Tango: Understanding the Dynamics Behind Multiple Bank Lending and Its Implications

In this paper we investigate the matching process between banks and large borrowers that switch from single to multiple bank lending relationships in the corporate loan market. Using a unique dataset on all large credit exposures (about 214,000) of all Israeli commercial banks in the period between 2005 and 2015, we highlight the systemic externalities of micro-prudential regulation. We find, inter alia, that regulatory limits on credit exposures aimed at limiting an individual bank's concentration risk lead large borrowers to turn to multiple lending. This increases the level of asset commonality among banks, and the systemic risk arising from this indirect contagion channel. We find that large borrowers are more likely to establish a new lending relationship with big banks and with the banks that are familiar with the borrower's business profile, whether through existing loans to a group of borrowers to which the borrower belongs, or through acquaintance with the industry in which the borrower operates. Furthermore, we find that borrowers tend to establish a new lending relationship with banks whose asset portfolio is correlated with that of their original lender. This result may possibly be related to the tendency of banks to become more similar in their credit portfolios in order to benefit from a too many to fail implicit guarantee.

The Interplay between Regulations and Financial Stability

The crisis demonstrated that microprudential regulation focusing on the risks taken by individual banks is not sufficient to prevent crises. This is because it ignores systemic risk. Six types of systemic risk are identified, namely: (i) panics – banking crises due to multiple equilibria; (ii) banking crises due to asset price falls; (iii) contagion; (iv) financial architecture; (v) foreign exchange mismatches in the banking system; (vi) behavioral effects from Knightian uncertainty. We focus on the first three as they are arguably the main causes of the 2007–9 crisis and consider regulatory and other policies to counteract them.

Evolution of micro-prudential regulators and macro-prudential regulators in the global financial regulatory system

The global financial integration (GFI) has augmented the international financial flow movement without restructuring global financial regulatory system (GFRS). The goal of the global financial regulatory system is to maintain global level stability. In GFRS, the financial stability board (FSB) is responsible for the macro-prudential regulation and the micro-prudential regulation is monitored by international standard setting bodies (SSBs), international financial institutions (IMF and World Bank) and national financial regulators. These micro-prudential regulation and macro-prudential regulation are non-binding in the legal sense. However, these regulations examine as a standard of efficiency. The member nations are strictly implementing the standards because it provides stringent firewall during the unwanted financial turmoil. It also reflects the strength of the member nation. So, the evolution of micro-prudential regulation and macro-prudential regulation is a continuous process; it has to be evolved and developed as per the dynamic changes in the global financial system.

The Interplay between Regulations and Financial Stability

The crisis demonstrated that microprudential regulation focusing on the risks taken by individual banks is not sufficient to prevent crises. This is because it ignores systemic risk. Six types of systemic risk are identified, namely: (i) panics - banking crises due to multiple equilibria; (ii) banking crises due to asset price falls; (iii) contagion; (iv) financial architecture; (v) foreign exchange mismatches in the banking system; (vi) behavioral effects from Knightian uncertainty. We focus on the first three as they are arguably the main causes of the 2007-9 crisis and consider regulatory and other policies to counteract them.

New trends in the system regulating the market of bank services

The severity of the last financial crisis for the European financial markets, the economy, and society makes the scientists and financial analysts start to seek answers with great openness not only to the question of how to reduce its negative effects in the future, but also of how the system regulating financial institutions will look like in the future. The article discusses three options of the positions on the future regulatory tendencies: theoretical alternative, option presented in reports and expert studies, and the version arising from observations of the current practices of functioning of the European banks. The aim of the article is to confront the views on the future trends in the regulation of the banking sector from theoretical, consulting point of view, and the view formulated on the basis of evalua-tion of banking practices.

МАКРОПРУДЕНЦИАЛЬНАЯ ПОЛИТИКА В ПОСТКРИЗИСНОМ БАНКОВСКОМ РЕГУЛИРОВАНИИ

The author looks into the optimal model of international banking regulation using principles and mechanism of macroprudential policy. Severity of the recent global financial crisis uncovered a series of deficiencies in traditional (microprudential) regulation. This triggered a broader and advanced understanding of the regulatory framework while putting on the agenda priorities of interrelationships between micro- and macro-levels. In fact, microprudential regulation lacks reliable tools that would address key determinants known for their contribution to financial instability including interconnectedness of systemically important banks, deficiencies of their stress resilience to adverse externalities, and systemic risks that undermine soundness of the financial system. Any of the above stress factors taken in isolation may incite crises, probability of which, however, could be reduced by instruments that link key performance indicators of the banking sector with macro-level dynamics. Although the concept of macroprudential approach in regulation is yet to be finalized, its instruments has already proved their validity and efficiency in navigating regulators with higher accuracy of capital adequacy measurement over the extended time horizon, coping with the excessively increasing assets, limiting credit appetites of banks, and ensuring countercyclicality of banking performance thus smoothening financial cycles. Unlike traditional regulation, the macroprudential domain provides more insights (however, still to a limited extent) into how to balance among the objectives of the post-crisis regulatory paradigm – banking sector dynamics, sustainable economic growth, and financial stability, which all together appear to be a trilemma of the global financial environment. It is believed that further operationalization of macroprudential regulation will add more consistency to national regulatory regimes that will give rise to further internationalization of the Basel Accords including standards and recommendations of Basel III. Despite promising perspectives for minimization of exogenous and endogenous risks in the banking industry, macroprudential mechanism is yet to find fine-tuned analytical tools that would quantify elements that are critical for the settlement of the regulatory ‘trilemma’ aiming at enhanced sustainability of international financial intermediation amid souring macro-level parameters and market pessimism. Besides, international regulators are still in search for the unbiased and rigor criteria of macroprudential institutional framework. Even though central banks are currently the place for macroprudential policy and supervision, the latter demands more rational grouping of, and customized approach for, its functions and responsibilities. This ensued from the specifics of macroprudential policy actions that may ultimately compromise independence of the central bank’s monetary policy, especially in the framework of inflation targeting, and impair financial cycle elasticity. Importance of the institutional design is also urged by closer synchronization of macroprudential policy with other areas of macro-financial management and supervision. This stands in line with macroprudentialism as a driving force of crisis mitigation. However, missing the acceptable macroprudential standards (in addition to instruments) will be seriously affecting shaping the integrated mechanism of banking regulation eligible for the objectives of post-crisis recovery.

Ethical Perspective of the Financial Sector

In recent years misconduct issues have often arisen across markets and systematically important banks. As a result, there has been a notorious and exacerbated crisis of public confidence in the financial sector. It causes customers of financial services to be deterred from using the system and thus compounding the problem of stability even further. Hence, policymakers and supervisors are called upon re-thinking priorities when regulating financial business, turning to areas such as culture, conduct, integrity, and ethics, as means to guarantee the integrity of the entire financial industry. Traditionally, it has been argued that the key element to rule conduct in the financial sector is the coordination between macro and micro prudential policies, aiming at restoring public confidence and protecting market stability. The proposition is that today’s micro-prudential regulation, which is focused on individual institutions and instruments, must be strengthened and supplemented by macro-prudential regulation of the financial system. The reason is that macro-prudential regulation recognises the risks to the entire financial system, and seeks to fix the mismatch between risk-taking and risk capacity within firms, specially the highly interconnected firms. This paper proposes that such integration between macro and micro-prudential policies is complemented by means of designing and implementing a coherent risk-based approach to regulation and supervision that lies on three areas: i. comprehends the multiple dimensions of conduct risk and how it is perceived by regulators and regulated firms and individuals, ii. considers the psychological elements of the decision making process, and how human judgements about risks are affected by external factors, and iii. the two previous elements contribute to build a concept of “conduct risk” and how it could be better managed by prioritising conduct of business rules, as one of the pillars of the risk-based approach to regulation. The argument put forward here is that risk-based regimes facilitate the identification, management and mitigation of conduct risk in financial markets. Conduct risk defined as a type of operational risk that involves the actions and omissions of financial institutions and individuals within, regarded as misconduct, unethical and corrupt practices.

Heterogeneite de la Transmission de la Politique Monetaire et Evaluation Interne du Risque de Credit : Analyse en Equilibre Partiel

This article presents a partial equilibrium model of the credit market, with banking duopoly subject to a regulatory capital. The results of the model reveal a heterogeneity of monetary policy transmission, due to the disparity of internal rating based methods used by banks to calculate risk-weighted assets and capital requirement. The comparative statics exercise shows a weakening of the credit channel because of risk estimation bias and internal rating methods variability. Thus, the article highlights the strategic issue of the “laissez-faire” given to banks in determining their regulatory capital and calls for a reconciliation between micro-prudential regulation and macroeconomic policy making so as to establish macro-prudential regulation.

The Theoretical Framework of Macroprudential Policy and its Place in the Scheme of Economic Policy

Microprudential regulation and supervision – focused on institutional risks – cannot guarantee the stability of the financial system. Therefore special attention should be paid to macroprudential regulation and supervision to address systemic risks. The purpose of this study is to provide the historical context and a theoretical framework for macroprudential regulation and supervision – a new area of economic policy. To this end, we shall examine the causes for the spread of macroprudential policy, its basic concepts, and thirdly, its place within the scheme of economic policies.

Bank Capital Structure and Financial Innovation: Antagonists or Two Sides of the Same Coin?

This article examines the challenges to banking capital regulation posed by ongoing financial innovation through regulatory capital arbitrage (RCA). On the one hand, such practice undermines the quality of regulatory capital, eroding prudential capital standards, but most importantly it creates a distortion in the regulatory capital ratio measures, which prevents investors and regulators from identifying the bank’s real underlying risks. Opportunities for RCA arise as a consequence of the inherent mismatch of accounting goals, corporate law, and prudential regulation—all interacting with the notion of capital for banks. On the other hand, financial innovation is the result of banks’ risk-management policies. In order to reduce the cost of capital and compliance, banks engage in derivatives, structured finance, and hybrid instruments, thus altering the risk/return of their cash flow and the information released to the market for disclosure. In a way, regulation is the solution but also part of the problem. Implementing too severe rules for capital and disclosure, as well as fair value measurement for financial reporting purposes, may result in strengthening regulatory capital standards and limiting the opportunities for arbitrage at the expense of constraining banks’ risk-management policies. To validate this hypothesis, the article examines three problematic areas for capital micro-prudential regulation: hybrid instruments and structured finance, assets valuation and provisioning, and disclosure. The analysis is integrated with an assessment of the same issues from the perspective of macro-prudential regulation. In relation to these areas, the article discusses the regulator’s approach and regulatory strategies implemented. Macro-prudential regulation is essential to reduce RCA. Basel III has created regulation based on a multiple metric system supported by a strengthened risk-weight capital ratio and a comprehensive legal framework for supervisor and resolution. While these legal frameworks provide constraints that mutually reinforce prudent behaviour, it is important to point out that the regulation has to be functional for the market under examination in order to strike the right balance between regulatory flexibility and robust, enforceable standards.

Bank Capital Structure and Financial Innovation: Antagonists or Two Sides of the Same Coin?

This article examines the challenges to banking capital regulation posed by ongoing financial innovation through regulatory capital arbitrage. On the one hand, such practice undermines the quality of regulatory capital, eroding prudential capital standards, but most importantly it creates a distortion in the regulatory capital ratio measures, which prevents investors and regulators from identifying the bank’s real underlying risks. Opportunities for regulatory capital arbitrage arise as a consequence of the inherent mismatch of accounting goals, corporate law and prudential regulation – all interacting with the notion of capital for banks. On the other hand, financial innovation is the result of banks’ risk-management policies. In order to reduce the cost of capital and compliance banks engage in derivatives, structured finance and hybrid instruments, altering the risk/return of their cash flow and the information released to the market for disclosure. In a way, regulation is the solution but also part of the problem. For this reason, new regulation strategies for banks need to be implemented. Systemic risk and balance-sheet risk need to be tackled respectively with macro- and micro-prudential regulation. This would involve an international harmonization of the accounting standards and individualised capital adequacy requirements for banks. The regulation has to be functional for the market under examination. The regulator should therefore consider the adoption of prudential filters to make static variables such as accounting rules, which are normally focused on evaluation, more dynamic to give banks some financial flexibility in their risk-management policies.

Jointly Optimal Regulation of Bank Capital and Liquidity

In an economy with financial frictions, banks endogenously choose excessive leverage and maturity mismatch in equilibrium, as they fail to internalize the risk of socially wasteful fire sales. Macroprudential regulators can achieve efficiency with simple linear constraints, which require less information than Pigouvian taxes. The liquidity coverage and net stable funding ratios of Basel III can implement efficiency. Additional microprudential regulation of leverage is required when bank failures are socially costly. Micro‐ and macroprudential rules are imperfect substitutes. Optimally, macroprudential policy reacts to systematic risk and credit conditions over the cycle, while microprudential policy reacts to systematic and idiosyncratic risk.

Pricing the Credit-Risk Put Embedded in Borrowers’ Extendible Credit Commitments, with Its Application to Basel-3 Micro-Prudential Regulation

This research makes two contributions: 1) use a term structure framework to price analytically the put option implicit in borrowers’ extendible credit commitments and 2) use the latter to compute in a ratings-based model the capital charge corresponding to the credit-risk exposure of such commitments. Since the term structure of interest rates is stochastic, the zero-coupon bonds in the put closed-form solution delink discounting factor from the credit and funding rates that define the credit spread appearing in the put payoff. By essence, extendible commitments straddle the term-based commitment classification of Basel-3 simplified approach. To improve this, we formulate a ratings-based model that combines extendible put values with new coefficients (forward funding proportion and exposure at funding) as well as a matrix that captures credit-ratings migration over time. Moreover, the combination is versatile enough to deal with a borrower’s credit downgrade and its attendant incremental Basel-3 capital charge.

Stricter microprudential supervision versus macroprudential supervision

Purpose – The purpose of this paper is to develop an explicitly macroprudential supervisory framework designed to identify threats to financial stability use existing mechanisms to reduce the risk of these threats and to provide information to the authorities to more efficiently mitigate any instability that does arise. Design/methodology/approach – This paper begins with an analysis of the limitations of microprudential regulation. It then develops a macroprudential surveillance framework focused on those financial markets that have the potential to undermine financial stability. It concludes with a discussion of how the surveillance results may be used to enhance financial stability. Findings – The current supervisory focus on microprudential supervision of systemically important institutions is insufficient; an explicitly macroprudential focus is required. Research limitations/implications – Although this paper’s conceptual framework is applicable to all advanced financial systems the discussion of specific regulatory structures focuses on the USA. Practical implications – An explicit supervisory focus on the threats posed by major financial markets is feasible and desirable. Social implications – The probability of a financial crisis and the economic damage caused by a crisis can be significantly reduced by redirecting some regulatory efforts toward in-depth analysis of major financial markets. Originality/value – The paper emphasizes that macroprudential supervision must include both quantitative and detailed analysis of the qualitative aspects of key markets.

The Macro-prudential aspects of loan-to-deposit-ratio-linked reserve requirement

Micro-prudential regulation is sometimes more focused on the health of the financial institutions and pays less attention to the objective of sustainable intermediation and financial stability in the long run. A macro-prudential policy is formulated to reduce this myopic tendency. This article shows analytically how Loan-to-Deposit-Ratio (LDR)-linked Reserve Requirement (RR) can be used to apply counter-cyclical measures in banking industry by providing disincentive mechanism when a bank operates outside the preferred operational corridor. At the lower limit of LDR, a requirement of higher RR can push banks to extent more loans in order to support economic development in a period of economic bust. At the upper limit of LDR, a requirement of higher RR and/or capital can also provide disincentive to slow down its investment activities in an economic booming period and manage liquidity risk better.

Contribution of macroeconomic factors to the prediction of small bank failures

Microprudential regulation is an integral part of any banking supervisory framework. By analysing the link between economic conditions and the survival of small co-operative banks, this study sheds light on the importance of the economic environment after assessing individual bank stability over time. The results show that bank failure is better captured when we account for the state of the economy both at the national and the regional level. Moreover, voluntary closures and acquisitions across provinces appear to be related with bank distress. Our findings have important policy implications. First, using a wider spectrum of information increases the accuracy of default prediction models, improving the supervisory toolbox used to monitor the health of small banks. Second, economic downturns increase a co-operative bank's default risk, supporting the introduction of countercyclical capital buffers to lessen the negative effects associated to bank instability.

Basel III B: Basel III Overview

In the wake of the financial crisis of 2007-2009, the Basel Committee on Banking Supervision (BCBS) faced the critical task of diagnosing what went wrong and then updating regulatory standards aimed at preventing it from occurring again. In seeking to strengthen the microprudential regulation associated with the earlier Basel Accords while also adding a macroprudential overlay, Basel III consists of proposals in three main areas intended to address 1) capital reform, 2) liquidity standards, and 3) systemic risk and interconnectedness. This case considers the causes of the 2007-2009 financial crisis and what they suggest about weaknesses in the Basel regime as it then existed. It then summarizes the provisions of Basel III to allow for an evaluation of whether it was an effective response to the causes of the financial crisis.

The framework for financial stability: Serbian and Ukrainian approaches

The development and implementation of any policy require the creation of preconditions for ensuring the independence of such a policy. In order to provide such preconditions, it is necessary to build up an institutional framework and regulate the key principles of development and implementation of an appropriate policy. the macroprudential policy is no exception, either. The macroprudential policy is a new policy area, which aims to identify, analyze and counter risks to the financial system as a whole, as opposed to traditional microprudential regulation and supervision, whose focus is exclusively on the risks of individual institutions. In many countries, the processes of appropriate legislation and building an institutional framework are ongoing. The article is focused on a comparative analysis of the Serbian and the Ukrainian approaches to macroprudential policymaking. The differences and the similarities between the Ukrainian and the Serbian macroprudential policymaking models are generalized.

The Winner's Curse: Evidence on the Danger of Aggressive Credit Growth in Banking

Excessive credit creation by banks was at the root of the recent financial crisis. Nevertheless, micro-prudential regulation lacks a clear methodology to identify these banks. Combining arguments from banking and auction theory, we show that overoptimism causes excessive lending, subsequently yielding abnormal loan write-offs. We propose a new measure of excessive credit growth known from macroeconomics to identify credit booms and test our model for German bank and bankportfolio level data. Unlike traditional measures of (excessive) loan growth, our new measure identifies banks that are affected by abnormal loan write-offs, need capital support, or default in subsequent years.

Monetary policy and credit cycles: A DSGE analysis

The recent financial crisis revealed several flaws in both monetary and financial regulation. Contrary to what was believed, price stability is not a sufficient condition for financial stability. At the same time, micro-prudential regulation alone becomes insufficient to ensure the financial stability objective. In this paper, we propose an ex-post analysis of what a central bank could have done to improve the reaction of the economy to the financial bubble. We study by means of a financial accelerator DSGE model the dynamics of our economy, first, when the central bank has only traditional objectives, and second, when an additional financial stability objective is added. Overall, results indicate that a more aggressive monetary policy would have had little success in improving the response of the economy to the financial bubble, as the actions of the central bank would have remained limited by the use of a single instrument, the interest rate.