Regulatory Capital Arbitrage Research Articles

Why do Moroccan banks securitize?

PurposeThis paper analyzes the ex-ante determinants of asset securitization in Moroccan banks, providing a detailed exploration of factors influencing securitization in the Moroccan banking sector.Design/methodology/approachThe study focuses on funding, performance, risk transfer and regulatory capital arbitrage hypotheses. By employing a probit model, we examined all Moroccan banks that securitized their assets from 2002 to 2022. Additional analyses were conducted with alternative variables and by splitting the sample into two periods, 2002–2013 and 2014–2022, to assess the impact of the regulation law 119-12 implemented in 2013 on the Moroccan securitization market.FindingsThe results indicate that the search for alternative funding sources and bank size emerge as significant factors driving securitization in Morocco. Additionally, there is limited evidence that loan portfolio quality is a decisive factor to securitize. Meanwhile, there is no evidence that securitization is driven by performance and regulatory capital arbitrage. Robustness tests further support these findings, while also suggesting that banks may engage in securitization to enhance their performance and, to a lesser extent, reduce regulatory capital.Originality/valueThis paper contributes to the empirical literature by identifying the determinants that drive Moroccan banks to securitize, addressing a research gap in the relatively understudied Moroccan securitization market. The findings provide valuable insights for bankers, investors and policymakers, highlighting the potential benefits of securitization and suggesting policy changes to foster a robust securitization market while ensuring financial stability.

Bank Regulatory Capital Arbitrage: Evidence from Housing Overappraisals

The overstatement of asset collateral values reduces bank capital requirements. We identify this novel form of regulatory arbitrage by studying housing overappraisals, the difference between housing collateral values computed by appraisers and actual transaction prices. We leverage granular loan-level data from Spain and a kink in the scheme of residential mortgage risk weights to show that tighter regulatory requirements cause larger overappraisals. This bias depends on the relationship between appraisers and banks; appraisers inflate mortgage collateral values only for their major customer banks. On average, overappraisals lower risk-weighted mortgages by 9%. Mortgage overappraisals allow banks to free up regulatory capital to support additional risk-taking in the corporate loan market. This paper was accepted by Victoria Ivashina, finance. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.4805 .

Book-to-market equity and asset correlations—An international study

In this paper, we examine the use of book-to-market equity (BE/ME) as a determinant of asset correlations in the Basel Accord on regulatory capital requirements. Utilizing an international sample from 38 countries during 1989–2017, we discover that asset correlations, controlling for firm size and default probability, are negatively associated with BE/ME. We further decompose BE/ME according to Daniel and Titman (2006) and Penman et al. (2007) to explore why BE/ME can capture variations in asset correlations. The former method demonstrates that obligors with higher assets-in-place (higher BE/ME) exhibit lower asset correlations, and the latter approach reveals that obligors with higher operating risk have lower asset correlations. These findings suggest that BE/ME is potentially a crucial factor in improving estimates of asset correlations and reducing bank regulatory capital arbitrage.

Capital Requirements and Bank Risk-Taking under Imperfect Supervision

This paper studies the interactions between multiple capital requirements using a novel approach. The approach is based on the classical moral hazard: deposit competition leads to excessive risk-taking by banks. While risk-based capital requirements can reduce this risk-taking incentive, it comes at the cost of banks conducting regulatory capital arbitrage under an internal ratings-based (IRB) approach. This issue is further exacerbated under weak supervisory environment. We study whether adding a non risk-based leverage ratio can reduce arbitrage under imperfect supervision. The model shows that the risk-based capital requirements can reduce bank excessive risk-taking with arbitrage if the regulator imposes enough supervisory power. Once a non risk-based leverage ratio is introduced, arbitrage becomes less likely and the minimum supervisory power to restrict arbitrage also decreases. However, the ratio may induce some prudent banks to invest more aggressively, increasing aggregate risk-taking. Therefore, the banking regulator faces a trade-off between restricting arbitrage and banking stability.

Testimony of Erik F. Gerding Before the U.S. House of Representatives Subcommittee on Consumer Protection and Financial Institutions on 'Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending'

Risk is building in the leveraged loan and collateralized loan obligation (“CLO”) markets. These two markets are connected: leveraged loans are being repackaged into CLOs just as mortgages and mortgage-backed securities were used to create collateralized debt obligations (“CDOs”), the financial products at the heart of the financial crisis 11 years ago. There are important differences but also troubling parallels between the leveraged loan/CLO markets and the earlier mortgage/CDO markets. One alarming similarity is the decline in leveraged loan underwriting standards: the market is now dominated by “covenant-lite loans.” Covenant-lite loans permit greater leverage by borrowers and remove an early warning system for lenders. Purchases of CLOs by banks and other regulated financial institutions made in order to game crucial regulatory capital requirements (“regulatory capital arbitrage”) remain a significant concern . Like mortgages and CDOs, leveraged loans and CLOs form a pipeline or system. Disruptions at either end of the system can cause financial havoc on the other end and then ricochet back. This is akin to a coiled spring or “crisis accordion.” Losses or disruptions in the leveraged loan/CLO markets, even if they do not approach the levels of mortgages/CDOs in the global financial crisis could still be significant, e.g., amplifying a recession. We should be humble about our ability to predict the upper bound of financial market disruptions or crises. Some tranches of CLO securities appear not to trade actively. Many CLO securities trade on opaque markets lacking transparent prices. A lack of trading of CLO securities undermines the economic rationale of these securities, as well as their safety and favorable regulatory treatment. A lack of transparent prices means that neither the marketplace nor regulators can rely on prices to police risk-taking in the CLO market. Regulators must monitor and analyze data on leveraged loans and CLO markets. The OFR needs cooperation from other financial regulators in assessing risk in these markets. Lack of data sharing among financial regulators remains a crucial weakness. The OFR needs an independent source of funding. Regulators need minimum standards in their examinations with respect to assessing bank exposure to leveraged loans. I also recommend: - Stress testing of financial markets, not just individual institutions; - Requiring financial regulators to conduct war games to prepare for market disruptions; - Underscoring that the burden is on financial institutions to prove that leveraged loans and CLOs are safe rather than on regulators to prove that they are unsafe. If data gathering reveals significant systemic risk in leveraged lending/CLO markets, regulators should use a mix of tools, including limiting bank investments in CLOs, enhanced and countercyclical capital requirements, and the Volcker Rule “covered funds” provisions.

Securitization and business cycle: an agent-based perspective

We study the effects of loans and mortgages securitisation on business cycles by using a large-scale agent-based stock-flow consistent macroeconomic model and simulator, that we enriched by including a financial vehicle corporation (FVC), that buys loans and mortgages from banks and issues ABSs and MBSs, and a mutual fund, that invests both in ABSs and MBSs. Households own the equity of the mutual fund in the form of equity shares. By means of securitisation, banks conduct regulatory capital arbitrage and reduce risk weighted assets in their balance sheet, in order to lend more loans and mortgages. Results show that different levels of securitisation propensity are able to affect credit and business cycles in different manners. On one side, securitisation increases banks lending activity, influencing positively investment and consumption. On the onther side, the increased amount of credit amplifies the negative shocks, due to higher loans write-offs probability, triggered by the boosted leding activity. Firms' bankruptcies impact the equity of banks, affecting their ability to grant new loans to consumption goods producers (CGPs), which need credit for their production activity, and mortgages to households, which are not able to purchase housing units. CGPs soon go bankrupt and households see their capital income reduced. The predominance of one effect on the other depends on the level of securitisation propensity and the time span considered.

Insider perspectives on European banking challenges in the post-crisis regulation environment

The purpose of this paper is to make a highly topical and practical contribution by investigating the interplay between capital and liquidity risk management and managerial decision making in banking, following the Basel III introduction for enhancing the safeguards against systemic risk. Specifically, we attempt to gauge the experience and assess the degree of tensions among banking practitioners’ perspectives on the reformed banking liquidity practice and risk-capital management in light of the newly introduced increased capital and liquidity requirements, which are to become fully and unilaterally effective as of 2019. As currently seen the liquidity provision requirement has become a distinct form of ‘sharing’ financial risks in the global economy, which includes the supply of capital from its issuers. This article reviews the issue from a European perspective attempting to gain insight into: (1) the suggestion that the new regulations lack internal consistency owed to their complexity, which creates the potential for both inter- and intra-company regulatory capital arbitrage and credit constriction; and (2) the suggestion that increased capital and liquidity requirements may have a significant impact on bank behaviour and/or certain business model segments. Both of the above can potentially distort managerial behaviour through altering managerial incentives and hence fail to adequately regulate bank behaviour. With regard to the liquidity requirements, whilst we do not attempt to quantifiably assess the degree to which liquidity regulations (the liquidity coverage ratio in particular—LCR henceforth) affect returns on equity/assets to banks, our interviews are used as a triangulating measure for complementing quantitative studies that can provide a further insight into the perception of affecting managerial incentives. We aim to add to, update, and enrich the studies around the vital research question of whether the new regulation and liquidity standards can achieve their ultimate objective of upholding financial soundness and stability. Therefore, this research is important to complete the extant literature on updated insiders’ perspectives that investigate the effectiveness of the new regulatory framework imminently to be fully applicable by 2019. Where the views of the professionals who have voiced their concerns, support, and/or proposals provide for a material contribution, these have also been provided.

The other (commercial) real estate boom and bust: The effects of risk premia and regulatory capital arbitrage

• Required returns mainly drive commercial real estate (CRE) capitalization rates. • CRE risk premia stem mainly from general risk premia and capital requirements. • Weakened capital requirements on CMBS mainly drove the mid-2000 s CRE price boom. • The ensuing bust was triggered by rising general risk premia in the financial crisis. • More recent rises in CRE prices mainly stem from unusually low real Treasury yields. In the 2000 s, U.S. commercial real estate (CRE) prices experienced a boom and bust as dramatic as the more widely analyzed swings in house prices and contributed significantly to bank failures. We model short-run and long-run movements in capitalization rates (rent-to-price-ratio) and risk premia for office building and apartments. In the mid-2000s’ boom, CRE prices were mainly driven by declines in required risk premia that stemmed from a weakening of capital requirements. In the bust, CRE price declines were initially driven by a jump in general risk premia and later by a tightening of effective capital requirements on commercial mortgage-backed securities (CMBS) from the Dodd-Frank Act. The subsequent recovery in CRE prices was induced and sustained by unusually low real Treasury yields. We conclude that macro-prudential regulation of leverage may help limit asset price booms by preventing sharp declines in risk premia.

Risk management with weighted VaR

AbstractThis article studies the optimal portfolio selection of expected utility‐maximizing investors who must also manage their market‐risk exposures. The risk is measured by a so‐called weighted value‐at‐risk (WVaR) risk measure, which is a generalization of both value‐at‐risk (VaR) and expected shortfall (ES). The feasibility, well‐posedness, and existence of the optimal solution are examined. We obtain the optimal solution (when it exists) and show how risk measures change asset allocation patterns. In particular, we characterize three classes of risk measures: the first class will lead to models that do not admit an optimal solution, the second class can give rise to endogenous portfolio insurance, and the third class, which includes VaR and ES, two popular regulatory risk measures, will allow economic agents to engage in “regulatory capital arbitrage,” incurring larger losses when losses occur.

Risk Management with Weighted VaR

This article studies the optimal portfolio selection of expected utility maximizing investors who must also manage their market-risk exposures. The risk is measured by a so-called weighted Value-at-Risk (WVaR) risk measure, which is a generalization of both Value-at-Risk (VaR) and Expected Shortfall (ES). The feasibility, well-posedness, and existence of the optimal solution are examined. We obtain the optimal solution (when it exists) and show how risk measures change asset allocation patterns. In particular, we characterize three classes of risk measures: the first class will lead to models that do not admit an optimal solution; the second class can give rise to endogenous portfolio insurance; and the third class, which includes VaR and ES, two popular regulatory risk measures, will allow economic agents to engage in “regulatory capital arbitrage,” incurring larger losses when losses occur.

CHALLENGES FACING COMMERCIAL BANKS IN THE IMPLEMENTATION OF CAPITAL ADEQUACY REQUIREMENT IN BASEL III FRAMEWORK

Purpose: The purpose of the study was to identify challenges facing commercial banks in the implementation of capital adequacy requirement in Basel III framework.Methodology: A descriptive survey design was applied to a population of 43 commercial banks operating in Kenya. The target population composed of the 159 management staff currently employed at the head offices of the various commercial banks in Kenya. The population was composed of Senior, Middle and Junior or Entry level Management staff. A sample of 30% was selected from within each group. Primary data was gathered using questionnaires which were dropped off at the bank's head offices and picked up later when the respondents had filled the questionnaires. Descriptive analysis was used to analyze quantitative data while content analysis was used to analyze qualitative data.Results: The study concludes that the implementation of Basel III requirement has been faced by various challenges like growth barrier, regulatory constraints, risk and finance management culture and additional capital challenges. In addition, the study concluded that commercial banks face challenges in deciding how best to implement a solution that will allow them to comply with Basel III, how to operate the systems and processes for improved operational effectiveness, and how to understand and ultimately reduce their capital requirements.Unique contribution to theory, practice and policy: The study recommends that Banks should manage their risks more closely and avoid a build-up of unintended risk, reducing the opportunities for regulatory capital arbitrage. This would go a long way in eliminating growth barriers, regulatory constraints, capital adequacy requirement, risk and finance management culture and additional capital challenges.

What explains the recourse of US commercial banks to securitization?

PurposeThe purpose of this paper is to investigate the reasons that urge US banks to securitize.Design/methodology/approachThe authors apply a logistic regression model to a sample of 5,394 observations. The dependent variable takes 1 if the bank securitizes and 0 if not. The authors use also, a Heckman selection model to account for the potential dependence between the decision to securitize and the decision of which assets to securitize.FindingsThe results indicate that liquidity, credit risk transfer, regulatory capital arbitrage and profitability are the most important factors that drive securitization in the USA. Moreover, the nature of the asset securitized appears to be dependent on the objective that the bank pursues. For funding and capital arbitrage objectives, the bank needs to securitize its mortgage loans. However, for credit risk transfer purposes, it has to opt for a non mortgage securitization. The nature of the asset securitized can thus, be used as a signal for bank’s intentions to securitize.Originality/valueThis study contributes to a better understanding of the reasons that urge banks to securitize. It also presents, using a Heckman selection procedure, a detailed analysis that discriminates between different types of securitization.

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.

Impact of FAS 166/167 on Credit Card Securitization

We examine the impact of FAS 166/177 on the quantity and quality of credit card loans of the affected securitization banks. We focus on credit card securitization because its nature makes it most likely to be consolidated back onto the balance sheet after FAS 166/167. Using credit card loans of non-securitization banks as controls, we document the following findings. First, the balance of total managed credit card loans for securitization banks decreases significantly from pre to post-FAS 166/167 period. Second, we find significant lower asset quality for non-securitized credit card loans relative to securitized loans of the same securitization bank prior to the adoption of FAS 166/167. Furthermore, we find significant improvement of the asset quality for credit card loans of the securitization banks after the adoption of FAS 166/167, especially for banks whose regulatory capital ratios are closer to the legal minimum after the adoption of the accounting rules. Overall, our findings suggest that banks have less opportunity to engage in regulatory capital arbitrage after the adoption of FAS 166/167 and adjust their risk taking behavior accordingly.

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.

The solvency of financial institutions in Spain: lessons from securitization

On analysing a sample of Spanish banks, we find that securitization has a slightly negative impact on the soundness of the issuing entity. An unbalanced dynamic panel model was estimated using the forward orthogonal deviations GMM method and used to analyse 537 traditional securitizations issued by 61 banks between 1998 and 2012. The analysis revealed that the entities’ soundness became weaker immediately prior to the crisis, but this effect became insignificant after 2007. Securitization has facilitated a process of regulatory capital arbitrage leading to lower capital requirements while, at the same time, giving rise to a slight worsening of the quality of the originators’ portfolios. It was found that profitability, liquidity and inflation positively affect solvency, while changes in short-term interest rates affect it negatively.

Securitization in East Asia

Securitization offers a range of benefits for Asia's financial systems and economies as a mechanism to assist funding and investment. As a form of structured finance, reliable and efficient securitization can assist development by enabling financial systems to deepen and strengthen?thus contributing to overall economic growth and stability.It must be recognized, however, that there are both overt and more subtle risks in certain uses of securitization. The credit and liquidity crisis that began in the United States and spread to other developed financial systems in mid-2007 exposed the danger associated with securitization: excessive risk-taking or regulatory capital arbitrage rather than a tool to assist more conventional or conservative approaches to funding, risk management, or investment. Securitization has also been criticized for rendering financial markets opaque, while contributing to a growing emphasis in the global economy of credit intermediation conducted in capital markets rather than through banks.This study examines the institutional basis of these concerns by investigating the use of securitization in East Asia, questioning both the growth in regional activity since the 1997/98 Asian financial crisis, and the reasons for it remaining constrained. The paper concludes with a discussion of proposals to support proper development of securitization in the region, including institutional mechanisms that could better allow securitization to enhance development and financial stability. If East Asia begins to make fuller use of securitization, its motive will be to meet funding or investment needs in the real economy rather than balance sheet arbitrage of the kind that peaked elsewhere in 2007.

The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage

The last decade?s boom and bust in U.S. commercial real estate (CRE) prices was at least as large as that in the housing market and also had a large effect on bank failures. Nevertheless, the role of CRE in the Great Recession has received little attention. This study estimates cohesive models of short-run and long-run movements in capitalization rates (rent-to-price-ratio) and risk premiums across the four major types of commercial properties. Results indicate that CRE price movements were mainly driven by sharp declines in required risk premia during the boom years, followed by sharp increases during the bust phase. Using decompositions of estimated long-run equilibrium factors, our results imply that much of the decline in CRE risk premiums during the boom was associated with weaker regulatory capital requirements. The return to normal risk premia levels in 2009 and 2010 was first driven by a steep rise in general risk premia that occurred after the onset of the Great Recession and later by a tightening of effective capital requirements on commercial mortgage-backed securities (CMBS) resulting from the Dodd-Frank Act. In contrast to the mid-2000s boom, the recovery in CRE prices since 2010 has been mainly driven by declines in real Treasury yields to unusually low levels. Our findings have important implications for the channels through which macro-prudential regulation may or may not be effective in limiting unsustainable increases in asset prices.

The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage

The last decade’s boom and bust in U.S. commercial real estate (CRE) prices was at least as large as that in the housing market and contributed significantly to bank failures. Nevertheless, the role of CRE in the Great Recession has received little attention. This study estimates cohesive models of short-run and long-run movements in capitalization rates (rent-to-price-ratio) and risk premiums across the four major types of commercial properties. Results indicate that CRE price movements were mainly driven by sharp declines in required risk premia during the boom years, followed by sharp increases during the bust phase. Using decompositions of estimated long-run equilibrium factors, our results imply that much of the decline in CRE risk premiums during the boom was associated with weaker regulatory capital requirements. The return to normal risk premia levels in 2009 and 2010 was first driven by a steep rise in general risk premia that occurred after the onset of the Great Recession and later by a tightening of effective capital requirements on commercial mortgage-backed securities (CMBS) resulting from the Dodd-Frank Act. In contrast to the mid-2000s boom, the recovery in CRE prices since 2010 has been mainly driven by declines in real Treasury yields to unusually low levels. Our findings have important implications for the channels through which macro-prudential regulation may or may not be effective in limiting unsustainable increases in asset prices.

The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage

The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage