Regulatory Capital Requirements Research Articles

Failure of capital requirements regulation in the banking industry: evidence from a bank-based financial system

This article studies the impact of Basel I and Basel II regulation in a bank-based financial system on the degree of competition in the banking sector, as measured via the Panzar and Rosse statistic. Strikingly, our results suggest that, contrary to the regulator’s expectation, stability-oriented regulation reduces competition in the banking sector. Further analysis suggests that while Basel does not have a significant impact on the large banks, it reduces competition among other banks, which move towards uncompetitive dynamics. This shift towards monopoly is aligned with the hypothesis of this regulation to create competitive advantages for large banks at the expense of the others.

Between Prudential Regulation and Shareholder Value: An Empirical Perspective on Bank Shareholder Equity (2001-2017)

Abstract We analyse the effects of changes in regulatory capital requirements under Basel III on the dynamic evolution of bank shareholder equity over time. Evidence from managerial and regulatory reports shows that bank shareholder equity stands between micro-prudential regulatory capital requirements and managerial pursuit of equity economising strategies. Shareholder value strategies see shareholders as the equity investment remuneration recipients. Micro-prudential regulators, in turn, address them as equity investment providers. With opposing cash streams, one orientation puts the other to a test. The article visualises this conflict by analysing the actual shareholder contribution to the bank equity position in nine case studies of European financial institutions between 2001 and 2017; our evidence-based financial analysis applies an innovative method to data directly extracted from financial statements, in order to measure this equity position evolution and assess bank equity dynamics in light of revised regulatory capital requirements and persistent assurance of shareholder value thriving in managerial reports. The choice of in-depth analysis of a sample of relevant case studies overcomes the absence of detailed data on changes in bank equity in existing databases.

Between Prudential Regulation and Shareholder Value: An Empirical Perspective on Bank Shareholder Equity (2001-2015)

We analyse the effects of changes in regulatory capital requirements under Basel III on the dynamics of bank shareholder equity. Evidence from managerial and regulatory reports shows that bank shareholder equity stands between Basel III regulatory capital requirements and managerial pursuit of equity economising strategies. Shareholder value strategies see shareholders as the equity investment remuneration recipients. Regulators, in turn, address them as equity investment providers. With opposing cash streams, one concept put the other to a test. The paper visualises this conflict by analysing the actual shareholder contribution to the bank equity position in nine case studies of European financial institutions between 2001 and 2017; our empirical financial analysis applies an innovative method to data extracted from financial statements, to measure these equity position evolutions and assess bank equity dynamics in light of revised regulatory capital requirements and persistent assurance of shareholder value thriving in managerial reports. The choice of in-depth analysis of a sample of relevant case studies overcomes the absence of detailed data on changes in bank equity in existing databases.

The Market Risk Premium for Unsecured Consumer Credit Risk

We use the prices of credit card asset-backed securities to study the market risk premium associated with unsecured consumer credit risk. The consumer credit risk premium has historically been comparable to high yield corporate bond spreads, but has increased dramatically since the financial crisis. We find evidence that this increase is primarily due to balance-sheet costs imposed by recent changes in regulatory capital requirements which have effectively placed credit card securitizations back onto issuer balance sheets. These changes in capital regulation may have added hundreds of basis points to the cost of unsecured household credit. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Modelling Corporate Probability of Default – A Possible Supervisory Benchmark Model

In recent years, supervisory bodies around the world have lost some of their confidence in the estimations of credit risk parameters at banks applying the internal ratings-based methodology. Supervisory experience shows that differences in risk metrics and ultimately in regulatory capital requirement levels stem primarily from inconsistencies in the modelling techniques applied and the various methodological approaches, rather than from any actual differences between the inherent risks of bank portfolios. To avoid this unwanted effect, in its supervisory review of banks’ internal capital adequacy assessment process, the Central Bank of Hungary (Magyar Nemzeti Bank, MNB) aims at specifying the necessary capital requirements by developing and applying harmonised benchmark models. This study shows how it is possible to estimate a probability of default (PD) for corporate portfolios, which is based on large banks’ corporate default rate data series and available corporate financial data, uses a harmonised methodology that factors in differences between the credit quality ratings of various customers, and is suitable for the supervisor’s calculation of the capital requirement for any given bank. Nonetheless, there may also be other factors in addition to individual financial data (e.g. qualitative expert elements, sector information) that may affect credit quality; identifying these may be one of the objectives of benchmark model development.

The Use of Mutual Information to Improve Value-at-Risk Forecasts for Exchange Rates

In this paper, we show a simple but novel approach in an attempt to improve value-at-risk forecasts. We use mutually dependent covariate returns to create exogenous break variables and jointly use the variables to augment GARCH models to account for time-variations and breaks in the unconditional volatility processes simultaneously. A study of hypothetical mutual dependencies between volatility and the covariates is first carried out to investigate the levels of the shared mutual information among the variables before using the augmented models to forecast 1% and 5% value-at-risks. The results provide evidence of some substantial exchange of information between volatility and the lagged exogenous covariates. In addition, the results show that the estimated augmented models have lower volatility persistence, reduced information leakages, and improved explanatory powers. Furthermore, there is evidence that our approach leads to fewer violations, improved 1% value-at-risk forecasts, and optimal daily capital requirements for all the models. There is, however evidence of relative superiority of the majority of the models for the 5% value-at-risks forecasts from our approach, although they have relatively higher failure rates. Based on these results, we recommend the incorporation of our approach to existing risk modeling frameworks. It is believed that such models may lead to fewer bank failures, expose banks to optimal market risks, and assist them in computing optimal regulatory capital requirements and minimize penalties from regulators.

Insolvency Risk: Issues and Challenges for Public Sector Commercial Banks of India

This paper thoroughly examined the insolvency risk of four major commercial banks of India namely, State Bank of India, Punjab National Bank, Bank of Baroda, and Canara Bank during the period from 2005-06 - 2017-18 and scrutinized whether the regulatory capital requirement as per the Reserve Bank of India norms was enough to insulate commercial banks from the potential threat of insolvency risk. Moreover, the impact of the main determinants on the parameter used to measure insolvency risk namely, Z-score was also analyzed. Our study clearly showed that the insolvency risk of all these banks increased significantly since the value of Z-score dipped substantially overtime. Further, the analysis also revealed that the current level of regulatory capital of the banks was not enough to overcome the potential threat of insolvency risk. Finally, percentage of nonperforming assets to total advances pertaining to the industrial sector was found to be an important determinant that aggravated the insolvency risk of banks. All these findings clearly highlighted that it is not the opportune time for the Reserve Bank of India to ease-off the regulatory capital norms regarding the capital risk adequacy ratio (CRAR). Besides, there is an urgent need for commercial banks to improve the quality of lending pertaining to the industrial sector of the economy along with stepping up their credit business regarding the personal loan segment. Moreover, too much government intervention distorts the automatic functioning of financial institutions. Rather, a mechanism should be devised to make these institutions more accountable.

Credit risk measurement: Evidence of concentration risk in Polish banks’ credit exposures

In recent years, there has been a lot of scientific research stressing the importance of understanding and measuring concentration risk in credit portfolios. The article presents credit risk measurement within the capital requirements regulation of the corporate sector. Main objective is to assess the financial stability of the banking sector from a credit risk perspective. The empirical analysis was based on the individual data from different sources (covering the period 2007 -2018), which are as follows: prudential reporting, business register, financial and behavioural data and balance of payments. This paper analyses the exposure of Polish banks to credit risk arising from different economic sectors. The evaluation includes the firm-level probabilities of default, loss given default, expected losses and unexpected losses. The measures of expected and unexpected losses were estimated by using a structural multi-risk factor approach. While conducting the research, it has been noticed that a credit risk differs across various industries as well as at different phases of economic cycle. Furthermore, the research results indicate that both from the standpoint of individual banks and prudential authorities the correlation risk is being underestimated.

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

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

Impact of Expected Shortfall Approach on Capital Requirement Under Basel

This paper proposes a method that uses volatility index of US and six other markets of Pacific Basin, namely Hong Kong, Australia, India, Japan, Korea, and China, to provide value-at-risk (VaR) and expected shortfall (ES) forecasts. Empirical constants that are used to multiply the levels of volatility indexes for estimating VaR and ES of various significance levels for 1–22 days ahead, one by one, for seven market indexes have been statistically determined using daily data spanning from 4.75 to 16 years. It is because it would be inappropriate to simply scale up the one-day volatility by multiplying the square root of time (or the number of days) ahead to determine the risk over a longer horizon of [Formula: see text] days. Results show that the shift to ES approach generally increases the regulatory capital requirements from 2.09% of India market to 8.56% of Korea market except for the China market where ES approach yields an unexpected decrease of 3.21% of capital requirement.

France

The Less Significant Institutions (LSI) sector in France is very small in terms of market share and is diversified by size and business model (Table 1). It proved itself resilient during the financial crisis and is not a source of systemic risk. The sector has a high cost structure and faces a number of competitive and other challenges. The regulatory framework, based on the Capital Requirements Regulation (CRR)/Capital Requirements Directive (CRD) IV, is the same as for Significant Institutions (SIs) but the supervisory framework under the Single Supervisory Mechanism (SSM) is very different. The French Prudential Supervision and Resolution Authority (ACPR) remains the direct supervisor of LSIs but it is now subject to the oversight of the European Central Bank (ECB), which also has full responsibility for certain common procedures. The ACPR has continued its comprehensive supervisory approach, both on-site and off-site, but reflecting the SSM’s emphasis on greater harmonization, it has had to become more procedural and may have lost elements of flexibility. In response to SSM initiatives, the ACPR has sharpened its focus on governance issues, although business model and profitability risk remains the main challenge for the LSI sector.

France

Macroprudential policy in France is the joint responsibility with several European institutions. With the operationalization of the EU Capital Requirement Directive and Capital Requirement Regulation (CRD/CRR), the French authorities have implemented, several capital buffers, as well as the liquidity coverage ratio (LCR), based on this framework. In France, Haut conseil de stabilité financière (HCSF) is the macroprudential authority established in accordance with recommendation European Systemic Risk Board (ESRB)/2011/13 and the designated authority established in accordance with Article 136 of CRD and is in charge of activating several measures in the CRD/CRR framework as well has direct responsibilities over several tools outside this framework, for example borrower-based tools.

Tax and Nontax Incentives in Income Shifting: Evidence from Shadow Insurers

ABSTRACTUsing the shadow insurance setting, we study the interplay between tax and nontax incentives in income shifting. Shadow insurance involves intercompany transactions designed to help firms meet regulatory capital requirements. However, prior to the Tax Cuts and Jobs Act of 2017 (TCJA), foreign-owned life insurance firms could save taxes by using shadow insurance to shift U.S. profits to tax havens. Consistent with expectations, we find that while nontax incentives appear to be the dominant factor behind firms' use of shadow insurance, tax considerations also played a role for certain firms. We also find that shadow insurance is associated with lower liquid asset holdings and increased credit risk. Overall, our results suggest that taxes were an important incentive for foreign-owned life insurance firms to use shadow insurance pre-TCJA. Moreover, in this setting, nontax considerations appeared to have motivated U.S.-owned firms' use of tax havens.

Non-performing loans in European systemic and non-systemic banks

PurposeThe distinction between systemic banks (GSIBs) and non-systemic banks (non-GSIBs) is driven by policy reasons. This study aims to examine the behaviour of non-performing loans in European GSIBs and non-GSIBs from 2004 to 2013.Design/methodology/approachThe author uses regression methodology to analyse the association between non-performing loans (NPLs) and the state of the economy.FindingsThe author finds that more profitable banks witness higher NPLs regardless of them being systemic or non-systemic. Secondly, GSIBs have fewer NPLs during economic booms and during periods of increased lending, while non-GSIBs experience higher NPLs during periods of increased lending. The author also observes that European non-GSIBs that exceed regulatory capital requirement also experience higher NPLs. In the post-crisis period, there is a significant and negative relationship between NPLs and the economic cycle for GSIBs in the post-financial crisis period and a significant and positive relationship between NPLs, loan supply and bank profitability for GSIBs in the post-financial crisis period; on the other hand, there is a significant and negative relationship between NPLs and regulatory capital ratios for non-GSIBs in the post-financial crisis period and a significant and positive relationship between NPLs and bank profitability for non-GSIBs in the post-financial crisis period. The findings have implications.Originality/valueTo the best of the author’s knowledge, the literature on the determinants of NPL has not empirically examined the behaviour of NPLs in European GSIBs and non-GSIBs. This paper examines this issue to provide insights to help policymakers and academics understand the peculiarities of NPLs in Europe.

White Paper: How Malaysian Banks can Elevate B40 and MSME Lending

The B40 (Bottom 40% of Household Income) and MSME (Micro Small Medium Enterprise) are a critical component of the Malaysian economy and financial system. They are supported by a complex financial market ecosystem. MSMEs tend to lack financial market and technological sophistication and demand for external financing is driven by mature firms typically older than 5 years. Younger firms rely on personal savings and informal financing networks. There are opportunities in the domestic market for lenders to overcome known supply-side impediments. Malaysia’s situation is not unique. Internationally, while shifting demand and supply side impediments affect MSME access to finance, credit supply side factors dominate. Since most MSMEs are family owned firms, agency considerations may also underpin the preference for external financing by informal or private lenders. However, in the post Global Finance Crisis setting, supply-side impediments have provided the funding opportunity for alternative non-bank financial intermediaries. In the European Union, which has the benefit of a single currency, the alternative finance market is growing. Importantly, participation is characterized by younger and more financial literate and technology savvy borrowers. In Malaysia, well known demand and supply-side impediments along with poor technical infrastructure and financial literacy, especially in remote and agriculturally based areas, limit what is easily achieved in terms of expanding the B40 and MSME loan portfolio. Option-like risk management products could also be made available to reduce earnings volatility and improve credit quality, especially for MSMEs, although these will need to be designed (in the case of Malaysia) to be shariah compliant. Demand side improvements could focus on improving the bank-customer relationship with engagement at the early business stage, while supply side improvements could focus on alternate methods of credit scoring and more granular loan segmentation, especially for urban-based B40 borrowers. Nonetheless, there is still scope for innovative financing solutions for loan book growth using (a) partnerships with digital data providers and Fintech operations; (b) underwriting lending services directly by government; and (c) indirectly through the reevaluation of current regulatory capital requirements that further support B40 and MSME lending. Also, a more activist banking agenda including community outreach could form the centerpiece of any new lending strategy to support a financially inclusive society.

The Effects of Regulatory Capital Requirements and Ownership Structure on Bank Lending in Emerging Asian Markets

This study examines the impact of regulatory capital requirements and ownership structure on bank lending in Emerging Asian Markets. The findings of the study imply that banks with excess capital are less affected by capital constraints and enjoy opportunities to extend their credit portfolios. The monitory policy indicator has the expected negative and significant impact on bank lending. In case of well-capitalized banks, the interaction between the excess capital and monetary policy indicator has a significant positive relation with bank lending, which means that banks with excess capital have capability to raise uninsured financing and shield their loan portfolios as compared to less-capitalized banks that reduce their lending in the period of monetary tightening. In the case of bank ownership structure, banks with excess capital ratios and ownership concentration lead towards an increase in lending activity. The findings also show that well-capitalized banks with managerial ownership tend to reduce lending which validates agency theory of corporate governance.

Financial Intermediaries as Suppliers of Housing Quality

I show how financial intermediaries affect rental housing quality and affordability by supplying real estate investors with financing for quality improvement projects (i.e., renovations). First, I document a historic surge in improvement activity since the Great Recession. Then, using exogenous variation generated by a 2015 change in regulatory capital requirements, I find that a reallocation of bank credit toward improvement projects accounts for 24% of quality improvements since 2015. The shock increases the supply of high-quality apartments and lowers their rent. However, it raises the average apartment's rent and accounts for 32% of historically high rent growth over 2015-16.

A Dynamic Model of Endogenous Bank Capital Buffer

We develop a dynamic model of endogenous bank capital choice in which banks cannot access the equity market to raise capital in some states due to equity market frictions. In these frictional states, banks with a shortage in bank capital need to choose between shrinking their relationship lending and eating up their capital buffer to meet the capital requirements. Our model suggests that a typical bank will try to keep valuable relationship lending and prefer to eat up capital buffers first. Intertemporally, this effect also leads to banks keeping capital buffers above the regulatory capital requirement. Thus in the aggregate, our model quantitatively shows that capital requirements alleviate credit rationing in bad states of the economy by inducing a higher endogenous bank capital buffer which effectively insures the banks from bankruptcy, and hence reducing bankruptcy rate and the associated credit supply loss.

Reserve Capital buffer as an Instrument of Macroprudential Policy

The analysis of Basel III main provisions shows that within the macroprudential policy, increasing the financial stability of the banking sector is achieved by growing the capital of banks and creating new tools to solve short-term liquidity problems. The proposed measures seem well developed, except one fact — the quantitative values of the regulatory requirements for growing the bank capital are insufficient to achieve the macroprudential policy objectives. This study aims to develop analytical tools allowing to form quantitative objectives of the macroprudential policy and to deliver them by streamlining the capital requirements of banks. The methods of comparative and GAP analyses were used in the study. The empirical analysis was performed with the data on the Russian stock index IMOEX dynamics, the data from the reports by the Bank of Russia and financial reports of systemically important Russian banks. According to the study results, a quantitative strategic objective of the macroprudential policy in the Russian Federation was determined, a gradual increase in the capital adequacy ratio of Russian banks to 40% was proposed, a calendar plan was developed to achieve the strategic objective stagewise in 10 years, and banks are realistic in achieving this objective. As a regulatory instrument to grow the capital adequacy of banks according to the target level, it is proposed to use an additional regulatory capital requirement in the form of a reserve buffer of a dynamic and adaptive nature. The empirical analysis of the possibilities and consequences of a new regulatory instrument application proved the expediency of its introduction to improve the effectiveness of the macroprudential policy in the Russian Federation.

Regime switching dynamic correlations for asymmetric and fat-tailed conditional returns

A non-Gaussian multivariate regime switching dynamic correlation model for financial asset returns is proposed. It incorporates the multivariate generalized hyperbolic law for the conditional distribution of returns. All model parameters are estimated consistently using a new two-stage expectation–maximization algorithm that also allows for incorporation of shrinkage estimation via quasi-Bayesian priors. It is shown that use of Markov switching correlation dynamics not only leads to highly accurate risk forecasts, but also potentially reduces the regulatory capital requirements during periods of distress. In terms of portfolio performance, the new regime switching model delivers consistently higher Sharpe ratios and smaller losses than the equally weighted portfolio and all competing models. Finally, the regime forecasts are employed in a new dynamic risk control strategy that avoids most losses during the financial crisis and vastly improves risk-adjusted returns.