Regulatory Capital Requirements Research Articles

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.

The AnaCredit regulation is in place — a reflection on data-driven reporting: What has been achieved by the banks and regulators, and what remains to be done?

By introducing the AnaCredit regulation, the European Central Bank (ECB) has taken the concept of data-driven regulatory reporting to an unprecedented level. In addition to an everincreasing burden of traditional template-based reports serving both supervisory and statistical purposes, credit institutions of the Euro area are requested to deliver micro-data on a loan-by-loan and borrower-by-borrower level on a monthly and quarterly basis. The data are compiled according to precise definitions and organised into an entityrelationship model. This innovative approach to data collection within the banking sector is premised on the following principles: any aggregated data can be obtained from granular data, but the reverse is not true — granular data enabling both drill-down and roll-up analysis; in order to be comparable, data need to be harmonised and standardised by way of common definitions and standards; data are of better quality when they are organised in a model reproducing business reality and input systems to the greatest extent possible; top-down indicators calculated from granular data are not necessarily known in advance as new indicators can emerge from correlations observed between the underlying data. This approach should alleviate the reporting burden put on credit institutions since it will be possible to compute new macro-prudential indicators from data that have already been collected. Ultimately, and to the extent that rules for data dissemination across the national and European authorities allow, it could also establish a bridge between statistical and supervisory needs, since numerous breakdowns required in templates forming part of the Capital Requirements Regulation (CRR)/ Capital Requirements Directive (CRD) IV package or in short-term exercises could be derived from AnaCredit data in a bottomup approach — or, AnaCredit data could be used as an analytical tool for supervisors. This paper explores, by illustrative examples, how some of the caveats of the AnaCredit regulation, from its conception to its application, may impede the fulfilment of its double objective with regards to the collection of high-quality granular credit data across the Euro area and to the reduction of the reporting burden. It concludes with a discussion of the necessity to break down the remaining silos within banks but also within national and European authorities, and to pursue the work initiated on a larger scale through initiatives such as the Banks’ Integrated Reporting Dictionary (BIRD) and the Integrated Reporting Framework (IReF).

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.

Parametric, Non-Parametric and Multivariate Analysis of Capital Structure During the Financial Crises in Jordanian Banks

Motivations: This research seeks to analyze the determinants of capital structure of the banking sector in Jordan taking into consideration bank business model (Islamic versus Commercial bank). The research also sheds light on the financial crises of 2007/2008 and its impact on the financing decision in the banking sector.Novelty: Although the topic of capital structure's determinants is well studied in non-financial firms, very few studies considered the financial firms, namely banks. Since the nature of operations and capital components for banks are totally different this research comes to fill the gap in the banking literature.Methodology and Methods: The study uses multivariate regression techniques of panel data besides the parametric and non-parametric analysis. Three measurements of capital structure are considered: leverage ratio, long term debt ratio and short-term debt ratio, the explanatory variables are included in two sets, bank specific characteristics and economic characteristics.Data and Empirical Analysis: Balanced panel data set was formed for 27 Jordanian banks during the period of 2003-2015. Empirically, the findings suggest a variation of capital structure determinants based on the variable of measurement. However, the analysis confirms that bank's profitability and bank's risk are major components of the capital structure decision regardless of its measurement variable. In addition to these two variables, liquidity, growth and taxes are important variable in the short-term debt financing, and retained earnings is important to the long-term financing. Empirically proven that Jordanian banks' capital structure decision is affected by the global financial crisis 2007/2008 and by bank type. Jordanian banks might differ in size, but this doesn't affect their policies toward the capital structure. The empirical results are consistent with the pecking order theory that profitable firms prefer to use more of their internal sources of funds rather than debt financing.Policy Implications: Due to the importance of the capital structure decision for banks and non-banks firms and based on our finding, the policy makers in Jordan and may in other similar countries should pay attention to capital requirement regulations as the determinants of leverage among banks are different based on the business model whether commercial or Islamic.

Regulatory Capital Management: Fair Value Measurement and Regulatory Capital Ratios

Abstract The calculation of the regulatory capital ratios according to the Capital Requirements Regulation (CRR) is based on the IFRS consolidated financial statements. Therefore, banks are able to influence their regulatory capital ratios through discretionary powers when measuring with fair values according to IFRS 13. This paper analyzes the effects that discretionary fair value changes have on the regulatory capital ratios. Furthermore, the impact of the prudent valuation according to article 105 CRR on the regulatory capital ratios is examined. While the results depend on a multitude of factors and vary from case to case, there are situations in which the same fair value change of an identical financial asset can have opposing effects on certain regulatory capital ratios depending on bank specific factors like its regulatory capitalization or its tax rate. As a result, decreasing fair values can in some circumstances lead to higher regulatory capital ratios and thus, indicate a greater solvency. In order to identify possible conflicts of interest, the effects of fair value changes on the comprehensive income are also included in the analysis because the comprehensive income serves as an important target figure for banks in addition to the regulatory capital ratios. JEL Classification: F380, G380, M410, M480

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.

Bank response to policy-related changes in capital requirements

We estimate how banks respond to regulatory capital requirements. We use a novel measure called capital surplus/shortfall, which we construct from notifications on regulatory capital requirements sent to Slovenian banks over the period 2009–2015. Capital surplus/shortfall is more relevant than capital adequacy ratio (CAR). It conveys more information about future lending because it is a forward-looking measure of bank capitalization. Our paper carries policy implications for supervisors in countries with a distressed banking sector. Using this measure we show that the same firm has on average a 3.54 p.p. lower loan growth when the loan is obtained through a bank with 1 p.p. higher capital shortfall. Finally, we show that in response to an increase in capital requirements banks engage in risk-taking behaviour.

IFR/IFD: Practical implications of a new prudential regime for principal trading firms

The Investment Firm Regulation and Directive package (IFR/IFD) presents a unique opportunity to design a bespoke European prudential regime for investment firms, including principal trading firms. Principal trading firms trade financial instruments for their own account and own risk and do not hold or manage client assets or money. The current Capital Requirements Regulation and Directive (CRR/CRDIV) were designed for banks and incorrectly assess risks connected to investment firms (such as trading firms). These types of firms have fundamentally different balance sheets, portfolios, holding periods and business models to which current metrics are not very well attuned. Although IFR’s methodologies are quite elegant in prescribing required capital for an incredibly diverse population of over 6,500 investment firms in Europe, there remain quite a few issues to be resolved. This is important because if metrics are implemented incorrectly, they may limit liquidity provision and risk transfer in the financial markets, thus affecting stability. Addressing these key elements will bring IFR/IFD closer to the policy intent to simplify and better tailor capital requirements, and other prudential requirements, to investment firms in order to make European markets more secure and more competitive.

Pricing Contingent Convertibles: A Derivatives Approach

This article provides an in-depth analysis of pricing and structuring of contingent convertibles (CoCos). These debt instruments convert into the equity of the issuing bank or suffer a write-down of the face value upon the appearance of a trigger event. This trigger mechanism provides an automatic strengthening of the capital structure of the bank. Equity is in this case injected on the very moment the bank is failing to meet the minimum regulatory capital requirements or when it is heading towards a state of non-viability. In this paper the pricing of CoCos is handled using two different approaches. The first approach starts from a credit derivatives background. A second approach tackles the pricing and structuring of a CoCo as an equity derivatives problem. Both models are applied on the CoCos issued by Lloyds and Credit Suisse and allow to quantify the risks embedded within each of these structures.

A Flexible Regime Switching Model for Asset Returns

A non-Gaussian multivariate regime switching dynamic correlation model for fi nancial 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 dynamic risk control strategy that avoids most losses during the fi nancial crisis and vastly improves risk-adjusted returns.

The Basel Capital Requirement, Lending Interest Rate, and Aggregate Economic Growth: An Empirical Study of Viet Nam

In recent years, the Vietnamese economy has shown signs of financial distress, and especially small banks have experienced serious liquidity and solvency problems. Based on the new policy of the State Bank of Vietnam, in order to ensure safe and effective banking operations, the Basel II accord will be widely applied to the whole banking system by 2018. This paper investigates the effects of the Basel II capital requirement implementation in Viet Nam on the bank lending rate and national output. The paper provides a theoretical framework as well as empirical model by developing a Vector Error Correction Model (VECM) over the period 2018 to 2016 by employing three groups of indicators (macroeconomics, banking, and monetary). The main finding of the paper is that at the bank level, a tightening of regulatory capital requirements does not induce a higher lending rate in the long run. Also, changes in micro-prudential capital requirements on banks have statistically significant spillovers on the GDP growth rate in the short term; yet, their effects significantly lessen over a longer period.

Agency Conflicts, Bank Capital Regulation, and Marking-to-Market

ABSTRACTWe show how shareholder-debtholder agency conflicts interact with strategic reporting under asymmetric information to influence bank regulation. Relative to a benchmark unregulated economy, higher capital requirements mitigate inefficient asset substitution, but potentially exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances distortions created by agency conflicts and asymmetric information while incorporating the social benefit of bank debt. Asymmetric information and strategic reporting only impact regulation for intermediate social debt benefit levels. For lower social debt benefits in this interval, regulatory capital requirements are insensitive to accounting reports, so bank balance sheets need not be marked to market to implement the optimal regulatory policy. For higher social debt benefits, however, capital requirements are sensitive to accounting reports, thereby necessitating mark-to-market accounting to implement bank regulation. Mark-to-market accounting is essential when bank leverage levels are high, and is more likely to be necessary as banks' asset risk or specificity increases.

Influence of regulatory capital requirements on the self-financing capacity of a banking company

Influence of regulatory capital requirements on the self-financing capacity of a banking company

A Dynamic Model of Bank Behaviour under Multiple Regulatory Constraints

We develop a dynamic structural model of bank behaviour that provides a microeconomic foundation for bank capital and liquidity structures and analyses the effects of changes in regulatory capital and liquidity requirements as well as their interaction. Our findings suggest that adjustments in both types of requirements can have an impact on loan supply, with considerable heterogeneity across banks and over time. The model illustrates that banks' reactions depend on initial balance sheet conditions and reconciles evidence on short-term reductions in loan supply with findings suggesting that better capitalized banks are better able to lend in the medium- to long-term. JEL Classification: G21, G28, G32

Macroprudential Regulation and Financial System (In)Stability – Regulatory Banking (Basel) & Insurance (Solvency) Capital Standards and Endogenous Destabilising Effects

The objective of this paper is to evaluate the extent to which the design of regulatory banking and insurance capital standards (Basel II/III and Solvency II) provide incentives for endogenously‐generated destabilising effects to the financial system. The literature has identified three areas whereby capital standards can be the source of endogenous financial instability, namely increased asset concentration, regulatory arbitraging, and capital standards procyclicality. We developed an empirical model that calculates regulatory capital requirements and associated metrics for a stylised balance sheet across banking and insurance regulatory frameworks and evaluated the three aforementioned areas in the context of financial system‐wide financial stability, rather than in each sector individually. We find that the design of regulatory capital standards can be the source of endogenous destabilising effects due to incentives for increased asset concentration and capital standard procyclicality. The support for the capital arbitraging hypothesis was weaker. We have concluded that the design of the Basel and Solvency regulatory capital frameworks, while designed to strengthen the stability of each sector individually, may ultimately incentivise behaviours across the banking and insurance industries that give rise to endogenously‐generated financial system‐wide instability, even though they are intended to reduce it.