Risk-based Capital Requirements Research Articles

Dynamic volatility regulation of financial institutions

Unlike non-financial firms, financial institutions are often heavily regulated to prevent bankruptcies and negative spillovers. A main regulatory tool is risk-based capital requirements. To reflect this reality, we develop a model that allows for dynamically updated asset risk, in contrast to standard contingent claim models that assume constant volatility. Regulators impose a decrease in asset volatility when the capital cushion becomes small, thereby reducing the risk of distress. We show that such regulation of financial institutions affects their credit spreads, credit ratings, transition matrices, valuation of liabilities, cost of deposit insurance, and risk-shifting incentives.

The Generalised Pareto Distribution Model Approach to Comparing Extreme Risk in the Exchange Rate Risk of BitCoin/US Dollar and South African Rand/US Dollar Returns

Cryptocurrencies are said to be very risky, and so are the currencies of emerging economies, including the South African rand. The steady rise in the movement of South Africans’ investments between the rand and BitCoin warrants an investigation as to which of the two currencies is riskier. In this paper, the Generalised Pareto Distribution (GPD) model is employed to estimate the Value at Risk (VaR) and the Expected Shortfall (ES) for the two exchange rates, BitCoin/US dollar (BitCoin) and the South African rand/US dollar (ZAR/USD). The estimated risk measures are used to compare the riskiness of the two exchange rates. The Maximum Likelihood Estimation (MLE) method is used to find the optimal parameters of the GPD model. The higher extreme value index estimate associated with the BTC/USD when compared with the ZAR/USD estimate, suggests that the BTC/USD is riskier than the ZAR/USD. The computed VaR estimates for losses of $0.07, $0.09, and $0.16 per dollar invested in the BTC/USD at 90%, 95%, and 99% compared to the ZAR/USD’s $0.02, $0.02, and $0.03 at the respective levels of significance, confirm that BitCoin is riskier than the rand. The ES (average losses) of $0.11, $0.13, and $0.21 per dollar invested in the BTC/USD at 90%, 95%, and 99% compared to the ZAR/USD’s $0.02, $0.02, and $0.03 at the respective levels of significance further confirm the higher risk associated with BitCoin. Model adequacy is confirmed using the Kupiec test procedure. These findings are helpful to risk managers when making adequate risk-based capital requirements more rational between the two currencies. The argument is for more capital requirements for BitCoin than for the South African rand.

RiskMetrics method for estimating Value at Risk to compare the riskiness of BitCoin and Rand

In this study, the RiskMetrics method is used to estimate Value at Risk for two exchange rates: BitCoin/dollar and the South African Rand/dollar. Value at Risk is used to compare the riskiness of the two currencies. This is to help South Africans and investors understand the risk they are taking by converting their savings/investments to BitCoin instead of the South African currency, the Rand. The Maximum Likelihood Estimation method is used to estimate the parameters of the models. Seven statistical error distributions, namely Normal Distribution, skewed Normal Distribution, Student’s T-Distribution, skewed Student’s T-Distribution, Generalized Error Distribution, skewed Generalized Error Distribution, and the Generalized Hyperbolic Distributions, were considered when modelling and estimating model parameters. Value at Risk estimates suggest that the BitCoin/dollar return averaging 0.035 and 0.055 per dollar invested at 95% and 99%, respectively, is riskier than the Rand/dollar return averaging 0.012 and 0.019 per dollar invested at 95% and 99%, respectively. Using the Kupiec test, RiskMetrics with Generalized Error Distribution (p > 0.07) and skewed Generalized Error Distribution (p > 0.62) gave the best fitting model in the estimation of Value at Risk for BitCoin/dollar and Rand/dollar, respectively. The RiskMetrics approach seems to perform better at higher than lower confidence levels, as evidenced by higher p-values from backtesting using the Kupiec test at 99% than at 95% levels of significance. These findings are also helpful for risk managers in estimating adequate risk-based capital requirements for the two currencies.

Stability versus Volatility: Hungarian Experiences with the First Five Years of Solvency II Regarding Quantitative Elements

It has been more than five years since the introduction of the Solvency II framework (S2), which determines how insurers should operate in Europe, and this allows for a detailed analysis of Hungarian developments. The new approach in S2 that makes it similar to banking regulation, including the market-consistent valuation principles and the application of a risk-based capital requirement, has stood the test of time in recent years: the various shocks did not undermine the stability of the Hungarian sector. This was largely due to the recommendation of the central bank of Hungary (Magyar Nemzeti Bank, MNB) on holding a volatility capital buffer. This is because the robust capital position of the sector as a whole has been maintained in the context of 50–100-basis point reductions in capital adequacy levels in certain individual cases, which justifies the use of the capital buffer. The balanced capital position was also influenced by the conservative investment strategy, which resulted in one of the lowest market risk exposures in Europe, against the backdrop of huge government securities holdings, even by international standards.

Capital, aggregate risk, insurance prices and regulation

We develop a general equilibrium model of competitive insurance and equity capital markets to show how aggregate asset and insurance liability risks affect insurance prices and regulation. In the unique equilibrium of the benchmark unregulated economy, insurers raise external capital solely by selling insurance and no outside equity. We derive the Pareto efficient allocation and implement it via multiple regulatory policies that combine risk-based capital requirements, asset risk constraints, reinsurance and bailouts. An efficient regulatory policy with a lower capital requirement must be accompanied by a more stringent asset risk constraint, and one with a capital requirement that is more sensitive to insurer assets should be less sensitive to insurer liabilities. When the aggregate asset and liability risks are below respective thresholds, insurees are fully insured in the optimally regulated economy, and the set of efficient regulatory policies does not vary with aggregate risk. Outside this region, however, insurees must bear aggregate risk with capital and asset risk constraints becoming tighter as either the aggregate asset or liability risk increases. The aggregate asset and liability risks could have opposing effects on the insurance price and insurer size in the regulated economy. Our results highlight the importance of tailoring regulatory policies to aggregate risk levels, and disentangling the impacts of aggregate asset and liability risks in analyses of how regulation influences insurance prices and insurer capitalization.

PRICING LONGEVITY-LINKED SECURITIES IN THE PRESENCE OF MORTALITY TREND CHANGES

ABSTRACTEven though the trend in mortality improvements has experienced several permanent changes in the past, the uncertainty regarding future mortality trends is often left unmodeled when pricing longevity-linked securities. In this paper, we present a stochastic modeling framework for the valuation of longevity-linked securities which explicitly considers the risk of random future changes in the long-term mortality trend. We construct a set of meaningful probability distortions which imply equivalent risk-adjusted pricing measures under which the basic model structure is preserved. Inspired by risk-based capital requirements for (re)insurers, we also establish a cost-of-capital pricing approach which then serves as the appropriate reference framework for finding a reasonable range for the market price of longevity risk. In a numerical application, we demonstrate that our model produces plausible risk loadings and show that a greater proportion of the risk loading is allocated to longer maturities when the risk of random future mortality trend changes is adequately modeled.

Salience, systemic risk and spectral risk measures as capital requirements

This paper evaluates the effectiveness of macroprudential capital requirements in the form of market risk measures in alleviating systemic risk, fire sales, and welfare losses in crisis resolution. We develop a general equilibrium, heterogeneous agent model with financial institutions subject to risk-based capital requirement constraint and compare the benchmark Value at Risk to three spectral risk measures. The key idea of alternative regulation is probability weighting, by which regulators overweight outcomes that are salient to them relative to their objective probabilities. We show that prudential instruments based on solely overweighting of tail market losses are preferable for policymakers aiming to reduce the likelihood of systemic crises. Overweighting both the downside and upside risks increases household welfare, but results in the financial sector’s risk-seeking preferences and exacerbates the systemic risk. The results suggest that overweighting worst-case and best-case outcomes can prevent fire sales, while overweighting intermediate outcomes leads to welfare improvements of the financial sector after uncertainty shocks.

Analysis of the Proposed 2020 FHFA Rule on Enterprise Capital

ABSTRACT This article examines the Federal Housing Finance Agency (FHFA)’s 2020 notice of proposed rulemaking (2020 NPR) for the government-sponsored enterprises’ capital standards and finds that there are several issues of concern that will distort the relationship between capital and risk. We urge FHFA to better tailor its proposed risk-based capital requirements to the risk and mission of these monoline entities and rely less heavily on a Basel-like framework. We offer a package of specific adjustments that will better align capital with risk, without reducing the overall rigor or stringency of the capital standard. Better tying capital to risk will result in a better regulated and stronger mortgage finance system.

The Moderating Effects of Capital Regulation and Supervisory Power on the Risk-Sensitivity of Bank Capital Requirements

Based on bank data from 61 of the largest banks in Asia and the Middle East, this paper presents an analysis of the effects that capital regulation and stringent supervisory actions have on the extent to which bank capital requirements are risk sensitive. While bank-specific factors, namely banks’ buffer, deposit, loans and supervisory power, are statistically-significant, there is no clear evidence to prove that capital regulation and GDP growth rate affect the risk sensitivity of banks. Using a robust one-step system GMM estimator, our results indicate that stricter supervisory power combined with capital regulatory regimes does enhance the risk sensitivity of banks. Our findings have two policy implications. First, the extent to which risk-based capital requirements are effective at controlling bank risk acts independently of the capital requirements set by authorities. Second, bank-specific factors have a more significant impact on risk at the bank level than external factors. To supervise and manage bank-risk level, there is a distinct requirement, at least in emerging economies, for regulators to monitor the operation and performance of banks in addition to verifying their compliance with capital requirements.

Central Banks and Climate Change

Central banks are increasingly called upon to address climate change. Proposals for central bank action on climate change range from programs of “green” quantitative easing to increases in risk-based capital requirements meant to deter banks from lending to climate-unfriendly business. Politicians and academics alike have urged climate risk as both macroeconomic and financial stability risk. Relative to counterparts abroad, the U.S. central bank—the Federal Reserve—has been more measured in its response. This Article offers a legal explanation why. It urges that, despite the substantive importance of climate change, the U.S. Federal Reserve presently has relatively limited legal authority to address that problem head-on. Drawing on insights from corporate finance and macroeconomics, the Article constructs a legal framework—stitching together a variety of Fed laws, regulations, and precedents of practice—to discern why many aspects of climate change sit outside the Fed’s legal remit today. Ultimately, the Article tackles one of the most pressing rule-of-law questions facing the Fed today: What are the limits of the Fed’s mandates to address climate change and how far can the Fed press beyond those mandates to make the economy greener? In doing so, the Article prompts reflection on the ideal role of the Fed vis-a-vis the fiscal authority of the Treasury, the political actors in Congress, and the Chief Executive.

On Regulation and Excess Reserves: The Case of Basel III

Recent studies suggest liquidity regulation contributed to the rise in excess reserves, but capital regulations may matter, too. We use a simple model to show that banks may tilt portfolios away from higher risk-weighted assets like loans and toward lower risk-weighted assets like reserves and Treasuries in response to higher risk-based capital requirements, but not in response to higher non-risk-based capital requirements. Empirical results suggest that advanced approaches banks, which were the focus of Basel III capital regulations that preceded Basel III liquidity regulations, held more excess reserves than smaller large banks after the regulatory changes, before later substituting Treasuries for these reserves.

Efficiency, productivity and competitiveness of the Malaysian insurance sector: an analysis of risk-based capital regulation

Risk-based capital is used to specify minimum capital requirements for insurers, but it can also cause insurers to bear higher risk if the actual risk of an asset is improperly assessed. This study investigates the efficiency, productivity and competitiveness of the Malaysian insurance industry. The usefulness of regulatory policies will be studied, with particular focus on the risk-based capital framework. This study includes all insurance firms operating in Malaysia between 2000 and 2017. Data envelopment analysis, Malmquist productivity index and Panzar–Rosse methodologies are employed. The findings indicate that life insurers are more efficient and competitive than general insurers. There is a deterioration in the efficiency and productivity of conventional insurers following implementation of risk-based capital requirements. The risk-based capital for Takaful framework, however, improves Takaful insurers’ efficiency and productivity. The findings have implications for business strategy development, such as the level of restrictions on insurance operations. General insurers are recommended to employ technology-enhancing pricing and claims systems to increase efficiency.

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.

Leverage Ratio: Micro Evidence of the Backstop Function to Risk-based Capital Requirements

I provide empirical evidence of how banks conceal their actual leverage risk on reporting days at the end of the quarter following the introduction of the leverage ratio (LR) public disclosure. Using a novel dataset of wholesale deposit transactions, I show that the intended backstop function of the LR to prevent the excessive build-up of leverage risk is generally effective. However, EU Banks, which follow a reference day calculation approach of the LR, that are relatively more constrained by the LR requirement than the risk-based capital requirement and are also close to the minimum LR requirement significantly contract their balance sheets by reducing short-term wholesale deposits at quarter-ends. They repay wholesale liabilities by reducing their loan holdings. At the same time, such banks increase the risk of the loan portfolio by originating higher-yielding loans.

PROPERTY RISK UNDER SOLVENCY II: EFFECTS OF DIFFERENT UNSMOOTHING TECHNIQUES

Solvency II imposes risk-based capital requirements on EU insurance companies. This paper evaluates the property risk standard model proposed. The calibration was performed from the IPD UK monthly index total returns for the period between December 1986 and December 2009. In general, it is considered that returns derived from valuation-based indices are smoother than those derived from transaction-based indices. This paper contributes to the existing literature by applying various unsmoothing techniques to this index. The results show that the capital requirements, applying the same calculation method (historical value at risk at the 99.5% confidence level) as in the calibration of the standard model, are generally bigger than those proposed in the standard model of Solvency II.

Sovereign Risk Spill-Overs to Banking Sectors in Central America and the Caribbean

Banking regulations (such as, risk-based capital framework and reserve requirements) have had the unintended consequence of incentivizing banks to hold more sovereign debt on their balance sheets than suggested by their strategic motives. As a result, bank stability now depends more heavily than before on the creditworthiness of governments. Despite this new reality, the impact of sovereign credit ratings on bank stability is still hotly debated in the Financial Economics literature. As this debate ensues little is known about the impact of sovereign credit ratings on bank stability in the Central American and Caribbean context, where sovereign debt crises have been frequent. This paper, therefore, examines the impact of sovereign credit ratings on bank stability as measured by non-performing loans (NPLs), in the Central American and Caribbean region. We use bank data on 24 countries from Central America and the Caribbean spanning the period from 1998–2014. Our results highlight the presence of a significant impact of sovereign rating downgrades on bank stability. The risk spill-over is particularly pronounced in countries that are externally vulnerable, measured by the degree of global exposure, and where financial disclosure requirements are weak. This strongly supports the global coordinated approach on macroprudential oversight.

Mortality risks, reinsurance and risk-based supervision

Under risk-based supervision, mortality risks are generally considered proportional to the number of insured lives (N). This assumption is, however, incorrect for volatility mortality risks (this being the key justification for life insurance), as this risk is proportional to √N. The main benefits of reinsurance are consequently not properly reflected in the risk-based capital requirements under risk-based supervision Pillar 1. Similar findings apply to unexpired risks, also called ‘premium risks’, in non-life insurance. In this article, volatility risks shall therefore be thoroughly considered in the formulation and assessment of the insurer’s reinsurance policy, i.e., under risk-based supervision Pillar 2.Keywords: Risk-based supervision; mortality risks; volatility; minimum capital requirements; normal power approximation; reinsurance

Regulating bank leverage

PurposeThis paper aims to study the design of bank capital regulation and points out a conceptual downside of risk-sensitive regulation. The author argues that when a bank is better informed about its risk than the regulator, designing regulation is subject to the Lucas critique. The second-best regulation could be risk-insensitive, which provides an explanation for the leverage ratio as a backstop to risk-based capital requirements. This paper offers empirical predictions and implications for policy.Design/methodology/approachThe argument in the paper is based on analytical results from mechanism design.FindingsOptimal bank regulation could be risk-insensitive, as is observed in practice in the form of the leverage ratio rule.Originality/valueCounter to conventional wisdom, the paper argues and provides a new explanation for why bank regulation should not be sensitive to the risk of the bank. The paper then offers empirical predictions and implications for policy.

Half-full or Half-empty? Financial Institutions, CDS Use, and Corporate Credit Risk

We construct a novel U.S. data set that matches bank holding company credit default swap (CDS) positions to detailed U.S. credit registry data containing both loan and corporate bond holdings to study the effects of banks' CDS use on corporate credit quality. Banks may use CDS to mitigate agency frictions and not renegotiate loans with solvent but illiquid borrowers resulting in poorer measures of credit risk. Alternatively, banks may lay off the credit risk of high quality borrowers through the CDS market to comply with risk-based capital requirements, which does not impact corporate credit risk. We find new evidence that corporate default probabilities and downgrade likelihoods, if anything, are slightly lower when banks purchase CDS against their borrowers. The results are consistent with banks using CDS to efficiently lay off credit risk rather than inefficiently liquidate firms.

Do higher capital standards always reduce bank risk? The impact of the Basel leverage ratio on the U.S. triparty repo market

Abstract While simpler than risk-based capital requirements, the leverage ratio may encourage bank risk-taking. This paper examines the activity of broker-dealers affiliated with bank holding companies (BHCs) and broker-dealers not affiliated with BHCs in the repurchase agreement (repo) market to test whether this may be occurring. Using data on the triparty repo market, the paper arrives at three findings. First, following the 2012 introduction of the supplementary leverage ratio (SLR), broker-dealer affiliates of BHCs decreased their repo borrowing but increased their use of repo backed by more price-volatile collateral. Second, the paper finds that regardless of whether a U.S. BHC-affiliated broker-dealer parent is above or below the SLR requirement, the announcement of the SLR rule has disincentivized those dealers affiliated with BHCs from borrowing in triparty repo. Finally, the paper finds an increase in the number of active nonbank-affiliated dealers in certain asset classes of triparty repo since the 2012 introduction of the supplementary leverage ratio. This illustrates how regulation can have competitive effects on the financial sector and may result in activities shifting among financial firms.