Risk-weighted Assets Research Articles

Adjusting denominators of capital ratios: Evidence from Japanese banks

This study examines Japanese banks’ behavior of adjusting denominators of capital ratios upon the introduction of Basel II regulations. The first analysis investigates the adjustments to the size and composition of portfolios to achieve the target risk-weighted asset (RWA). The second analysis investigates how quickly banks adjust the numerator and denominator of their capital ratio. We find evidence that banks adjusted the composition of their assets faster than their asset size to achieve the RWA targets under the macroeconomic and institutional conditions in Japan. In addition, we find that banks adjusted their level of regulatory capital faster than their RWAs to achieve the capital ratio targets. Furthermore, we find that banks that had less capital surplus shifted their portfolio composition toward lower-risk assets without reducing the total assets. The analyses provide policy implications for the time-varying minimum standards of Basel III.

The Credibility of European Bankss Risk-Weighted Capital: Structural Differences or National Segmentations?

Supranational institutions, academics and market analysts have increasingly questioned the reliability of bank risk-weighted assets (RWAs), a cornerstone of the system of minimum capital ratios designed by the Basel Committee on Banking Supervision. In fact, significant differences can be found in the banks’ average risk weights, both over time and across countries. Such differences can be explained by several factors, some of which may reflect the actual risk content of bank’s assets, while others may conceal distortions due to “RWA tweaking” and supervisory segmentations. We analyze a sample of 50 large European banks between 2008 and 2012 and document several meaningful findings. First, risk weights are affected by the banks’ size, business model and asset mix. Second, the adoption of internal ratings based (IRB) approaches is (as expected) a powerful driver of bank risk-weighted assets. Third, lower risk weights are positively linked to the banks’ capital cushion. Fourth, IRB adoption is more widespread in countries where supervisory capture is potentially stronger, due to a banking industry that is both larger (compared to GDP) and concentrated. Fifth, regulatory risk weights are not disconnected from market-based measures of bank risk.

Risk-based capital regulation revisited: evidence from the early 2000s

Purpose – The purpose of this study is to replicate Avery and Berger’s (1991) analysis using data from 2001 through 2011. Although risk-based capital (RBC) regulation is a key component of US banking regulation, empirical evidence of the effectiveness of these regulations has been mixed. Among the first studies of RBC regulation, Avery and Berger (1991) provide evidence from data on US banks that new RBC regulations outperformed old capital regulations from 1982 through 1989. Design/methodology/approach – Using data from the Federal Reserve’s Call Reports, the authors compare banks’ capital ratios and RBC ratios to five measures of bank performance: income, standard deviation of income, non-performing loans, loan charge-offs and probability of failure. Findings – Consistent with Avery and Berger (1991), the authors find banks’ risk-weighted assets to be significant predictors of their future performance and that RBC ratios outperform regular capital ratios as predictors of risk. Originality/value – The study improves on Avery and Berger (1991) by using an updated data set from 2001 through 2011. The authors also discuss some potential limitations of this method of analysis.

JPMorgan Chase London Whale Z: Background & Overview

In December 2011, the Chief Executive Officer and Chief Financial Officer of JPMorgan Chase (JPM) instructed the bank’s Chief Investment Office to reduce the size of its Synthetic Credit Portfolio (SCP) during 2012, so that JPM could decrease its Risk-Weighted Assets as the bank prepared to adopt the impending Basel III bank capital regulations. However, the SCP traders were also told to minimize the trading costs incurred to reduce Risk-Weighted Assets, while still maintaining the opportunity to profit from unexpected corporate bankruptcies. In an attempt to balance these competing objectives, head SCP derivatives trader Bruno Iksil suggested in January 2012 that the SCP expand a strategy first implemented in 2011 to buy large volumes of certain credit derivatives, while simultaneously selling large volumes of other credit derivatives. The strategy quickly proved unsuccessful, and JPM’s Chief Investment Officer ordered Iksil and the other SCP traders to halt this strategy on March 23. However, losses continued to mount as the credit derivative positions were unwound, ultimately reaching $6.2 billion by December 2012.

JPMorgan Chase London Whale A: Risky Business

In December 2011, the Chief Executive Officer and Chief Financial Officer of JPMorgan Chase (JPM) instructed the bank’s Chief Investment Office to reduce the size of its Synthetic Credit Portfolio (SCP) during 2012, so that JPM could decrease its Risk-Weighted Assets as the bank prepared to adopt the impending Basel III bank capital regulations. However, the SCP traders were also told to minimize the trading costs incurred to reduce Risk-Weighted Assets, while still maintaining the opportunity to profit from unexpected corporate bankruptcies. In an attempt to balance these competing objectives, head SCP derivatives trader Bruno Iksil suggested in January 2012 that the SCP expand a strategy first implemented in 2011 to buy large volumes of certain credit derivatives, while simultaneously selling large volumes of other credit derivatives. The strategy quickly proved unsuccessful, and JPM’s Chief Investment Officer ordered Iksil and the other SCP traders to halt this strategy on March 23. However, losses continued to mount as the credit derivative positions were unwound, ultimately reaching $6.2 billion by December 2012.

Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation, Capital Structure, and the Low-Risk Anomaly

Traditional capital structure theory predicts that reducing banks' leverage reduces the risk and cost of equity but does not change the weighted average cost of capital, and thus the rates for borrowers. We confirm that the equity of better-capitalized banks has lower beta and idiosyncratic risk. However, over the last 40 years, lower risk banks have not had lower costs of equity (lower stock returns), consistent with a stock market anomaly previously documented in other samples. A calibration suggests that a binding ten percentage point increase in Tier 1 capital to risk-weighted assets could double banks' risk premia over Treasury bills.

THE EFFECT OF CREDIT DERIVATIVES USAGE ON THE RISK OF EUROPEAN BANKS

Banks are the major participants in the derivatives credit markets. It was generally believed by top regulators that credit derivatives make banks sounder. After the international financial crisis, the positive view of the role of credit risk transfer has changed and credit derivatives have been blamed as one of the responsible of the subprime credit crisis. There are very few empirical works regarding this subject, but in particular in the case of the European banking sector. We use as measures of risk the Z-score, the two components, ZP1 and ZP2, and other proxies of credit risk like the risk-weighted assets and non-performing loans (NPL) ratio. In summary, our results show that European banks that use credit derivatives for hedging experience an improvement in their level of financial stability, while those who opt for a speculative position test negative. Accordingly and based on these data, the cause of the current crisis in Europe could not be directly attributed to the use of credit derivatives.

Capital and liquidity requirements: impact on bank lending spreads

This study provides an estimation of bank lending spreads in the context of new capital and liquidity requirements proposed under Basel III by constructing a stylised representative bank's financial statement. We show that the higher cost associated with an increase in the capital ratio may be recovered by increasing lending spreads. The results indicate that in the case of scheduled commercial banks, one-percentage point increase in capital ratio can be recovered by increasing the bank lending spread by 31 basis points which could go up to 100 basis points for six percentage point increase assuming that the risk-weighted assets are unchanged. We also provide the estimations for the scenarios of changes in risk-weighted assets, changes in return on equity (ROE) and the cost of debt.

Causes and Consequences of NPLs in Bosnia and Herzegovina Banking Sector

Abstract: This paper analyzes the relationship between risks to which banks are exposed, rate of non-performing loans as well as capital adequacy. The analysis was conducted among the banking sector of Bosnia and Herzegovina. For the purpose of the analysis, the International Monetary Fund data - Core Financial Indicators for the period 2008 – 2013 were used. This study differs from previous researches primarily in the fact that the case study is Bosnia and Herzegovina, where there haven't been similar studies. To analyze and evaluate the model, correlation and regression analysis were used. The paper points to those aspects which deserve further attention in order to achieve better and more efficient management of them. Results indicate the increase in risk-weighted assets and rising rates of non-performing loans as one of the component assets. At the same time the growth rate of non-performing loans leads to the growth in risk-weighted assets and therefore the bank is exposed to major risks. Higher return on assets, as an indicator of business performance and management resources and profitability, leads to capital adequacy improvement. There is a strong correlation between the rate of capital adequacy and non-performing loans and that requires further research. Results indicate that better liquidity control leads to a reduction in the rate of non-performing loans and consequently better liquidity position of banks, and thus reduction in liquidity risk. During the analysis it was found that a large proportion of non-performing loans to total loans leads to deterioration in the financial result which is further reflected in the banks' capital. When we talk about capital adequacy we come to the conclusion that the banking system in Bosnia and Herzegovina, despite all the shortcomings and problems is adequately capitalized.

Did the Czech and Slovak Banks Increase their Capital Ratios by Decreasing Risk, Increasing Capital or Both?

Abstract The average capital adequacy of Czech banks increased from 14.1% in 2009 to 17.1% in 2013. In the case of Slovak banks the figure increased even more, from 12.7% at end-2009 to 17.2% at end-2013. For the sample of the largest nine Czech and four Slovak banks we aim to identify the strategies that these banks adopted in order to increase their capital ratios. Our analysis shows that for Czech banks as with the large multi-national banks from advanced economies, increased capital has played a major role in increasing the average capital ratio. Slovak banks, in addition, significantly decreased their risk to strengthen the overall ratio. The results of our analysis are useful mainly from a regulatory point of view as in both the Czech Republic and Slovakia the countercyclical buffer is set to its minimum of 0% of risk-weighted assets and the national regulators may increase the buffer up to 2.5% in the medium or long term.

Capital Structure and Regulatory Capital of French Banks

Abstract Our paper consists mainly to shed light into the field of bank capital structure and regulatory capital. We use the panel data set of bank leverage and tier 1 capital ratio. Our dataset comprises the 172 French banks; commercial banks, cooperative banks, investment banks and saving banks covering the period of 2002 to 2012. We estimate models with generalized method of moments (GMM). Our results support both the theory of corporate finance and the buffer view, where a tendency towards the latter seems to be evident for banks. This is consistent with an effect of capital regulation on bank capital structure. We introduce also Tier 1 capital ratio as an explanatory variable to analyse the effect of capital regulation. However, Tier 1 capital total for banks seems to be increased. This implies that Risk-Weighted Assets increased, which may stem from internal model improvements. Furthermore, we show that the number of unprofitable, dividend-paying banks decreased. Our result indicates that this type of risk-shifting, where equity holders are favored over debt holders. The issuance of equity seems to be applied as a last remedy used when earnings are declining. All these findings are confirmed after taking into account an alternative measure the regulatory capital ratio in order to examine the capital regulation compliance of banks. Our finding contributes to the lack of the literature by investigating in this field of research.

OR Forum—Design of Risk Weights

Banking regulations set minimum levels of capital for banks. These requirements are generally formulated through a ratio of capital to risk-weighted assets. A risk-weighting scheme assigns a weight to each asset or category of assets and effectively functions as a linear constraint on a bank’s portfolio choice; it also changes the incentives for banks to hold various kinds of assets. In this paper, we investigate the design of risk weights to align regulatory and private objectives in a simple mean-variance framework for portfolio selection. By setting risk weights proportional to profitability rather than risk, the regulator can induce a bank to reduce its overall level of risk without distorting its asset mix. Because the regulator is unlikely to know the true profitability of assets, we introduce an adaptive formulation in which the regulator sets weights by observing a bank’s portfolio. The adaptive scheme converges to the same combination of weights and portfolio choice that would hold if the regulator knew the asset profitability. We also investigate other objectives, including steering banks to a target mix of assets, adding robustness, mitigating procyclicality, and reducing system-wide risk in a setting with multiple heterogeneous banks.

Optimal versus realized bank credit risk and monetary policy

Standard banking theory suggests that there exists an optimal level of credit risk that yields maximum bank profit. We identify the optimal level of risk-weighted assets that maximizes banks’ returns in the full sample of US banks over the period 1996–2011. We find that this optimal level is cyclical for the average bank, being higher than the realized credit risk in relatively stable periods with high profit opportunities for banks but quickly decreasing below the realized in periods of turmoil. We place this cyclicality into the nexus between bank risk and monetary policy. We show that a contractionary monetary policy in stable periods, where the optimal credit risk is higher than the realized credit risk, increases the gap between them. An increase in this gap also comes as a result of an expansionary monetary policy in bad economic periods, where the realized risk is higher than the optimal risk.

The “greatest” carry trade ever? Understanding eurozone bank risks

We show that eurozone bank risks during 2007–2013 can be understood as carry trade behavior. Bank equity returns load positively on peripheral (Greece, Italy, Ireland, Portugal, Spain, or GIIPS) bond returns and negatively on German government bond returns, which generated carry until the deteriorating GIIPS bond returns adversely affected bank balance sheets. We find support for risk-shifting and regulatory arbitrage motives at banks in that carry trade behavior is stronger for large banks and banks with low capital ratios and high risk-weighted assets. We also find evidence for home bias and moral suasion in the subsample of GIIPS banks.

Lessons from the European Financial Crisis

This paper distils three lessons for bank regulation from the experience of the 2009-12 euro-area financial crisis. First, it highlights the key role that sovereign debt exposures of banks have played in the feedback loop between bank and fiscal distress, and inquires how the regulation of banks' sovereign exposures in the euro area should be changed to mitigate this feedback loop in the future. Second, it explores the relationship between the forbearance of non-performing loans by European banks and the tendency of EU regulators to rescue rather than resolving distressed banks, and asks to what extent the new regulatory framework of the euro-area banking union can be expected to mitigate excessive forbearance and facilitate resolution of insolvent banks. Finally, the paper highlights that capital requirements based on the ratio of Tier-1 capital to banks' risk-weighted assets were massively gamed by large banks, which engaged in various forms of regulatory arbitrage to minimize their capital charges while expanding leverage. This argues in favor of relying on a set of simpler and more robust indicators to determine banks' capital shortfall, such as book and market leverage ratios.

Impact and Implementation Challenges of the Basel Framework for Emerging, Developing and Small Economies

This paper focuses on the impact of the Basel III accord on emerging, developing and small economies. It looks primarily at potential unintended consequences of the new rules. The areas of concern for both banks and regulators are found in increases in risk-weighted assets for trading exposures, in capital replenishments in jurisdictions with weaker governance and less developed financial markets, and in coping with enhanced liquidity requirements in multinational groups. The resulting recommendations concern consistent application of rules in various parts of multinational banks and the provision of adequate supervisory powers for adequate control of the institutions and markets.

The Global Risk Regime New Roles for Auditors

In the aftermath of the financial crisis the G20’s Financial Stability Board (FSB) invited auditors to play a more prominent role in assisting the FSB in its mandate to stabilize the global economy. The Basel Committee on Banking Supervision (BCBS) in its response to the financial crisis introduced new requirements aimed at achieving closer alignment between banks’ risk reporting and accounting systems. In the summer of 2015 the Institute of Chartered Accountants in England and Wales (ICAEW) published a consultation paper at the request of the UK’s Prudential Regulation Authority on providing assurance services for calculating banks’ risk weighted assets (RWAs) and capital ratios. Also in the summer of 2015 the Regulatory Oversight Committee (ROC) of the FSB published a consultation paper on establishing relationship data to create an authoritative record of control and ownership structures of legal entities aligned to the accounting principles applied in the preparation of consolidated financial statements.These and other initiatives provide the foundation on which the role of auditors and accountants in global regulatory regimes are being extended to support post-crisis initiatives aimed at restoring reliability and stakeholder confidence in banks’ risk reporting. This paper reports on the role of auditors in regulatory oversight and offers perspectives on further involvement. The authors explore existing mandates and potential expanded roles to include: the BCBS’s independent validation of compliance with its risk and data aggregation principles including that risk controls be as robust as financial accounting controls; the use of auditors third party assurance services applied to banks’ risk weighted asset (RWA) and capital ratio calculations; for accommodating the FSB’s newly designated privacy agent for masking derivatives counterparties; for assuring adherence to criteria for new securitizations and derivatives regulations; to validate legal identities and their ownership structures within the ROC’s new global legal entity identification system (GLEIS); and to extend auditors financial reporting taxonomies to prospectuses, articles of incorporations, contracts and other source documents.The authors draw comparisons with these regulatory developments and the US’s Sarbanes Oxley (SOX) legislation, and similar legislation in other jurisdictions that were enacted with the aim of reducing the risk of material misstatements in financial reporting. They consider whether the role and responsibilities of auditors framed in SOX legislation should be extended to risk reporting.Finally, the authors see an expanding role for accountants and auditors to adapt financial metrics and reporting to achieve more comprehensive and precise disclosure of accepted risks in audited financial statements. Risk Accounting, Confidence Accounting and Sustainability Accounting have already entered the accountants’ lexicon. These represent both a risk quantification and an accounting challenge as regulators seek to more fully engage accountants and auditors in achieving greater financial stability while risk adjusting the financial system.

Banking Regulation Of Western Balkan Countries

The current global economic crisis has affected the development of banking system in Western Balkan Countries, including Italy and Greece. These effects are expressed with the contraction of lending, fallen of foreign direct investments, fallen of the volume of remittances and fallen of international trade. The banking system continually faces new challenges in a dynamically changing financial system, and this makes difficult the implementation of bank regulation and supervision. All the countries have improved their banking regulation in order to avoid the contagion effect among banks and banking system in general, effects that get increased especially when banks are engaged in international banking. The standardization of regulatory requirements provides potential solution to the problems of regulating international banking. So, there is a moving through agreements like Basel Accords. For all these countries will be a comparison of regulatory capital to risk-weighted assets ratio and of capital to assets ratio in order to find out how well is capitalized their banking system. The sources of data are the reports of International Monetary Fund for a time series of 2008-2013. In the end there are some conclusions for the main problems that the implementation of supervision and bank regulation faces. Keywords: Basel Accords, Capital Ratio, Banking Regulation

The economic consequences of the TARP: The effectiveness of bank recapitalization policies in the U.S.

This study empirically analyzes the impact of the United States’ bank recapitalization program, the centerpiece of the United States’ $700 billion Troubled Asset Relief Program (TARP), on bank portfolios. Through superior empirical analysis and correct model specification, our findings overturn much of the existing literature on the effectiveness of capital injections into the banking sector in Japan and the United States. We show that the TARP program did not achieve the stated policy objective of stimulating bank lending. On the contrary, we find evidence that recipient banks grew assets significantly slower, particularly heavily risk-weighted assets such as loans. These findings are robust to various empirical specifications, including two-stage least squares estimation using instrumental variables, difference-in-difference techniques and generalized method of moments. These techniques control for pre-existing trends in loan growth while addressing potential endogeneity bias.

Did the EBA Capital Exercise Cause a Credit Crunch in the Euro Area?

We exploit a unique monthly dataset of bank balance sheets to document the lending behaviour of euro area banks that were subject to the EBA's 2011/12 Capital Exercise. This exercise was announced in October 2011 and required large European banking groups to meet a higher Tier 1 capital ratio by June 2012, after accounting for an unprecedented temporary buffer against exposure to sovereign debt. Controlling for bank characteristics and demand at the level of country of residence, we find that banks in a banking group that had to increase its capital by 1 percent of risk-weighted assets tended to have annualized loan growth (over the 9 month period of the exercise) that was between 1.2 and 1.6 percentage points lower than for banks in groups that did not have to increase their capital ratio. Looking at aggregate effects at the country level, we also find that banks that did not have to recapitalize did not substitute for more constrained lenders. Our results are of particular relevance for the decisions facing the new European Single Supervisor in advance of its Asset Quality Review due in November 2014.