Risk-weighted Capital Requirements Research Articles

Under-diversification and idiosyncratic risk externalities

We study the effects of idiosyncratic uncertainty on asset prices, investment, and welfare. We consider an economy with two main components: under-diversification and endogenous, countercyclical idiosyncratic risk. The equilibrium is subject to underinvestment and excessive aggregate risk-taking. Inefficiencies stem from an idiosyncratic risk externality, as firms do not internalize the effect of their investment decisions on the risk borne by others. Risk externalities depend on an idiosyncratic risk premium and a variance risk premium. We assess their magnitude empirically. The optimal allocation can be implemented through financial regulation using a tax benefit on debt and risk-weighted capital requirements.

The relationship between capital and liquidity prudential instruments

Basel III introduced unweighted capital standard and new regulatory liquidity standards to complement the revised risk-weighted capital requirements. This change in banking sector regulation raised questions on how the capital and liquidity requirements interact and how they should be jointly treated. In the paper, we assess how a regulatory and a subsequent economic shock, and banks’ subsequent response to it, affects compliance with the four regulatory requirements. We find that the capital and liquidity requirements can act as both, substitutes and complements, depending on the adjustment strategy banks choose to react to these shocks. We assert that to be able to properly calibrate macroprudential policy measures such as the counter-cyclical capital buffer, it is vital for macroprudential authorities to look at the initial levels of the other required ratios as well as to monitor banks’ subsequent response.

Capital requirements and mortgage pricing: Evidence from Basel II

As a result of the Basel II reforms, capital requirements on UK mortgages fell substantially in coincidence with the financial crisis. We exploit a novel, loan-level dataset on within-lender variation in risk-weighted capital requirements and a triple-difference identification strategy to estimate the pass through of capital requirements to mortgage rates. We find that a 1pp lower risk-weighted capital requirement leads to a reduction in rates by 10–16bp on average, with stronger effects for less-capitalized lenders. The competitive advantage induced by multi-tier regulation also affects the composition of banks mortgage portfolios, with larger lenders specializing in lower risk loans. Finally, our results support the use of countercyclical capital requirements to sustain lending in a crisis.

Default Probability Assessment for Project Finance Bank Loans and Basel Regulations: Searching for a New Paradigm

Syndicated loan data from India suggest that despite the pressure on margins and volumes, available “bankable” deals in infrastructure are still strongly contested by commercial lenders. With the implementation of Ind AS accounting norms (IFRS) for commercial banks, the expected credit loss–based provisions have to be set by the bank based on internally estimated probability of default (PD) for different loan portfolios. This change may lead to heavier risk-weighted capital requirements for banks, thus impacting the project finance business. Basel III norms and subsequent discussion papers propose a revised standardized approach doing away with internal modeling approaches and introduction of standardized output floors for specialized lending, including project finance. In this light, the authors present a cash flow simulation model to address the issue of PD estimation by simulating key risk factors. This method may be useful as each project and each sector is unique and so are the risks associated with it. Thus, the authors argue that the use of a simulation model will result in better assessment and monitoring of credit risk than conventional assessment methods, leading to lower default rates and therefore lower capital charge. The authors then suggest some new rules of engagement for project finance lenders to stay relevant in the changing regulatory scenario. TOPICS:Simulations, project finance, credit risk management Key Findings • Probability of default estimation and subsequent impact on credit risk capital is important for project finance lenders in India especially after emerging Basel III reforms and subsequent discussion papers on credit risk capital. (Informally called as Basel IV) • The authors suggest a cash flow simulation model developed using risk parameters “specific” to each project. The application of the model is shown on a road project and it calculates cumulative default risk probability of the project. • The article argues that this model will result in better assessment and monitoring of credit risk. Authors also suggest new rules for engagement for the project finance lenders in the emerging regulatory scenario.

Risk-weighted capital requirements and portfolio rebalancing

Abstract We use a 2013 Norwegian policy reform to study how banks react to higher capital requirements and how these adjustments transmit to the real economy. Using bank balance sheet data, we document that banks raise capital ratios by reducing risk-weighted assets. Most of the reduction in risk-weighted assets is accounted for by a reduction in average risk weights. Consistent with this reduction in risk, we document a substantial decline in credit supply to the corporate sector relative to the household sector. We also show that banks react to higher requirements by increasing interest rates, consistent with the reduction in corporate credit growth being supply driven. Using administrative loan level tax data, we document a reduction in lending on the firm level. This is robust to controlling for firm fixed effects, thereby accounting for potential firm-bank matching. Finally, we find that the reduction in bank lending has a negative impact on firm employment growth and that this effect is driven by small firms.

The Effects of Leverage Ratio Adjustment on Banks' Balance Sheets: Impact of the Risk Measurement Approach

We examine the effects of the recently introduced regulatory leverage ratio, which aims to backstop existing risk-weighted capital requirements, on banks' balance sheets. We observe on average a deleveraging process, while banks simultaneously increase their risk-weighted assets. Having less regulatory leeway, banks applying the standardized approach are more inclined to raise capital in order to adjust the leverage ratio upwards. This implies that such banks become more stable as intended by policy makers. In contrast, the need to raise capital is significantly less pronounced for banks using internal models, which face more adjustment leeway when increasing their leverage ratio. Our findings suggest that imposing an unweighted leverage restriction does not necessarily alleviate the benefits from minimizing risk-weighted assets.

Leverage Regulation and Market Structure: An Empirical Model of the UK Mortgage Market

I develop a structural model of mortgage demand and lender competition to study how leverage regulation a ffects the equilibrium in the UK mortgage market. Using variation in risk-weighted capital requirements jointly across lenders and mortgages with di fferential loan-to-values, I show that a one-percentage-point increase in risk-weighted capital requirements increases lenders' marginal cost of originating mortgages by about 26 basis points (11 percent) for the average mortgage product. I use the estimated model to study proposed leverage regulations. Counterfactual analyses show that large lenders exploit a regulatory cost advantage, which increases concentration of mortgage originations by about 20 percent, and suggest that banning high loan-to-value mortgages may reduce large lenders' equity bu er.

Bank Capital Buffers in a Dynamic Model

We estimate a dynamic structural banking model to examine the interaction between risk-weighted capital adequacy and unweighted leverage requirements, their differential impact on bank lending, and equity buffer accumulation in excess of regulatory minima. Tighter risk-weighted capital requirements reduce loan supply and lead to an endogenous fall in bank profitability, reducing bank incentives to accumulate equity buffers and, therefore, increasing the incidence of bank failure. Tighter leverage requirements, on the other hand, increase lending, preserve bank charter value and incentives to accumulate equity buffers, therefore leading to lower bank failure rates.

Risk-Weighted Capital Requirements and Portfolio Rebalancing

In this paper we investigate how banks respond to increases in risk-weighted capital requirements. We use cross-sectional variation in capital ratio changes induced by a policy-reform to isolate the causal effects of capital requirements. We find that banks increased their capital ratios by raising equity and reducing average risk-weights. We do not find strong support for detrimental effects on credit growth on average. We find, however, that banks that are more likely to be capital constrained reduced their overall credit growth. We also find that relatively profitable banks are less likely to shift their composition of credit.

Bank Leverage Ratios and Financial Stability: A Micro- and Macroprudential Perspective

Bank leverage ratios have made an impressive and largely unopposed return; they are mostly used alongside risk-weighted capital requirements. The reasons for this return are manifold, and they are not limited to the fact that bank equity levels in the wake of the global financial crisis (GFC) were exceptionally thin, necessitating a string of costly bailouts. A number of other factors have been equally important; these include, among others, the world's revulsion with debt following the GFC and the eurozone crisis, and the universal acceptance of Hyman Minsky's insights into the nature of the financial system and its role in the real economy. The best examples of the causal link between excessive debt, asset bubbles, and financial instability are the Spanish and Irish banking crises, which resulted from nothing more sophisticated than straightforward real estate loans. Bank leverage ratios are primarily seen as a microprudential measure that intends to increase bank resilience. Yet in today's environment of excessive liquidity due to very low interest rates and quantitative easing, bank leverage ratios should also be viewed as a key part of the macroprudential framework. In this context, this paper discusses the role of leverage ratios as both microprudential and macroprudential measures. As such, it explains the role of the leverage cycle in causing financial instability and sheds light on the impact of leverage restraints on good bank governance and allocative efficiency.

A Heterogeneous Agent Model for Assessing the Effects of Capital Regulation on the Interbank Money Market Under a Corridor System

Money markets play an important role in the implementation of monetary policy. Their structure and dynamics have, however, changed significantly in recent years. In particular, a number of new banking regulations will affect the behaviour of money market participants, and so have the potential to affect money market interest rates. This paper offers a model to examine how prudential regulation might affect interbank overnight interest rates where the central bank implements monetary policy using a corridor system. Combined with a set of assumptions as to the cost banks might incur in meeting regulatory capital requirements, it offers a framework with which to explore how such prudential regulation might affect the dynamics of overnight interest rates. The results — which are illustrative — estimate the interest rates at which banks might borrow and lend reserves overnight in the presence of prudential regulation. They suggest that risk-weighted capital requirements might increase the average level of overnight interbank interest rates, while the regulatory minimum leverage ratio might decrease it. If applied to real-world data on central bank reserves balances and regulatory metrics, this model also offers an insight into how central bank policymakers could — if they so choose — amend their operational frameworks to account for the effects of regulation.

Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis

The U.K. bank Northern Rock became the first high-profile casualty of the global financial crisis of 2007–2008 when it suffered its depositor run in September 2007. In spite of the television images of long lines of depositors outside its branch offices, the run on Northern Rock was unlike the textbook retail depositor run caused by coordination failure. Also, contrary to received wisdom, its reliance on securitization was not an immediate factor in its failure. Rather, its problems stemmed from its high leverage coupled with reliance on institutional investors for short-term funding. When the de-leveraging in the credit markets began in August 2007, Northern Rock was uniquely vulnerable to the shrinking of lender balance sheets arising from the tick-up in measured risks. Financial regulation that relies on risk-weighted capital requirements is powerless against such runs. The Northern Rock case also offers lessons concerning the economics of short-term debt.

Capital management in mutual financial institutions

Capital management by mutual financial institutions (such as credit unions) provides a valuable testing ground for assessing the impact of capital regulation and theories of managerial behaviour in financial institutions. Limited access to external equity capital means that capital accumulation must be met primarily by reliance on retained earnings. To deal with shocks to the capital position and avoid breaching regulatory requirements, managers will aim to have a buffer of capital in excess of the regulatory minimum. Moreover, mutual governance arrangements and an absence of capital market discipline mean that managers have discretion to set target capital ratios which differ significantly from industry averages. This paper develops a formal model of capital management and risk management in mutual financial institutions such as credit unions which reflects these industry characteristics. The model is tested using data from larger credit unions in Australia, which have been subject to the Basel Accord Risk Weighted Capital Requirements since 1993. The data supports the hypothesis that credit unions manage their capital position by setting a short term target profit rate (return on assets) which is positively related to asset growth and which is aimed at gradually removing discrepancies between the actual and desired capital ratio. Desired capital ratios vary significantly across credit unions. There is little evidence of short run adjustments to the risk of the asset portfolio to achieve a desired capital position.

Effects of stock mispricing and regulatory capital constraints on bank lending

From long-term performance of bank holding company shares, this paper infers the effect of possible stock undervaluation on bank lending between 1989 and 1993, when many banks were constrained by risk-weighted capital requirements. Investment in high-risk assets, including loans, is found to have been negatively related to long-term stock performance. The negative relationship between lending and future stock performance, however, was as strong among well-capitalized banks unconstrained by capital requirements as that among low-capital banks constrained by capital requirements. Based on these findings, stock mispricing resulting from asymmetric information between managers and outside investors does not appear to have significantly contributed to the credit crunch in the early 1990s. The negative relationship should be stronger among low-capital banks if high costs of equity and tightened capital requirements were the main reasons why banks reduced lending.

Private Actors and Public Policy: A Requiem for the New Basel Capital Accord

After the Asian crisis of 1997-98, policy-makers invested much energy in designing a new international financial architecture. However, many of the policy proposals that have emerged from think tanks and the multilateral agencies have proven unworkable or politically unpalatable. The debate focuses on state-led initiatives. But the assumption that public policy is by definition an output of public institutions is difficult to sustain in an era of global change. This article considers specialized forms of intelligence gathering and judgment determination which seem increasingly important as sources of governance in this era of financial market volatility: Moody's Investors Service and Standard & Poor's, the major bond rating agencies. More specifically, we examine a proposal of the Basel Committee on Banking Supervision to reform the existing capital adequacy framework by incorporating banks' own internal ratings and external bond ratings from the rating agencies, in order to calculate bank risk-weighted capital requirements. The article identifies a series of negative implications from the use of private rating agencies as a substitute for state-based regulation, premised on the organizational incentives that shape the ratings industry. Cementing these organizational incentives into the emerging financial architecture will, we argue, lead to negative social and economic consequences.

REFORMING BANK CAPITAL REGULATION: USING SUBORDINATED DEBT TO ENHANCE MARKET AND SUPERVISORY DISCIPLINE

In 1988 the Basel Capital Accord introduced minimum risk‐weighted capital requirements for internationally active banks. In recent years there has been a growing realization that there are significant problems with the capital guidelines. As financial firms have become more sophisticated and complex they have effectively arbitraged the requirements and have become so good at it that the regulations have essentially ceased being a safety and soundness issue for supervisors and have become more of a compliance issue. Indeed, the Basel Committee is now evaluating reforms to the capital accord and is considering various means to improve the risk‐capital relationship and to increase the role of market discipline. The authors argue that many of the problems that currently exist can be addressed, and some additional benefits not previously possible under the current capital guidelines can be realized, by increasing the role of subordinated debt in the bank capital structure. The authors discuss the potential benefits and offer a capital reform proposal that would improve both market and supervisory oversight. This should lead to more prudent risk management behavior by the larger, more complex banking organizations, resulting in a safer industry with less potential for systemic problems.

Financial Restructuring and Credit Unions

The nature of credit unions as mutual financial institutions is examined and the economic implications of mutuality explored. While manager-shareholder agency costs are likely to be exacerbated within credit unions, shareholder-debtholder agency costs are likely to be eliminated. In this context, the implications for credit unions of the Campbell Report, the Financial Institutions scheme, and the Wallis Inquiry are discussed. While the imposition of risk-weighted capital adequacy requirements are inconsistent with the institutional form of credit unions, regulatory measures such as monitoring of management contracts can be supported.