Risk-weighted Assets Research Articles

Frontier efficiency, capital structure, and portfolio risk: An empirical analysis of U.S. banks

Firm’ ability to effectively allocate capital and manage risks is the essence of their production and performance. This study investigated the relationship between capital structure, portfolio risk levels and firm performance using a large sample of U.S. banks from 2001 to 2016. Stochastic frontier analysis (SFA) was used to construct a frontier to measure the firm's cost efficiency as a proxy for firm performance. We further look at their relationship by dividing the sample into different size and ownership classes, as well as the most and least efficient banks. The empirical evidence suggests that more efficient banks increase capital holdings and take on greater credit risk while reducing risk-weighted assets. Moreover, it appears that increasing the capital buffer impacts risk-taking by banks depending on their level of cost efficiency, which is a placeholder for how productive their intermediation services are performed. An additional finding, is that the direction of the relationship between risk-taking and capital buffers differs depending on what measure of risk is used.

How Do European Banks Cope with Macroprudential Capital Requirements?

This paper studies the effect of macroprudential requirements on capital ratios for a sample of euro area banks. We first document that banks’ capital ratios are typically above minimum regulatory levels. The banks in our sample differ in their degree of systemic importance and once we split the banks according to this criterion, we find that non-systemically important banks build up capital buffers to a higher extent than systemically important banks and in excess of minimum requirements. The main channel through which these banks enhance their capital ratios is the optimization of risk-weighted assets (RWA), in particular by rebalancing portfolios towards safer assets.

Funding Liquidity and Risk Taking Behavior in Southeast Asian Banks

ABSTRACTThis research investigates the effect of funding liquidity on bank risk taking behavior. Some previous studies in developed countries have found that banks with higher deposit tend to be more aggressive in taking risks, because excess liquidity can reduce profitability and the existence of deposit insurance schemes. However, banks in developing countries tend to hold higher liquidity due to limited interbank money market infrastructure and low diversification of financial instruments. Using data from four developing countries in Southeast Asia from 2002 to 2016, this study found that in contrast to developed countries, banks with lower liquidity risk indicated by higher deposit ratios tend to take lower risks. These results are consistent for the two risk variables used, such as risk-weighted assets, and loan loss provision. The same results are also found after incorporating elements of bank characteristics and macroeconomic factors.

Estimating the Basel III Capital Requirement for Indian Banks

Abstract The study estimates the Basel-III capital requirement for Indian banks employing the methodology incorporating the reported tier-1, tier-2 capital, total capital and risk-weighted assets (RWAs) sourced from the Basel disclosures made by the banks on their websites. In order to understand the strategy and the response of different bank groups based on their ownership styles, this study, groups the banks into scheduled commercial banks, public sector banks group, and private banks and considers the data for the period 2002 – 2011. The results suggest that with an assumed growth of RWAs at 10%, banks in India would require additional minimum tier-1 capital of INR 2.51 trillion. With an assumed RWAs growth at 12% and 15%, the requirement would be in the order of INR 3.36 trillion and INR 4.74 trillion respectively. JEL classifications: E44, E61, G2, G21, G28 Keywords: Basel III, capital and liquidity, commercial banks, capital, countercyclical capital buffers, financial (in)stability

How do CoCo bonds impact a bank’s shareholder wealth?

The 2008 crisis highlighted the fragility of the banking system. To address this deficiency, the Basel committee agreed on the Basel III Accord to strengthen banks’ capital requirements. However, raising additional common equity funds is costly. Facedwith this problem, banks and regulators wonder whether capital can be raised lessexpensively. To this end, Contingent Convertible (CoCo) bonds have been designedto absorb banks’ losses in times of crisis. Might CoCo securities be an effective prevention and/or rescue solution? This article examines the impact of Debt-to-EquityCoCo bonds on a bank’s capital structure. For the first time, leverage ratios based onnon-risk-weighted-assets (NRWA) are used as equity conversion triggers instead oftraditional capital ratios based on risk-weighted-assets (RWA). We find that CoCobonds generally increase shareholder wealth by reducing their bankruptcy risk, except when the dilution effect offsets this positive effect. By boosting banks’ capacityto absorb losses while giving regulators more time to find a rescue solution, CoCobonds strengthen financial stability. We also highlight the importance of definingdifferent variables and parameters properly when designing CoCo bonds. Whenthese variables and parameters are appropriately chosen, CoCo bonds are able tofulfil their function as “going-concern” capital, while bank shareholders are capableof maximizing their wealth.

The Implications of Partially Using Internal Risk Models: Evidence from European Panel Data

In Europe, banks gradually roll-out the internal ratings-based approach (IRBA) across credit risk exposures. My findings imply a non-linear, U-shaped relation between the partial use of internal models and risk-weight densities: Banks firstly implement those portfolios that are most rewarding in terms of risk-weighted assets savings and afterwards such exposures that are more beneficial under the standard approach. This finding suggests that banks choose the sequence of IRBA extension strategically. Further, I show that some banks do not roll-out as stringently as demanded by regulators and therefore save implementation costs, while banks with a straight roll-out progress show a comparably higher loan growth. Overall, it seems that such 'non roll-out' banks firstly implement the more beneficial exposures, while further expensive implementation steps are avoided, which contradicts the purpose of policy makers to introduce internal models as a comprehensive risk governance tool.

Judging Banks' Risk by the Profits They Report

In competitive capital markets, portfolios of risky debt claims have high systematic risk exposure in bad times if they offer a high yield in good times. We apply this idea to measurement of bank risk. Rather than trying to directly measure asset risks on the balance sheet — the typical (manipulation-prone) approach in model-based regulation — we explore high rates of profit in good times as an indicator of systematic tail risk exposure. We show empirically, for cross-sections of banks in the financial crisis of 2007–2008 as well as the savings and loan crisis of the 1980s, that high accounting profitability prior to the crisis predicts high systematic tail risk of equity market values during the crisis, and most strongly so if pre-crisis profits arise from non-interest income or are paid out as dividends and managerial compensation. Pre-crisis profit measures do a better job in predicting systematic tail risk than conventional measures based on risk-weighted assets.

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.

Risk Reporting of the Banking Sector of Bangladesh: A Time Horizon Analysis

The study focused on the practical scenarios of bank risk disclosures where it is assumed that adequate risk disclosures expand the path of transparency in the marketplace. The reason is that the financial disclosures, including risk items, represent their image of the current and potential investors, and can impact their mentality about investment. The research analyzed the credit risk, market risk and operational risk reporting intensities in their reports. It is noted that the maximum Risk Weighted Assets (RWA) are held for credit risk of the banking system whereas the remaining part of the system utilized by the market risk and operational risk. It is found that the risk for the top five (5) or the top ten (10) banks is extremely high. The concentration symptom of risk is not good as the fewer borrowers occupied the most of the credit.

Banks Response to Higher Capital Requirements: Evidence from a Quasi-Natural Experiment

We study the impact of higher capital requirements on banks’ balance sheets and its transmission to the real economy. The 2011 EBA capital exercise is an almost ideal quasi-natural experiment to identify this impact with a difference-in-differences matching estimator. We find that treated banks increase their capital ratios by reducing their risk-weighted assets and - consistent with debt overhang - not by raising their levels of equity. Banks reduce lending to corporate and retail customers, resulting in lower asset-, investment- and sales growth for firms obtaining a larger share of their bank credit from the treated banks.

Modeling the impact of Basel III regulations on loan demand

PurposeThe purpose of this study is to provide an econometric modeling of demand for bank credit and not only offer useful insights to the decision-makers in the public and private sector but also support researchers and analysts in recognizing the determinants of lending in a major dynamic economic context.Design/methodology/approachThis study addresses the “supply-versus-demand-puzzle” by using a demand relationship and model loan demand as a function of interest rates and economic activity that may also capture supply effects. Loan demand modeled as a function of interest rates and economic activity not only represents a demand relationship but also captures supply effects. Using the generalized methods of moments estimation, the estimations are made robust to heteroskedasticity and/or autocorrelation of unknown form. GMM–Time series (HAC) option extends the robustness by using the weighting matrix that is robust to the contemporaneous correlation of unknown form to the autocorrelation of unknown form.FindingsIn a bank-dominated financial system like India, lending rates play a significant role in the transmission of monetary policy, as well as triggering and controlling loan demand and thereby exercising a pervasive effect on the output in the economy. The estimates indicate that the elasticity of loan demand is largely determined by the lending rate (0.6) and the economic activity (0.688). For one percentage point increase in capital ratio, the loan spread would rise by 31.4 basis points, which in turn would cause an increase of 18.8 basis points in loan demand assuming that risk-weighted assets are unchanged.Originality/valueThis is the first of its kind studying a banking system dominated emerging economy. Second, this study is based on a rich data set covering the period from 1979 to 2012, than other papers did, to capture the long-run association involving credit booms and busts and, thus, helps in avoiding the problem of estimation spanning the dominance of either boom or the bust alone. With a newer approach for quantification of the impacts of new regulatory standards, this study offers novel insights for the estimation of lending spreads.

Bank–insurer–firm tripartite interconnectedness of credit risk exposures in a cross-shareholding network

This study assesses the interconnectedness of credit risk exposures in a tripartite network of cross-shareholdings among banks, insurers, and firms in Japan’s stock market during the fiscal years 2008–2015. We use consistent measures: credit risk exposure by PD (probability of default)/LGD (loss given default) approach in Basel III and RORA (return on risk-weighted assets). We conduct a credit risk analysis of the risk exposures in the cross-shareholdings. The result shows that by following the PD/LGD approach, the credit risk weights become approximately 1.5–5 times as large as by the transitional risk weight method. The mean exposure-weighted risk for the firm’s shareholdings is 1.67 times as large as the bank’s and the insurer’s. We analyze the network structure of the cross-shareholdings using network centrality measures. Our analysis can provide each entity with important implications on credit risk management in their cross-shareholdings.

Systemic Banks, Capital Composition and Coco Issuance: The Effects on Bank Risk

This paper shows that systemic banks are prone to increase their capital ratio through a decline in risk-weighted assets density and an intense use of lower level capital. The market access of systemic firms, and the fact that they were singled out for higher capital requirements. seem to have biased them towards lower level capital, consistent with the theory that asymmetric information drives capital decisions. These effects are particularly strong for firms that were rather under-capitalized at the start of the period. More transparency in the pricing of lower capital level would reduce the incentives to use it, while strict capital composition requirements for firms with lower buffers would be an improvement.

Differential bank behaviors around the Dodd–Frank Act size thresholds

Abstract The Dodd–Frank Act created differential regulatory requirements for banks above specified asset size thresholds. Event study results imply greater expected net regulatory costs for above-threshold banks. Consistent with hypotheses that near-below-threshold banks alter their behavior to attempt to avoid or delay the regulatory costs and/or to ensure growth that they do experience is highly beneficial, we find that near-below-threshold banks grow assets, risk-weighted assets, and total loans more slowly, and charge higher rates on commercial loans. The results suggest that the Dodd–Frank Act created costs that near-below-threshold banks attempt to avoid by altering their behaviors in economically important ways.

How Do Sovereign Credit Ratings Help to Financially Develop Low-Developed Countries?

The paper investigates the importance of having a sovereign credit rating for a country’s financial development. After controlling for endogeneity and selection bias, the authors compare different aspects of the financial sector and the capital markets of recently rated countries with otherwise similar, but unrated countries. The findings indicate that obtaining a sovereign credit rating changes the composition of the assets of domestic banks and leads to a growth in bank assets. With a sovereign rating, the government is less dependent on bank financing and it can tap international bond markets. Banks subsequently provide more credit to the private sector, which translates into riskier debt holdings, resulting in an increase in the banks’ risk-weighted assets. In addition, an initial sovereign credit rating attracts foreign investors, both FDI and portfolio investments. Hence, the authors conclude that a sovereign credit provision plays a crucial role in enabling the financial development in a country.

Determinants of Capital Adequacy Ratio of Deposit Money Banks in Nigeria

Capital Adequacy Ratio (CAR) is an important measure of “safety and soundness” for banks and depository institutions because it serves as a buffer or cushion for absorbing losses. It is one of the major benchmarks for financial institutions the world over, especially with the introduction and adoption of the various Basel Accords. This study is an attempt to analyze the bank-specific determinants of CAR in the Nigerian Deposit Money Banks (DMBs) using balanced panel data collected from financial statements of 12 selected quoted banks for the ten-year period 2005-2014. The index for profitability which is ROA was found to be the most important determinant of CAR, having recorded the highest coefficient in the multiple regression result. The study found out that Capital Adequacy Ratio of Nigerian deposit money banks is well above the regulatory minimum set by CBN as well as the requirements of Basel Accord. Also, Nigerian banks’ risk portfolio is quite high and ROA is quite low. Depositors’ interests are well protected as the asset base of DMBs is well above the total deposits. The study concludes that CAR is largely determined by banks risk-portfolio, deposit level, profitability and asset quality and that CAR of Nigerian banks is well above the regulatory minimum. The study recommends that Nigerian deposit money banks should adopt a more pragmatic risk-management mechanism and a risk-based capital maintenance approach backed by a robust data management system. The study recommends improvement in operational performance of banks, strict compliance with various capital regulations, frequent stress tests for banks and more detailed disclosure practice to include details of changes in Tier I and Tier II capital, risk-weighted assets and trend analysis of changes in Capital Adequacy Ratio.

Proposal on ELBE and LGD In-Default: Tackling Capital Requirements after the Financial Crisis

Following the financial crisis, the share of non-performing loans has significantly increased, while the regulatory guidelines on the Internal-Ratings Based (IRB) approach for capital adequacy calculation related to defaulted exposures remains too general. As a result, the high-risk nature of these portfolios is clearly in danger of being managed in a heterogeneous and inappropriate manner by those financial institutions permitted to use the IRB system, with the consequent undue variability of Risk-Weighted Assets (RWA). This paper presents a proposal to construct Advanced IRB models for defaulted exposures, in line with current regulations, that preserve the risk sensitivity of capital requirements. To do so, both parameters Expected Loss Best Estimate (ELBE) and Loss Given Default (LGD) in-default are obtained, backed by an innovative indicator (Mixed Adjustment Indicator) that is introduced to ensure an appropriate estimation of expected and unexpected losses. The methodology presented has low complexity and is easily applied to the databases commonly used at these institutions, as illustrated by two examples. JEL Classification: C51, G21, G28, G32

Using Risk-Weighted Assets to Generate Risk-Weighted Fees to Counter the Effects of Basel III on Revenue Generation

Using Risk-Weighted Assets to Generate Risk-Weighted Fees to Counter the Effects of Basel III on Revenue Generation

Beyond Common Equity: The Influence of Secondary Capital on Bank Insolvency Risk

Banks adhere to strict rules regarding the quantity of regulatory capital held, but have some flexibility as to its composition. In this paper, we examine bank insolvency risk (distance to default) for listed North American and European banks over the period 2002-2014, focusing on sensitivity to capital other than common equity. Decomposing tier 1 capital into equity and non-core components reveals a heretofore unidentified variation in risk reduction capacity. Greater non-core tier 1 capital is associated with increased insolvency risk for larger and more diversified banks, impairing the risk reducing capacity of aggregate tier 1 capital. Overall tier 2 capital is not linked with insolvency risk, although a conflicting relationship is isolated conditional on the level of total regulatory capital held. Finally, the association between risk and capital is weakened when the latter is defined relative to risk-weighted assets.

Calculation of Risk Weighted Assets (RWA) via Machine Learning Technique

Calculation of Risk Weighted Assets (RWA) via Machine Learning Technique