Testing macroprudential stress tests: The risk of regulatory risk weights

We compare the capital shortfall measured by regulatory stress tests, to that of a benchmark methodology — the “V-Lab stress test” — that employs only publicly available market data. We find that when capital shortfalls are measured relative to risk-weighted assets, the ranking of financial institutions is not well correlated to the ranking of the V-Lab stress test, whereas rank correlations increase when required capitalization is a function of total assets. We show that the risk measures used in risk-weighted assets are cross-sectionally uncorrelated with market measures of risk, as they do not account for the “risk that risk will change.” Furthermore, the banks that appeared to be best capitalized relative to risk-weighted assets were no better than the rest when the European economy deteriorated into the sovereign debt crisis in 2011.     

Visible Reserves in Banks – Determinants of Initial Creation,Usage and Contribution to Bank Stability

The opportunity of building up visible “Reserves for General Banking Risks” by the bank management represents a peculiarity in the German financial accounting framework for banks. We investigate German banks' motives for the creation and usage of these reserves and assess their role in financial stability. We find that banks primarily create and use GBR reserves to build up Tier 1 capital for regulatory capital management and earnings management purposes. Most importantly, however, we also reveal that banks using these reserves are less likely to experience a future distress or a bank default event. We therefore conclude that the existence of GBR reserves within the financial accounting framework represents both a convenient capital and earnings management tool for bank managers and a beneficial regulatory instrument to enhance bank stability.     

Regulatory capital and asset risk transfer

We explore whether life insurers use a unique reinsurance arrangement to manage assets tied to their regulatory capital. Typical reinsurance allows insurers to reduce their regulatory capital by transferring liabilities (reserves), and the associated assets, to reinsurers. With modified coinsurance (ModCo), insurers maintain control of their liabilities and assets while transferring regulatory capital requirements to the reinsurer. Holding fixed an insurer's reported capital, we find that ModCo allows insurers to report higher risk-based capital ratios. Insurers with ModCo are less likely to fire sale downgraded bonds. We also find suggestive evidence of regulatory arbitrage, as most ModCo is purchased from reinsurers in countries with low capital requirements or within the same insurance group.     

The Squam Lake Report: Fixing the Financial System*

In these excerpts from The Squam Lake Report, fifteen distinguished economists analyze where the global financial system failed, and how such failures might be prevented (or at least their damage better contained) in the future. Although there were many contributing factors to the crisis—including “agency” problems throughout the financial system and a bankruptcy code poorly suited for reorganizing financial firms—at the core of the problem is a potential conflict between the risk-taking proclivity of financial institutions and the interests of the economy at large that must be managed at least in part through more effective regulation. The Squam Lake Report provides a nonpartisan plan to transform the regulation of financial markets in ways designed to limit systemic risk while preserving—to the extent possible and prudent—the economies of scale and scope that justify the existence of today's large financial institutions. To reduce the risks that large banks will fail, the authors call for higher capital requirements based on more effective assessments of the risks of bank assets and liabilities, as well as a new systemic regulator that should be part of the central bank. To reduce the costs of failure when it occurs, the authors propose that banks be required to create “living wills” laying out their plan to sell assets or shut down operations in the event of financial trouble. As part of that plan, regulators are urged to “aggressively encourage” banks to issue “contingent” debt capital securities that convert into equity.     

Do loan loss reserves behave like capital? Evidence from recent bank failures

Regulatory capital guidelines allow for loan loss reserves to be added back as capital. Our evidence suggests that the influence of loan loss reserves added back as regulatory capital (hereafter referred to as “add-backs”) on bank risk cannot be explained by either economic principles underlying the notion of capital or accounting principles underlying the recording of reserves. Specifically, we observe that, in sharp contrast to the economic notion of capital as a buffer against bank failure risk, add-backs are positively associated with the risk of bank failure during the recent economic crisis. Furthermore, the positive association of add-backs with bank failure risk is concentrated among cases in which the add-backs are highly likely to increase a bank’s total regulatory capital. The evidence cannot thus be fully explained by accounting principles either, since the role of loan loss reserves according to those principles does not depend on whether the reserves generate a regulatory capital increase. Additional analysis suggests that the observed influence of loan loss reserves on bank failure risk may be an unintended consequence of their regulatory treatment as capital.     

Internal capital market studies in empirical banking: Biases due to usage of assets instead of risk capital?

Unlike industrial companies, banks allocate “risk-taking potential” across subunits, instead of investment budgets or assets. Researchers typically do not have access to this data on risk-bearing capacity across subunits and use (changes in) assets or loans instead. Based on unique data from Germany, where banks disclose both assets and corresponding risk capital, we analyze whether the approximation potentially introduces an econometric bias in empirical banking studies on internal capital markets. We provide empirical evidence that the quality of the approximation is correlated with variables capturing the risk and business models of segments.     

Accounting for heritage assets: Thomas Holloway's picture collection, 1881–2019

In recent years, there has been a debate about whether the owners of “heritage assets” should include them on their balance sheets. We present a longitudinal study of the collection of 77 pictures donated by Thomas Holloway to Royal Holloway College between 1881 and 1883. We draw on archival material to analyse accounting practices for Holloway's picture collection, finding that the collection remained effectively invisible as an accounting object until 1999, when accounting requirements for heritage assets were first applied. We use Jean Baudrillard's “orders of simulacra” to study the relationship between accounting signs and their referents, and we draw on Bruno Latour's notion of “matters of concern” to investigate how changes in the accounting sign render the referent a complicating, agitating and provoking “matter” in different ways. The Royal Holloway financial statements currently present the picture collection by an accounting sign that we suggest is a “counterfeit” (signifying the money that could, counterfactually, be made from selling the paintings) but not a “simulation” (creating a hyperreality detached from the referent). This relationship between the sign and the referent makes up the ontological status of “assets” in accounting reports, rendering assets capable of triggering actual (rather than hyperreal) material effects.     

The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity

How can fire sales for financial assets happen when the economy contains well‐capitalized but nonspecialist investors? Our explanation combines rational expectations equilibrium and “lemons” models. When specialist (informed) market participants are liquidity‐constrained, prices become less informative. This creates an adverse selection problem, decreasing the supply of high‐quality assets, and lowering valuations by nonspecialist (uninformed) investors, who become unwilling to supply capital to support the price. In normal times, arbitrage capital can “multiply” itself by making uninformed capital function as informed capital, but in a crisis, this stabilizing mechanism fails.     

Terminal Value,Accounting Numbers,and Inflation

In a 2008 article published in this journal, Michael Bradley and Gregg Jarrell argue that the well‐known Gordon‐Shapiro (henceforth “GS”) model for calculating terminal values does not properly account for the effects of inflation. Bradley and Jarrell suggest modifying the growth factor in the standard GS model by adding an additional term to the nominal growth rate that reflects the positive effect of inflation on the value of existing assets. In this article, the authors support the original Gordon‐Shapiro method for calculating terminal values by showing what they believe to be an oversight of the Bradley‐Jarrell critique. According to the authors, the disagreement stems from the use of fundamentally different assumptions about the effect of inflation on the capital investment required to sustain a business. Although Bradley‐Jarrell agree with the authors that intrinsic value is the discounted value of future free cash flows, their assumptions about capital investment effectively lead them to conclusions similar to those practitioners who attempt to value companies on the basis of discounted future accounting earnings. Despite much common practice, the GS model was meant to be applied to free cash flows, not accounting earnings. And for companies with substantial capital investment, the differences between accounting earnings that involve accruals and free cash flows can be very large.     

Capital controls,competitive depreciation,and the technological frontier

This paper considers the internal and external welfare effects of international capital controls and real exchange rate undervaluation in a multi-country setting. I present a dynamic open-economy macro model with an endogenously determined rate of interest on internationally traded assets. All countries produce tradable and nontradable goods using technology that converges over time to a global frontier. The model quantifies the welfare effects of the unilateral implementation of capital controls that depreciate the real exchange rate in economies both already at and converging to the technological frontier. For developing economies, I demonstrate that such government interventions may constitute “beggar-thy-neighbor” policies.     

环境税率、双重红利与经济增长

本文构建了一个包含环境税、污染存量和预期寿命的世代交替模型,研究环境税对环境红利和经济发展红利的影响。基于新古典增长模型的研究表明,环境税能够实现双重红利(环境红利和经济发展红利),这契合“绿水青山就是金山银山”的绿色发展理念。从传导机制看,环境税通过负收入效应使得资本积累下降,同时,环境税通过健康效应使得预期寿命延长,这又使得资本积累增加。环境税通过影响资本积累,进而影响环境质量和经济发展。此外,环境税率上升使得用于环境治理的政府支出增加,这使得经济更容易产生环境红利。基于内生增长框架的分析表明,环境税有助于摆脱“环境贫困陷阱”,这为解释国家之间的收入差距提供了一个参考机制。数值模拟结果显示,在新古典增长框架和内生增长框架下,均存在最优的环境税率可以极大化人均产出和经济增长率。本文认为,合理的环境税率有助于推进减污降碳协同治理。     

The Contributions of Stewart Myers to the Theory and Practice of Corporate Finance*

In a 40‐plus year career notable for path‐breaking work on capital structure and innovations in capital budgeting and valuation, MIT finance professor Stewart Myers has had a remarkable influence on both the theory and practice of corporate finance. In this article, two of his former students, a colleague, and a co‐author offer a brief survey of Professor Myers's accomplishments, along with an assessment of their relevance for the current financial environment. These contributions are seen as falling into three main categories:

• ? Work on “debt overhang” and the financial “pecking order” that not only provided plausible explanations for much corporate financing behavior, but can also be used to shed light on recent developments, including the reluctance of highly leveraged U.S. financial institutions to raise equity and the recent “mandatory” infusions of capital by the U.S. Treasury.
• ? Contributions to capital budgeting that complement and reinforce his research on capital structure. By providing a simple and intuitive way to capture the tax benefits of debt when capital structure changes over time, his adjusted present value (or APV) approach has not only become the standard in LBO and venture capital firms, but accomplishes in practice what theorists like M&M had urged finance practitioners to do some 30 years earlier: separate the real operating profitability of a company or project from the “second‐order” effects of financing. And his real options valuation method, by recognizing the “option‐like” character of many corporate assets, has provided not only a new way of valuing “growth” assets, but a method and, indeed, a language for bringing together the disciplines of corporate strategy and finance.
• ? Starting with work on estimating fair rates of return for public utilities, he has gone on to develop a cost‐of‐capital and capital allocation framework for insurance companies, as well as a persuasive explanation for why the rate‐setting process for railroads in the U.S. and U.K. has created problems for those industries.

     

Solvency, Capital Allocation, and Fair Rate of Return in Insurance

In this article, we consider the links between solvency, capital allocation, and fair rate of return in insurance. A method to allocate capital in insurance to lines of business is developed based on an economic definition of solvency and the market value of the insurer balance sheet. Solvency, and its financial impact, is determined by the value of the insolvency exchange option. The allocation of capital is determined using a complete markets’ arbitrage‐free model and, as a result, has desirable properties, such as the allocated capital “adds up” and is consistent with the economic value of the balance sheet assets and liabilities. A single‐period discrete‐state model example is used to illustrate the results. The impact of adding lines of business is briefly considered.     

An analysis and critique of the BIS proposal on capital adequacy and ratings

This paper examines two specific aspects of stage 1 of the Bank for International Settlement’s (BIS’s) proposed reforms to the 8% risk-based capital ratio. We argue that relying on “traditional” agency ratings could produce cyclically lagging rather leading capital requirements, resulting in an enhanced rather than reduced degree of instability in the banking and financial system. Despite this possible shortcoming, we believe that sensible risk based weighting of capital requirements is a step in the right direction. The current risk based bucketing proposal, which is tied to external agency ratings, or possibly to internal bank ratings, however, lacks a sufficient degree of granularity. In particular, lumping A and BBB (investment grade corporate borrowers) together with BB and B (below investment grade borrowers) severely misprices risk within that bucket and calls, at a minimum, for that bucket to be split into two. We examine the default loss experience on corporate bonds for the period 1981–1999 and propose a revised weighting system which more closely resembles the actual loss experience on credit assets.     

国企混改实践中的认识误区和未来突破的关键问题

通过梳理和逻辑分析已经完成和正在进行的国企混改案例背后所揭示的事实,本文指出实践中存在的对国企混改的认识误区和国企混改未来突破需要解决的关键问题。以国企之间的“混”或通过基金的“混”来代替民资背景战投的引入,并不能真正实现国企经营机制转换和公司治理制度完善的最终混改目的。未来国企混改突破的关键在于,其一如何通过公司治理制度设计,使民资背景的战投激励相容,愿意参与国企的混改;其二如何实现产业集团向国有资本投资公司的转型,真正实现国有资本监管体系从“管企业”向“管资本”转化。在转型路径选择上,存在委派董事参与公司治理、与民资背景战投组成有限合伙构架以及国资转化为优先股三种可能的实现路径。     

Managerial incentives,capital reallocation,and the business cycle

We argue that when managers have private information about the productivity of assets under their control and receive private benefits, substantial bonuses are required to induce less productive managers to declare that capital should be reallocated. The need to provide incentives for managers to relinquish control links executive compensation to capital reallocation and managerial turnover over the business cycle, rendering them procyclical if expected managerial compensation increases when more managers are hired. Moreover, capital is less productively deployed in downturns because agency costs make reallocation more costly. Empirically, we find that both CEO turnover and executive compensation are remarkably procyclical.     

“Author’s Reply: Critique of Mexico’s New Social Security Act”, Octavio Maupomé-Carvantes,July, 1999

Abstract

This paper considers the pension plan as part of the capital structure of the sponsoring employer. This enables lessons from financial theory concerning capital structure to be used to answer the question, “What assets should a pension fund hold?” The standard Modigliani-Miller framework is expanded on to consider the implications of corporate tax. This leads to the conclusion that bond investment for pension plans has tangible advantages over holding risky assets (e.g., equities). The paper considers a case study of the pension plan of the Boots Company, a U.K. pharmacy retailer with a pension fund of around £2.3 billion ($3.5 billion), where these ideas were put into practice. Finally, the paper discusses the value released to shareholders and the extra security members of the pension fund have derived from putting theory into practice.     

Capital Constraints,Asymmetric Information,and Internal Capital Markets in Banking: New Evidence

A growing literature investigates the role of internal capital markets in mitigating financial constraints faced by the subsidiaries of a conglomerate. Most studies have relied on indirect tests based on correlations between the cash flows and the investment of the subsidiaries. In contrast, we avoid the widespread criticisms of such specifications by providing direct tests that focus on the mechanisms through which internal reallocations of funds occur. We find that internal capital markets are used by multibank holding companies to mitigate capital constraints faced by individual bank subsidiaries. In addition, we show that internal capital management within a multibank holding company involves not only the movement of capital to those subsidiaries with a relatively greater need for capital but also the movement of assets (loans) from less well capitalized to better capitalized subsidiaries by means of loan sales and purchases among the subsidiaries. Furthermore, net loan sales are used to allow efficiency‐enhancing specialization among bank subsidiaries, insofar as those subsidiaries with the best loan origination opportunities are able to focus on loan originations even if they do not have sufficient capital to hold the loans. Our evidence is consistent with banks affiliated with holding companies more actively participating in loan sales and purchases because, by using their internal secondary loan market, they are able to avoid the “lemons” problem faced by stand‐alone banks.     

Bank liquidity,the maturity ladder,and regulation

We investigate the liquidity management of 62 Dutch banks between January 2004 and March 2010, when these banks were subject to a liquidity regulation that is very similar to Basel III’s Liquidity Coverage Ratio (LCR). We find that most banks hold more liquid assets against their stock of liquid liabilities, such as demand deposits, than strictly required under the regulation. More solvent banks hold fewer liquid assets against their stock of liquid liabilities, suggesting an interaction between capital and liquidity buffers. However, this interaction turns out to be weaker during a crisis. Although not required, some banks consider cash flows scheduled beyond 1 month ahead when setting liquidity asset holdings, but they seldom look further ahead than 1 year.     

Competitive effects of Basel II on US bank credit card lending

We analyze the potential competitive effects of the proposed Basel II capital regulations on US bank credit card lending. We find that bank issuers operating under Basel II will face higher regulatory capital minimums than Basel I banks, with differences due to the way the two regulations treat reserves and gain-on-sale of securitized assets. During periods of normal economic conditions, this is not likely to have a competitive effect; however, during periods of substantial stress in credit card portfolios, Basel II banks could face a significant competitive disadvantage relative to Basel I banks and nonbank issuers.