The effect of capital adequacy guidelines on large bank holding companies

The United States federal bank regulators imposed numerical capital guidelines in 1981. If these guidelines are binding on bank holding companies, then theoretical evidence suggests that banking organizations may be increasing asset risk. This study tests empirically the hypothesis that the guidelines are binding. Two models of changes in bank holding company equity capital to assets ratios are developed and tested using maximum likehood estimation: a regulatory model and a market model. The results indicate that most large bank holding companies are influenced by regulatory forces.     

Bank capital and credit market competition: Will competitive pressure lead to higher capital levels?

This paper establishes a theoretical model to study the relationship between credit market competition and bank capital. In the model, bank capital can alleviate the debt overhang problem, and the extent to which banks can enjoy the gain of holding capital is decreasing in the competitive pressure in the credit market. It is shown that credit market competition reduces banks' incentive to hold capital. Deposit insurance also induces banks to hold less capital. In addition, bank capital regulation is welfare improving, and banks may voluntarily hold capital in excess of regulatory minimums.     

The impact of bank regulations, supervision, market structure, and bank characteristics on individual bank ratings: A cross-country analysis

We use country level data and bank level data from 71 countries and 857 banks to investigate the impact of bank regulations, supervision, market structure, and bank characteristics on individual bank ratings. The results indicate that less cost efficient banks, with higher than average levels of provisions relatively to their income, and lower liquidity tend to have lower ratings. Larger and more profitable banks tend to obtain higher ratings. Higher equity to assets ratio results in higher ratings only when we do not control for bank supervision and regulations. Capital requirements, restrictions on bank activities, official disciplinary power, explicit deposit insurance scheme, higher deposit insurer power, liquidity and diversification guidelines, entry requirements, fraction of entries denied, and economic freedom have a significant impact on ratings in all of our specifications. Disclosure requirements and foreign banks entry have a significant impact on ratings only when we simultaneously control for the regulatory environment and the market structure, while auditing requirements have a significant impact only when we control for the regulatory environment alone. Finally, banks in developed countries are assigned higher ratings. However, this impact disappears when we include the regulatory and supervision variables in the models.     

The regulations–risk taking nexus under competitive pressure: What about the Islamic banking system?

Does market power condition the effect of bank regulations and supervision on bank risk taking? We focus on three regulatory tools: capital requirements, the restriction of activities, and official supervisory powers. Employing 10 years of unbalanced panel data on 123 Islamic and conventional banks operating in the Middle East and Asia, we arrive at the following conclusions. First, banking market power strengthens the negative impact of capital regulation on bank risk taking. Second, our empirical results suggest that the negative effect of activity restrictions on stability is diminished when banks have greater market power. Finally, we do not find strong evidence that the negative effect of supervisory power on banks’ risk taking is conditioned by their competitive behavior. In further analysis, we differentiate between Islamic and conventional banks regarding their competition, as well as their risk behavior. The results differ according to the banking business model. These findings could be useful for bank regulators in light of the accomplishment of Islamic banks’ regulatory framework. Indeed, the adoption of Basel III represents a significant regulatory challenge, given that it does not take into account the specificities of Islamic banks.     

Banks’ capital buffer,risk and performance in the Canadian banking system: Impact of business cycles and regulatory changes

Using quarterly financial statements and stock market data from 1982 to 2010 for the six largest Canadian chartered banks, this paper documents positive co-movement between Canadian banks’ capital buffer and business cycles. The adoption of Basel Accords and the balance sheet leverage cap imposed by Canadian banking regulations did not change this cyclical behavior of Canadian bank capital. We find Canadian banks to be well-capitalized and that they hold a larger capital buffer in expansion than in recession, which may explain how they weathered the recent subprime financial crisis so well. This evidence that Canadian banks ride the business and regulatory periods underscores the appropriateness of a both micro- and a macro-prudential “through-the-cycle” approach to capital adequacy as advocated in the proposed Basel III framework to strengthen the resilience of the banking sector.     

Why European Banks Are Undercapitalized and What Should Be Done About It

Major European banks are significantly undercapitalized as compared to large American banks, and, more importantly, as compared to the capital levels they would need to survive another severe financial crisis. Bank capital shortfalls in Italy, Spain, Germany, France and the United Kingdom, in particular, are largely the consequence of European bank regulations that: (1) apply static risk weights to assets like mortgages and sovereign debt; (2) fail to require an overall market‐based capital ratio that is high enough to enable banks to survive a severe financial crisis; (3) fail to get banks to promptly write down their impaired assets to market value; (4) subject banks to weak stress tests that can create a false impression of capital adequacy; and (5) fail to compel banks to retain sufficient earnings and to raise sufficient capital externally to eliminate capital shortfalls promptly, all apparently out of fear that being tougher might cause investors and customers to lose confidence in the banks. This article summarizes important recent independent bank stress testing that has quantified the capital shortfalls in European banks. The recent highly publicized regulatory interventions to resolve failing European banks were inevitable due to these shortfalls. The authors recommend steps European bank regulators should take to address the problem and to eliminate the risk of serious capital shortfalls. In the absence of such steps, bank depositors, customers, and security holders should be prepared to expect further unwelcome surprises as the risks inherent in allowing undercapitalized banks to operate will continue to materialize in more bank failures.     

Shadow Banking,Risk Transfer,and Financial Stability

Shadow banking is the process by which banks raise funds from and transfer risks to entities outside the traditional commercial banking system. Many observers blamed the sudden expansion in 2007 of U.S. sub‐prime mortgage market disruptions into a global financial crisis on a “liquidity run” that originated in the shadow banking system and spread to commercial banks. In response, national and international regulators have called for tighter and new regulations on shadow banking products and participants. Preferring the term “market‐based finance” to the term “shadow banking,” the authors explore the primary financial instruments and participants that comprise the shadow banking system. The authors review the 2007–2009 period and explain how runs on shadow banks resulted in a liquidity crisis that spilled over to commercial banks, but also emphasize that the economic purpose of shadow banking is to enable commercial banks to raise funds from and transfer risks to non‐bank institutions. In that sense, the shadow banking system is a shock absorber for risks that arise within the commercial banking system and are transferred to a more diverse pool of non‐bank capital instead of remaining concentrated among commercial banks. The article also reviews post‐crisis regulatory initiatives aimed at shadow banking and concludes that most such regulations could result in a less stable financial system to the extent that higher regulatory costs on shadow banks like insurance companies and asset managers could discourage them from participating in shadow banking. And the net effect of this regulation, by limiting the amount of market‐based capital available for non‐bank risk transfer, may well be to increase the concentrations of risk in the banking and overall financial system.     

A PRACTICAL APPROACH TO CAPITAL STRUCTURE FOR BANKS

Like U.S. companies in many industries. American's bank's attention to capital structure is reflected in their high level of stock repurchases in recent years. But, if banks are responding to some of the same economic forces that are driving industrial firms to shed excess capital, there are some important differences between banks and industrials that complicate the process of establishing appropriate capital levels for banks. The most important difference comes from regulation. Since the implementation by FDICIA of risk based capital guidelines in the early 1990s, the capital ratios of U.S. banks have increased substantially. In fact, most U.S. banks today carry considerably more capital than is required by the regulators. This tendency to exceed regulatory capital levels is especially pronounced for smaller institutions, which can in turn be explained by the riskier profile of smaller banks: While such banks have the highest proportion of the lowest-risk assets (such as cash, mortgages, and marketable securities), they also have a much greater degree of concentration (and co-variance) among their riskier assets.
This article recommends using a quantitative economic approach (such as a RAROC model) to generate a lower bound on the amount of necessary capital. This estimate can then be translated into a target capital structure by taking account of a variety of practical, qualitative considerations, including banks' preference to maintain capital levels that provide a comfortable margin above bank regulators' "well capitalized" levels. Although such considerations will vary in importance from one bank to another, they will generally include management's risk tolerance, regulatory constraints, market pressures (as reflected in peer group capital levels), the bank's prospects and investment plans, and, for larger banks, rating agency requirements.     

Bank regulation and supervision: what works best?

This paper uses our new database on bank regulation and supervision in 107 countries to assess the relationship between specific regulatory and supervisory practices and banking-sector development, efficiency, and fragility. The paper examines: (i) regulatory restrictions on bank activities and the mixing of banking and commerce; (ii) regulations on domestic and foreign bank entry; (iii) regulations on capital adequacy; (iv) deposit insurance system design features; (v) supervisory power, independence, and resources; (vi) loan classification stringency, provisioning standards, and diversification guidelines; (vii) regulations fostering information disclosure and private-sector monitoring of banks; and (viii) government ownership.The results, albeit tentative, raise a cautionary flag regarding government policies that rely excessively on direct government supervision and regulation of bank activities. The findings instead suggest that policies that rely on guidelines that (1) force accurate information disclosure, (2) empower private-sector corporate control of banks, and (3) foster incentives for private agents to exert corporate control work best to promote bank development, performance and stability.     

The dark side of liquidity creation: Leverage and systemic risk

We consider a model in which the threat of bank liquidations by creditors as well as equity-based compensation incentives both discipline bankers, but with different consequences. Greater use of equity leads to lower ex-ante bank liquidity, whereas greater use of debt leads to a higher probability of inefficient bank liquidation. The bank's privately-optimal capital structure trades off these two costs. With uncertainty about aggregate risk, bank creditors learn from other banks’ liquidation decisions. Such inference can lead to contagious liquidations, some of which are inefficient; this is a negative externality that is ignored in privately-optimal bank capital structures. Thus, under plausible conditions, banks choose excessive leverage relative to the socially optimal level, providing a rationale for bank capital regulation. While a blanket regulatory forbearance policy can eliminate contagion, it also eliminates all market discipline. However, a regulator generating its own information about aggregate risk, rather than relying on market signals, can restore efficiency and market discipline by intervening selectively.     

The impact of banking regulations on banks' cost and profit efficiency: Cross-country evidence

This paper uses stochastic frontier analysis to provide international evidence on the impact of the regulatory and supervision framework on bank efficiency. Our dataset consists of 2853 observations from 615 publicly quoted commercial banks operating in 74 countries during the period 2000-2004. We investigate the impact of regulations related to the three pillars of Basel II (i.e. capital adequacy requirements, official supervisory power, and market discipline mechanisms), as well as restrictions on bank activities, on cost and profit efficiency of banks, while controlling for other country-specific characteristics. Our results suggest that banking regulations that enhance market discipline and empower the supervisory power of the authorities increase both cost and profit efficiency of banks. In contrast, stricter capital requirements improve cost efficiency but reduce profit efficiency, while restrictions on bank activities have the opposite effect, reducing cost efficiency but improving profit efficiency.     

The role of regulatory capital in international bank mergers and acquisitions

When investigating the role of regulatory capital in bank mergers and acquisitions (M&As) we finds that US targets are better capitalized than their acquirers and non-acquired peers and that US banks maintain higher capital levels than European banks. Thus, US banks strategically raise their capital levels to avoid regulatory scrutiny. Furthermore, more value is created for targets with high excess capital and in M&As involving targets with considerably higher excess-capital ratios than their acquirers. Thus, the excess regulatory capital hypothesis is supported. Finally, market prices reflect the influence that capital has on the probability of the merger's regulatory approval.     

Crises,Liquidity Shocks,and Fire Sales at Commercial Banks

If liquidity shortages cause financial crises, a lender of last resort can provide funds to banks facing potential fire sales. However, if funding problems primarily occur at banks with existing solvency problems, then government liquidity programs may not spur bank lending. We find that commercial bank funding does not typically dry up in a crisis, not even during the subprime crisis. Rather, weak banks are more likely to borrow less. Furthermore, banks rely more on deposits and newly issued equity than fire sales. When they do sell assets, they cherry pick assets in order to alleviate pressure from capital regulations.     

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.     

Impact of regulatory interactions on bank capital structure

This article examines a bank's optimal capital structure and risk-taking decisions in a regulated environment. We focus on the interactive nature of the Fed's collateralized discount window lending and the FDIC's deposit insurance. Such regulatory interactions are shown to have nonlinear and nonuniform impacts on the bank's leverage and risk-taking decisions. Thus, bank moral hazard problems may persist, even when banks are charged risk-adjusted deposit insurance premia and are also subject to market discipline through subordinate debt. Our analysis yields several new policy implications about the design and pricing of bank regulations.     

The pernicious effects of contaminated data in risk management

Banks hold capital to guard against unexpected surges in losses and long freezes in financial markets. The minimum level of capital is set by banking regulators as a function of the banks’ own estimates of their risk exposures. As a result, a great challenge for both banks and regulators is to validate internal risk models. We show that a large fraction of US and international banks uses contaminated data when testing their models. In particular, most banks validate their market risk model using profit-and-loss (P/L) data that include fees and commissions and intraday trading revenues. This practice is inconsistent with the definition of the employed market risk measure. Using both bank data and simulations, we find that data contamination has dramatic implications for model validation and can lead to the acceptance of misspecified risk models. Moreover, our estimates suggest that the use of contaminated data can significantly reduce (market-risk induced) regulatory capital.     

Are regulatory capital adequacy ratios good indicators of bank failure? Evidence from US banks

Motivated by massive bank failures during the financial crisis, this paper examines whether capital adequacy ratios required by regulators are associated with bank failure. It investigates whether the association is affected by the bank's proximity to the minimum required capital ratios. If results show a significant association between regulatory capital and failure of banks falling below the minimum capital ratios, then the ratios are set at an adequate level. Examining a sample of 560 US bank holding companies for the period 2003–2009, results reveal that the association between the core (Tier 1) capital ratio and bank failure becomes significant only if the bank holding company has a Tier 1 capital ratio of less than 6%. This is the level below which US bank regulators do not regard banks as being well capitalized. During the financial crisis period of 2007–2009, there is a significant association only when the criterion is set at or above 8%. Market-based probability of default is more significantly associated with failure relative to Tier 1 capital ratio. The findings of this paper are relevant to regulatory policy discussions and Basel III deliberations on capital adequacy at times of financial turmoil.     

资产透明度、监管套利与银行系统性风险

资产不透明的金融机构过度依赖批发性融资进行监管套利不利于系统性风险的防控。在此背景下,本文首先在经典银行道德风险模型的基础上引入关联性,从资产透明度和监管套利的视角分析银行系统性风险累积的内在机理。而后利用2007-2018年中国上市银行微观数据,构建资产透明度指标和系统性风险指标(SRISK、MES),对理论推论进行实证检验。主要结论有:(1)资产不透明、监管套利会提高银行的系统性风险。(2)监管套利弱化了资产透明度和资本监管机制对银行系统性风险承担的约束作用,资产透明度与资本监管机制在约束系统性风险承担中的协调作用不明显。(3)以大银行为主的债权银行受监管套利的影响相较于受资产透明度的影响更明显。在此基础上,我们对完善金融风险防范体系以及监管机制提出了若干建议。     

The Impact of SFAS No. 114 on the Linear Information Dynamic for Commercial Banks

Increase (decrease) in loan loss provisions would decrease (increases) bank earnings, but increase (decreases) regulatory capital. Previous studies have separately documented earnings and capital management behavior via loan loss provisions by commercial banks. However, it is difficult to isolate a bank's demand for increasing earnings from its demand for regulatory capital because earnings is a source of capital. Based on the objective bank function, this study investigates the impact of SFAS No. 114 on the information content of loan loss provisions in relation to both earnings quality and capital adequacy in a linear information dynamic framework. Test results show that the association between market value with loan loss provisions became significantly stronger for commercial banks in the post- than in the pre-adoption period. As a result, SFAS No. 114 is also found to positively affect the association of market value with both bank earnings and regulatory capital through the clean surplus relation because of the higher value relevance of loan loss provisions. The findings thus provide empirical evidence that SFAS No. 114 has significantly complemented banking regulations in enhancing (reducing) the (dispersion from the) accounting measurement construct of loan loss provisions.     

The Future of Banking Regulation in Developed Countries: Lessons from and for Europe

If the bank regulatory structure in developed countries, particularly those in the EU (as well as the US), were not changed, considerable private and social costs could be incurred. We first outline the current EU regulatory framework and describe and analyze recent bank crises and failures. Based on this record and on the (beneficial for consumers) changes in EU banking regulation, on new data on bank capital/asset ratios in ten European countries, and on an analysis of market and technological changes, we conclude that the present regulatory structure is unlikely to achieve banking stability in the future. We then propose and describe a regulatory framework that can deal effectively with this situation and show how it would affect EU banks.