A cost-benefit analysis of capital requirements adjusted for model risk

Capital adequacy is the key microprudential and macroprudential tool of banking regulation. Financial models of capital adequacy are subject to errors, which may prevent from estimating a sufficient capital base to absorb bank losses during economic downturns. In this paper, we propose a general method to account for model risk in capital requirements calculus related to market risk. We then evaluate and compare our capital requirements values with those obtained under Basel 2.5 and the new Basel 4 regulation. Capital requirements adjusted for model risk perform well in containing losses generates in normal and stressed times. In addition, they are as conservative as Basel 4 capital requirements, but they exhibit less fluctuations over time.     

Procyclicality in Basel II: Can we treat the disease without killing the patient?

The debate over the potential procyclicality of bank capital requirements under Basel II has focused overwhelmingly on peak-to-trough variation in minimum regulatory requirements. In this paper, we re-examine the problem from the perspective of market discipline. First, we show that the marginal impact of introducing Basel II depends strongly on the extent to which market discipline leads banks to vary lending standards procyclically in the absence of binding regulation. Second, we evaluate policy options not only by their efficacy in dampening cyclicality in capital requirements, but equally by how well the information value of Basel II market disclosures is preserved.     

A Critique of Revised Basel II

This paper critiques the revised Basel II capital requirements for banks. To provide a framework for analysis, the XYZ theory of regulatory capital is formulated. Independent of the XYZ theory, we argue that the revised Basel II capital rule for credit risk is not a good approximation to the ideal rule. Based on this, and using the XYZ theory, we argue that: (1) the revised Basel II rules should not replace the existing approaches for determining minimal capital standards, but should be used in conjunction with them, and (2) that calibrating the capital rules to maintain aggregate market capital is a prudent procedure.     

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.     

The New Basel Capital Accord: Making it Effective with Stronger Market Discipline

In January 2001 the Basel Committee on Banking Supervision proposed a new capital adequacy framework to respond to deficiencies in the 1988 Capital Accord on credit risk. The main elements or 'pillars' of the proposal are capital requirements based on the internal risk-ratings of individual banks, expanded and active supervision, and information disclosure requirements to enhance market discipline. We discuss the incentive effects of the proposed regulation. In particular, we argue that it provides incentives for banks to develop new ways to evade the intended consequences of the proposed regulation. Supervision alone cannot prevent banks from 'gaming and manipulation' of risk-weights based on internal ratings. Furthermore, the proposed third pillar to enhance market discipline of banks' risk-taking is too weak to achieve its objective. Market discipline can be strengthened by a requirement that banks issue subordinated debt. We propose a first phase for introducing a requirement for large banks to issue subordinated debt as part of the capital requirement.     

The Basel Committee proposals for a new capital accord: implications for Italian banks

Following a few general considerations on the recently proposed revision of the Basel Agreement on capital adequacy, this paper focuses on the first pillar of the Basel Committee proposals, the handling of capital requirements for credit risk in the banking book. The Basel Committee envisages an approach alternatively based on external ratings or on internal rating systems for the determination of the minimum capital requirement related to bank loan portfolios. This approach supports a system of capital requirements that is more sensitive to credit risk. On the basis of specific assumptions, these requirements provide a measure of the value at risk (VaR) produced by models used by major international banks. We first address the impact of the standardised and (internal ratings-based) IRB foundation approach using general data on Italian banks loans' portfolios default rates. We then simulate the impact of the proposed new rules on the corporate loan portfolios of Italian banks, using the unique data set of mortality rates recently published by the Bank of Italy. Three main conclusions emerge from the analysis: (i) the standardised approach implicitly penalizes Italian banks in their interbank funding as their rating is generally below AA/Aa, (ii) the average default rate experienced by Italian banks is higher than the one implied in the benchmark risk weight (BRW) proposed by the Basel Committee for the IRB foundation approach, thereby potentially leading to an increase in the regulatory risk weights, and (iii) the risk-weight is based on an average asset correlation that is significantly higher than the one historically recorded within the Italian banks' corporate borrowers. These findings support the need for a significant revision of the basic inputs and assumptions of the Basel proposals. Finally, in relation to the conditions that allow the capital market to effectively discipline banks, we comment on the proposals advanced in relation to the third pillar of the new capital adequacy scheme.     

Modelling Deposit Insurance Scheme Losses in a Basel 2 Framework

This paper extends the existing literature on deposit insurance by proposing a new approach for the estimation of the loss distribution of a Deposit Insurance Scheme (DIS) that is based on the Basel 2 regulatory framework. In particular, we generate the distribution of banks’ losses following the Basel 2 theoretical approach and focus on the part of this distribution that is not covered by capital (tail risk). We also refine our approach by considering two major sources of systemic risks: the correlation between banks’ assets and interbank lending contagion. The application of our model to 2007 data for a sample of Italian banks shows that the target size of the Italian deposit insurance system covers up to 98.96% of its potential losses. Furthermore, it emerges that the introduction of bank contagion via the interbank lending market could lead to the collapse of the entire Italian banking system. Our analysis points out that the existing Italian deposit insurance system can be assessed as adequate only in normal times and not in bad market conditions with substantial contagion between banks. Overall, we argue that policy makers should explicitly consider the following when estimating DIS loss distributions: first, the regulatory framework within which banks operate such as (Basel 2) capital requirements; and, second, potential sources of systemic risk such as the correlation between banks’ assets and the risk of interbank contagion.     

Capital adequacy rules, catastrophic firm failure, and systemic risk

This paper studies capital adequacy rules based on Value-at-Risk (VaR), leverage ratios, and stress testing. VaR is the basis of Basel II, and all three approaches are proposed in Basel III. This paper makes three contributions to the literature. First, we prove that these three rules provide an incentive to increase the probability of catastrophic financial institution failure. Collectively, these rules provide an incentive to increase (not decrease) systemic risk. Second, we argue that an unintended consequence of the Basel II VaR capital adequacy rules was the 2007 credit crisis. Third, we argue that to reduce systemic risk, a new capital adequacy rule is needed. One that is based on a risk measure related to the conditional expected loss given insolvency.     

银行信用风险评估模型的选择及应用策略分析

相比于巴塞尔新资本协议的现代化管理要求,我国银行在信用风险管理方面的能力,基础相对薄弱,无法全面适应银行业未来经营发展、市场竞争、业务持续发展等需求.为此,文章将通过银行信用风险评估模型的构建,从中提出强化信用风险管理体系的方法,进而为银行信用风险管理水平的提高,提供有效的依据.     

Optimal portfolios with minimum capital requirements

We propose a novel approach to active risk management based on the recent Basel II regulations to obtain optimal portfolios with minimum capital requirements. In order to avoid regulatory penalties due to an excessive number of Value-at-Risk (VaR) violations, capital requirements are minimized subject to a given number of violations over the previous trading year. Capital requirements are based on the recent Basel II amendments to account for the ‘stressed’ VaR, that is, the downside risk of the portfolio under extreme adverse market conditions. An empirical application for two portfolios involving different types of assets and alternative stress scenarios demonstrates that the proposed approach delivers an improved balance between capital requirement levels and the number of VaR exceedances. Furthermore, the risk-adjusted performance of the proposed approach is superior to that of minimum-VaR and minimum-stressed VaR portfolios.     

Loan pricing under Basel II in an imperfectly competitive banking market

The new Basel II Accord (2006), established new and revised capital requirements for banks. In this paper we analyze and estimate the possible effects of the new rules on the pricing of bank loans. We relate to the two approaches for capital requirements (internal and standardized) and distinguish between retail and corporate customers. Our loan-equation is based on a model of a banking firm facing uncertainty operating in an imperfectly competitive loan market. We use Israeli economic data and data of a leading Israeli bank. The main results indicate that high quality corporate and retail customers will enjoy a reduction in loan interest rates in (big) banks which, most probably, will adopt the IRB approach. On the other hand high risk customers will benefit by shifting to (small) banks that adopt the standardized approach.     

巴塞尔III及其对中国银行业的影响

分析了巴塞尔Ⅲ资本监管改革的理念和内容,按照巴塞尔Ⅲ和中国银监会资本监管方案的标准,以17家上市商业银行2010年的数据为例,测算了新指标对银行业的短期和长期影响。研究表明,无论从资本充足率还是杠杆率角度看,中国银行业的短期资本缺口不大,但长期资本缺口巨大。因此,监管部门应加强合作,密切关注银行业在实施巴塞尔Ⅲ期间对实体经济和资本市场的影响。     

Capital requirements under the credit risk-based framework

This work aims to study the hypothesis of lower capitalization of banks under the risk-based rules introduced in Basel II. In this sense, an assessment of the impact of these rules on the capital requirements for non-financial firms’ credit risk is performed. A comparison with Basel I is presented and intervals of variation for the risk drivers such that capital requirements exceed the ones under Basel I are established. Data for a European country supports the hypothesis of a smaller capitalization of banks under the risk-based framework, as far as credit risk in concerned.     

巴塞尔Ⅲ下市场风险资本框架的改革及中国商业银行的应用

本次金融危机中众多欧美大型银行因市场风险控制不力而遭受巨大损失。为此,巴塞尔委员会对原有的市场风险监管框架做出修订,并以此构成了巴塞尔Ⅲ的重要组成部分。本文基于对巴塞尔市场风险监管框架发展的思路和脉络分析,研究和评价了金融危机后巴塞尔Ⅲ下市场风险资本框架的改革。最后结合我国商业银行实践,分析了我国市场风险管理的发展及对巴塞尔市场风险监管框架的应用。     

Liquidity and bank capital structure

Bank capital requirements reduce the probability of bank failure and help mitigate taxpayers’ sharing in the losses that result from bank failures. Under Basel III, direct capital requirements are supplemented with liquidity requirements. Our results suggest that liquidity provisions of banks are connected to bank capital and that changes in liquidity indirectly affect the capital structure of financial institutions. Liquidity appears to be another instrument for adjusting bank capital structure beyond just capital requirements. Consistent with Diamond and Rajan (2005), we find that liquidity and capital should be considered jointly for promoting financial stability.     

An Assessment of Basel II Procyclicality in Mortgage Portfolios

In this paper we develop a probability of default (PD) model for mortgage loans, taking advantage of the Spanish Credit Register, a comprehensive database on loan characteristics and credit quality. From that model, we calculate different types of PDs: point in time, PIT, through the cycle, TTC, average across the cycle and acyclical. Then, we compare capital requirements coming from the different Basel II approaches. We show that minimum regulatory capital under Basel II can be very sensitive to the risk measurement methodology employed. Thus, the procyclicality of regulatory capital requirements under Basel II is an open question, depending on the way internal rating systems are implemented and their output is utilised. We focus on the mortgage portfolio since it is one of the most under researched areas regarding the impact of Basel II and because it is one of the most important of banks’ portfolios.     

Loan pricing under Basel capital requirements

We analyze the loan pricing implications of the reform of bank capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only a very high social cost of bank failure might justify the proposed IRB capital charges, partly because the net interest income from performing loans is not counted as a buffer against credit losses. A net interest income correction for IRB capital requirements is proposed.     

Bank regulation and international financial stability: A case against the 2006 Basel framework for controlling tail risk in trading books

In attempting to promote international financial stability, the Basel Committee on Banking Supervision (2006) provided a framework that sought to control the amount of tail risk that large banks around the world would take in their trading books relative to their corresponding minimum capital requirements. However, many of these banks suffered significant trading losses during the recent financial crisis. Our paper examines whether the Basel framework allowed banks to take substantive tail risk in their trading books without a capital requirement penalty. We find that it allowed banks to do so and that its minimum capital requirements can be notably procyclical. Hence, focusing on the way the Basel framework sought to control the amount of tail risk in trading books relative to their corresponding minimum capital requirements, our paper supports the view that it was not properly designed to promote financial stability. We also discuss alternative regulatory frameworks that would potentially be more effective than the Basel framework in preventing banks from taking substantive tail risk in their trading books without a capital requirement penalty.     

On the Role of Regulatory Banking Capital

In this paper the authors study the role of regulatory banking capital and analyze the incentive effects of the Basel II Accord. They argue that Basel II may become a source of systemic risk due to endogenous risk and the risk sensitivity of the capital requirements. In this context they note that financial instability may enter via the asset side of the banks' balance sheets when banks are forced to sell assets in order to maintain the capital buffer prescribed by Basel II.     

Capital shocks, bank asset allocation, and the revised Basel Accord

In contrast to the 1988 Basel Accord (Basel I), the revised risk-based capital standards (Basel II) propose regulatory capital requirements based on credit ratings. This paper develops a theoretical model to analyze how banks will adjust their low and high credit risk commercial loans under the proposed newer standard. Capital-constrained banks respond to an adverse capital shock by reducing high credit risk loans, while under certain circumstances, low credit risk loans may actually increase. When compared to Basel I, it is shown that high-risk loans are reduced more under Basel II, but whether a bank reduces total lending more under Basel I or under the revised standards depends on a complex interaction of factors.