Capital requirements and bank behavior in the UK: Are there lessons for international capital standards?

The financial crisis prompted widespread interest in developing a better understanding of how capital regulation drives bank behavior. This paper uses a unique, comprehensive database of regulatory capital requirements on all UK banks to examine their effects on capital, lending and balance sheet management behavior. We find that capital requirements that include firm-specific, time-varying add-ons set by supervisors affect banks’ desired capital ratios and that resulting adjustments to capital and lending depend on the gap between actual and target ratios. We use these results to measure the effects of a capital regime that includes features similar to those embedded in the UK framework. Our results suggest that countercyclical capital requirements may be less effective in slowing credit activity when banks can readily satisfy them with lower-quality (lower-costing) capital elements versus higher-quality common equity. Given the size of the UK banking sector and the global nature of many of the largest institutions in the UK banking sector, the results have implications for the ongoing debate surrounding the design and calibration of international capital standards.     

RISK MANAGEMENT TECHNIQUES EMPLOYED WITHIN THE U.S. CREDIT UNION INDUSTRY

This paper reports the findings of a national survey regarding the financial management practices of United States credit unions. The US credit union industry is clearly in a period of transition. The study indicates that the way in which credit unions approach financial management may have a decided impact on how successful the industry adjusts to deregulated marketplaces. The research highlights the importance of managed growth through selective product diversification, identification of profitable market niches, and the use of modern risk management techniques.     

Do credit unions use their tax advantage to benefit members? Evidence from a cost function

This paper examines whether the credit union income tax subsidy is passed along to members or consumed by managers. To that end, we estimate a translog cost function for credit unions and mutual thrifts that is tailored to the unique objectives of mutually owned depository institutions. We find that credit unions with residential common bonds have higher costs than mutual thrifts, but single common bond occupational and associational credit unions are more cost efficient. Thus, it appears that residential credit unions engage in expense preference behavior and hence redirect some portion of their tax benefit away from members.     

Financial and economic performance of major Brazilian credit cooperatives

The credit union's main functions are the provision of individual financial loans based on collective savings, reaching up to provide full banking services, with expansion of its social function. Cooperatives are an alternative to supply a credit demand in the market, because a third of the municipalities have no bank branches. Although the participation of cooperatives in credit operations is still small compared to the Brazilian national banking system, its continued growth demonstrates the importance of this sector. In this sense, the analysis of the performance of these cooperatives becomes relevant to the extent that incentives to industry expansion differ from other financial institutions. In this context, this study aimed to analyze which the financial and economic performance of Brazil's largest credit unions. This performance analysis was performed using the indicators proposed by the CAMEL model, then the data envelopment analysis (DEA). It can be seen that there is a positive relationship between the use of variables in the model and the measurement of financial performance of credit unions. Moreover, according to the results, it can be observed that Uniprime Northern Paraná, Sicoob Cocred and Sicredi North RS/SC were cooperatives that stood out as efficient.     

Credit unions vs. commercial banks,who takes more risk?

A unique feature of the financial services industry is that both shareholder-owned banks and member-owned credit unions coexist and compete against each other. In this study, we investigate two research questions. First, we compare risk-taking by banks and credit unions, with an additional consideration as to how regulatory oversight (state or federal) relates to such risk-taking. Second, we examine how competition affects the difference in risk-taking between these two types of financial institutions. To answer both questions, we rely on a matched sample (by loan type, size, and county) of commercial banks and credit unions, covering the period between 2010 and 2017. We use three empirical proxies for risk-taking, the Z-score, measuring an institution’s insolvency risk, as well as the ratios of non-performing loans to total loans and loan charge-offs to total loans, measuring the credit risk. Our results suggest that banks tend to engage in more risk-taking than credit unions; however, state regulatory oversight reduces the risk-taking gap, especially in terms of the Z-score. We further find that competition induces different risk-taking behaviors in banks and credit unions. Our results are robust to several alternative specifications.     

Regulatory Capital Charges for Too‐Connected‐to‐Fail Institutions: A Practical Proposal

The recent financial crisis has highlighted once more that interconnectedness in the financial system is a major source of systemic risk. I suggest a practical way to levy regulatory capital charges based on the degree of interconnectedness among financial institutions. Namely, the charges are based on the institution's incremental contribution to systemic risk based on a risk budgeting approach. The imposition of such capital charges could go a long way towards internalizing the negative externalities associated with too‐connected‐to‐fail institutions and providing managerial incentives to strengthen an institution's solvency position, and avoid too much homogeneity and excessive reliance on the same counterparties in the financial industry.     

Economic and regulatory capital allocation for revolving retail exposures

We present two internal capital allocation models and compare the capital ratios they generate with those prescribed by the latest revision of Basel’s New Capital Accord proposal for advanced retail portfolios, which allows for explicit future margin income recognition. Given a test portfolio of credit card exposures that we assemble, we find that Basel’s ratios are closer to those generated by our models for low credit risk segments. We attribute the discrepancies to the different ways Basel and our models account for future margin income, to Basel’s assumptions about asset correlations and to one model taking macroeconomic conditions into account.     

Measuring Integrated Market and Credit Risk in Bank Portfolios: An Application to a Set of Hypothetical Banks Operating in South Africa

The banking crises of the ‘90s emphasize the need to model the connections between financial environment volatility and the potential losses faced by financial institutions resulting from correlated market and credit risks. Due to the number of variables that must be modeled and the complexity of the relationships an analytical solution is not feasible. We present here a numerical solution based on a simulation model that explicitly links changes in the relevant variables that characterize the financial environment and the distribution of possible future bank capital ratios. This forward looking quantitative risk assessment methodology allows banks and regulators to identify potential risks before they materialize and make appropriate adjustments to bank portfolio credit qualities, sector and region concentrations, and capital ratios on a bank by bank basis. It also has the potential to be extended so as to assess the risks of correlated failures among a group of financial institutions (i.e., systemic risk analyses). This model was applied by the authors to the study of the risk profile of the largest South African Banks in the context of the Financial System Stability Assessment program undertaken by the IMF in 1999. In the current study, we apply the model to various hypothetical banks operating in the South African financial environment and assess the correlated market and credit risks associated with business lending, mortgage lending, asset and liability maturity matches, foreign lending and borrowing, and direct equity, real estate, and gold investments. It is shown to produce simulated financial environments (interest rates, exchange rates, equity indices, real estate price indices, commodity prices, and economic indicators) that match closely the assumed parameters, and generate reasonable credit transition probabilities and security prices. As expected, the credit quality and diversification characteristics of the loan portfolio, asset and liability maturity mismatches, and financial environment volatility, are shown to interact to determine bank risk levels. We find that the credit quality of a bank's loan portfolio is the most important risk factor. We also show the risk reduction benefits of diversifying the loan portfolio across various sectors and regions of the economy and the importance of accounting for volatility shocks that occur periodically in emerging economies. Banks with high credit risk and concentrated portfolios are shown to have a high risk of failure during periods of financial stress. Alternatively, banks with lower credit risk and broadly diversified loan portfolios across business and mortgage lending are unlikely to fail even during very volatile periods. Asset and liability maturity mismatches generally increase bank risk levels. However, because credit losses are positively correlated with interest rate increases, banks with high credit risk may reduce overall risk levels by holding liabilities with longer maturities than their assets. Risk assessment methodologies which measure market and credit risk separately do not capture these various interactions and thus misestimate overall risk levels.     

The diversification and financial performance of US credit unions

For US credit unions, revenue from non-interest sources has increased significantly in recent years. We investigate the impact of revenue diversification on financial performance for the period 1993–2004. The impact of a change in strategy that alters the share of non-interest income is decomposed into a direct exposure effect, reflecting the difference between interest and non-interest bearing activities, and an indirect exposure effect which reflects the effect of the institution’s own degree of diversification. On both risk-adjusted and unadjusted returns measures, a positive direct exposure effect is outweighed by a negative indirect exposure effect for all but the largest credit unions. This may imply that similar diversification strategies are not appropriate for large and small credit unions. Small credit unions should eschew diversification and continue to operate as simple savings and loan institutions, while large credit unions should be encouraged to exploit new product opportunities around their core expertise.     

Liquidity risk management and credit supply in the financial crisis

Liquidity dried up during the financial crisis of 2007-2009. Banks that relied more heavily on core deposit and equity capital financing, which are stable sources of financing, continued to lend relative to other banks. Banks that held more illiquid assets on their balance sheets, in contrast, increased asset liquidity and reduced lending. Off-balance sheet liquidity risk materialized on the balance sheet and constrained new credit origination as increased takedown demand displaced lending capacity. We conclude that efforts to manage the liquidity crisis by banks led to a decline in credit supply.     

Credit Derivatives and the Default Risk of Large Complex Financial Institutions

This paper proposes and implements a multivariate model of the coevolution of the first and second moments of two broad credit default swap indices and the equity prices of sixteen large complex financial institutions. We use this empirical model to build a bank default risk model, in the vein of the classic Merton-type, which utilises a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the conditions of the global credit environment. In the first step, we estimate the dynamic correlations and volatilities describing the evolution of the CDS indices and the banks’ equity prices and then impute the implied assets and their volatilities conditional on the evolution and volatility of equity. In the second step, we show that there is a substantial ‘asset shortfall’ and that substantial capital injections and/or asset insurance are required to restore the stability of our sample institutions to an acceptable level following large shocks to the aggregate level of credit risk in financial markets.     

Does adding up of economic capital for market- and credit risk amount to conservative risk assessment?

There is a tradition in the banking industry of dividing risk into market risk and credit risk. Both categories are treated independently in the calculation of risk capital. But many financial positions depend simultaneously on both market risk and credit risk factors. In this case, an approximation of the portfolio value function separating value changes into a pure market risk plus pure credit risk component can result not only in an overestimation, but also in an underestimation of risk. We discuss this compounding effect in the context of foreign currency loans and argue that a separate calculation of economic capital for market risk and for credit risk may significantly underestimate true risk.     

Capital Allocation for Portfolio Credit Risk

Capital allocation rules are derived that maximize leverage while maintaining a target solvency rate for credit portfolios where risk is driven by a single common factor and idiosyncratic risk is fully diversified. Equilibrium conditions ensure that capital allocations depend on interest earnings as well as credits’ probability of default, endogenous loss given default, and asset correlation. Capitalization rates exceed those estimated using Gaussian credit loss models. Results demonstrate that credit risk is undercapitalized by the Basel II AIRB approach in part because of ambiguities regarding the definition of loss given default. An alternative proposed capital rule removes this bias.     

Financing Shipping Companies and Shipping Operations: A Risk‐Management Perspective

Shipping has always been a volatile and cyclical business. The extreme changes in revenues, operating cash flows, and asset values during the recent financial crises have upset the usual means of financing shipping companies. While bank debt will remain important in the future, the new regulatory environment has been forcing shipping banks to shift these risks from their balance sheets to capital markets through instruments such as loan securitization. As a result, the shipping industry will increasingly look to capital markets for external funds. And shipping banks are likely to change from being commercial bank lending institutions to becoming more like investment banks that arrange a variety of financing solutions, including high yield bonds or public equity. Risk management will be central to shipping companies in this new environment. Shipping companies can manage their own risks by modifying operations, employing freight and vessel price derivatives, or adjusting their capital structures. To arrive at the value‐maximizing combination of these three basic methods, they must decide which risks to bear, which to manage internally, and which to transfer to the capital markets. These decisions require shipping financial managers to assess the effect of each risk on firm value, understand how each contributes to total risk, and determine the most cost‐effective way to limit that risk to an acceptable level.     

THE EFFECTS OF BANK CONSOLIDATION ON RISK CAPITAL ALLOCATION AND MARKET LIQUIDITY

We investigate the effects of financial market consolidation on the allocation of risk capital in a financial institution and the implications for market liquidity in dealership markets. An increase in financial market consolidation can increase liquidity in foreign exchange and government securities markets. We assume that financial institutions use risk‐management tools in the allocation of risk capital and that capital is determined at the firm level and allocated among separate business lines or divisions. The ability of market makers to supply liquidity is influenced by their risk‐bearing capacity, which is directly related to the amount of risk capital allocated to this activity.     

Sovereign asset values and implications for the credit market

Using the contingent claim approach and market data on sovereign credit default swaps we assess the drivers of a country's risk perception. Deriving market-based asset values for a set of advanced economies we gain insights into the capital markets' perspectives on sovereign creditworthiness. We find the market-based asset values to be positively influenced by debt and to be an early risk indicator for economic developments. In a cross-section analysis we identify drivers of the economic risk of countries. Clustering the countries according to their debt to asset value ratios provides further insights into the market perceptions of sovereign credit risk. For example we find that the asset values of countries with higher ratios react to changes in the global equity market. Countries with a lower ratio react more to the political stability within the country.     

Capital structure,credit risk,and macroeconomic conditions

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.     

Does concurrent management of mutual and hedge funds create conflicts of interest?

This paper shows that conflicts of interest may exist in cases where a hedge fund manager starts a mutual fund but not in the opposite case. We compare performance, asset flows, and risk incentives to establish several key differences between these two scenarios: First, prior to concurrent management, hedge fund managers experience worse performance while mutual fund managers achieve better performance relative to their full-time peers. Second, hedge fund managers who choose concurrent management are disproportionately the ones with less experience. Their hedge funds tend to suffer a decline in performance after the event. By contrast, mutual fund managers who choose concurrent management tend to outperform their full-time peers. Based on our findings, we make important recommendations for policy makers and companies. The relevance of our recommendations extends beyond the small share of companies presently engaged in concurrent management.     

Fund Management and Systemic Risk – Lessons from the Global Financial Crisis

Fund managers play an important role in increasing efficiency and stability in financial markets. But research also indicates that fund management in certain circumstances may contribute to the buildup of systemic risk and severity of financial crises. The global financial crisis provided a number of new experiences on the contribution of fund managers to systemic risk. In this article, we focus on these lessons from the crisis. We distinguish between three sources of systemic risk in the financial system that may arise from fund management: insufficient credit risk transfer to fund managers; runs on funds that cause sudden reductions in funding to banks and other financial entities; and contagion through business ties between fund managers and their sponsors. Our discussion relates to the current intense debate on the role the so‐called shadow banking system played in the global financial crisis. Several regulatory initiatives have been launched or suggested to reduce the systemic risk arising from non‐bank financial entities, and we briefly discuss the likely impact of these on the sources of systemic risk outlined in the article.     

New Directions in Risk Management

Following the 1991 recession, financial institutions investedheavily in risk management capabilities. These investments targetedfinancial (credit, interest rate, and market) risk management.I will show that these investments helped reduce earnings andloss volatility during the 2001 recession, particularly by reducingname and industry-level credit concentrations. I also suggestthat the industry now faces major risk challenges (better treatmentof operational, strategic, and reputational risks and betterintegration of risk in planning, human capital management, andexternal reporting) that are not addressed by recent investmentsand that will require development of significant new risk disciplines.