The welfare cost of bank capital requirements

Capital requirements are the cornerstone of modern bank regulation, yet little is known about their welfare cost. This paper measures this cost and finds that it is surprisingly large. I present a simple framework, which embeds the role of liquidity creating banks in an otherwise standard general equilibrium growth model. A capital requirement limits the moral hazard on the part of banks that arises due to deposit insurance. However, this capital requirement is also costly because it reduces the ability of banks to create liquidity. The key insight is that equilibrium asset returns reveal the strength of households’ preferences for liquidity and this allows for the derivation of a simple formula for the welfare cost of capital requirements that is a function of observable variables only. Using US data, the welfare cost of current capital adequacy regulation is found to be equivalent to a permanent loss in consumption of between 0.1% and 1%.     

Financial liberalization and bank risk-taking: International evidence

This paper analyzes the channels through which financial liberalization affects bank risk-taking in an international sample of 4333 banks in 83 countries. Our results indicate that financial liberalization increases bank risk-taking in both developed and developing countries but through different channels. Financial liberalization promotes stronger bank competition that increases risk-taking incentives in developed countries, whereas in developing countries it increases bank risk by expanding opportunities to take risk. Capital requirements help reduce the negative impact of financial liberalization on financial stability in both developed and developing countries. However, official supervision and financial transparency are only effective in developing countries.     

National culture and bank risk-taking

We investigate the relation between national cultural values and bank risk. Despite the rigid transnational regulatory oversight of systemic European banks, we find evidence of an economically significant association between cultural values and domestic bank risk. Specifically, we report a positive (negative) association between the cultural values of individualism and hierarchy (trust) and domestic bank risk-taking. Consistent with our predictions, this relation weakened during the recent financial crisis and does not hold for global banks, regardless of the period under investigation. Our findings are robust to endogeneity tests that mitigate concerns regarding reverse causality and confounding effects affecting our conclusions.     

The pass-through of bank capital requirements to corporate lending spreads

We study the impact of higher bank capital requirements on corporate lending spreads using granular bank- and loan-level data. Our empirical strategy employs the heterogeneity in capital requirements across banks and time of implementation in Switzerland. We find that changes in the capital deviation from the regulatory minimum affect lending spreads asymmetrically. In response to a reduction in the capital deviation, banks with deficits with respect to their risk-weighted capital requirement raise spreads relative to banks with surpluses and de-leverage. Banks respond to higher requirements by raising spreads and, for deficit banks, by cutting lending.     

Do capital requirements affect cost efficiency? Evidence from China

This paper contributes to the debate on the effect of capital requirements on cost efficiency. We study the relation between capital ratio and cost efficiency for Chinese banks over the period 2004–2009, taking advantage of the profound regulatory changes in capital requirements that occurred during this period to measure the exogenous impact of an increase in the capital ratio on banks’ cost efficiency. We find that such an increase has a positive effect on cost efficiency, the size of which depends to an extent on the bank's ownership type. Our results therefore suggest that capital requirements can improve cost efficiency.     

Capital regulation,deposit insurance and bank risk: International evidence from normal and crisis periods

In this paper, we examine the impact of capital regulation on bank risk and the moderating role of deposit insurance on the relationship between capital regulation and bank risk during both normal and crisis periods. Using an international sample of banks from 111 countries, our results show that stringent capital regulation reduces bank default risk, in general, during normal growth period, and this effect is not conditioned by the existence of explicit deposit insurance. Further, stringent capital regulation in place during the pre-crisis period reduces bank default risk during the crisis period, and this effect is stronger for countries with explicit deposit insurance during the pre-crisis period. These results have important policy implications to design the optimal bank regulations.     

Financial statement comparability and bank risk-taking

This study examines the relationship between financial statement comparability and bank risk-taking. Our analysis of a sample of publicly listed U.S. banks over the 1994–2019 period shows that banks with more comparable financial statements are related to significantly less risk-taking. We also find that the negative relationship between comparability and risk-taking is more pronounced for firms with more severe moral hazard and agency problems. Our documented findings are robust across alternative measures of comparability and risk-taking and considering change analysis, after controlling for strength of corporate governance and using propensity score matching and two-stage least squares estimation to address endogeneity concerns. Our analysis also shows that the relationship between financial statement comparability and bank risk-taking is stronger for smaller banks than for larger banks. Overall, this study provides unique insights into the role of financial statement comparability in curbing risk-taking in the banking sector.     

Credit derivatives, capital requirements and opaque OTC markets

In this paper we study the optimal design of credit derivative contracts when banks have private information about their ability in the loan market and are subject to capital requirements. First, we prove that when banks are subject to a maximum loss capital requirement the optimal signaling contract is a binary credit default basket. Second, we show that if credit derivative markets are opaque then banks cannot commit to terminal-date risk exposure, and therefore the optimal signaling contract is more costly. The above results allow us to discuss the potential implications of different capital adequacy rules for the credit derivative markets.     

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.     

Pre-positioning for effective resolution of bank failures

Large bank failures are often handled differently to other firm failures because suddenly closing a large bank and consequently freezing otherwise liquid claims raises financial stability concerns. As a result, substantial public funds are often used as part of the resolution process, which can undermine market discipline and longer-term financial stability. We propose a resolution scheme that enables the good portion of creditors’ claims to be quickly made available to them in way that maintains market discipline while managing the liquidity effects of large bank failures. We report on a New Zealand study into making the scheme work in practice.     

Bank size, market concentration, and bank earnings volatility in the US

We examine whether bank earnings volatility depends on bank size and the degree of concentration in the banking sector. Using quarterly data for non-investment banks in the United States for the period 2004Q1-2009Q4 and controlling for the quality of management, leverage, and diversification, we find that bank size reduces return volatility. The negative impact of bank size on bank earnings volatility decreases (in absolute terms) with market concentration. We also find that larger banks located in concentrated markets have experienced higher volatility during the recent financial crisis.     

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.     

Unbounded liabilities,capital reserve requirements and the taxpayer put option

When firms access unbounded liability exposures and are granted limited liability, then an all equity firm holds a call option, whereby it receives a free option to put losses back to the taxpayers. We call this option the taxpayer put, where the strike is the negative of the level of reserve capital at stake in the firm. We contribute by (i) valuing this taxpayer put, and (ii) determining the level for reserve capital without a reference to ratings. Reserve capital levels are designed to mitigate the adverse incentives for unnecessary risk introduced by the taxpayer put at the firm level. In our approach, the level of reserve capital is set to make the aggregate risk of the firm externally acceptable, where the specific form of acceptability employed is positive expectation under a concave distortion of the cash flow distribution. It is observed that, in the presence of the taxpayer put, debt holders may not be relied upon to monitor risk as their interests are partially aligned with equity holders by participating in the taxpayer put. Furthermore, the taxpayer put leads to an equity pricing model associated with a market discipline that punishes perceived cash shortfalls.     

Rethinking bank shareholder equity: The case of Deutsche Bank

We introduce and apply an innovative accounting approach to analyse the equity position of a European systemically important financial institution, Deutsche Bank, between 2001 and 2015. According to our findings, the actual contribution by shareholders to bank equity capital was limited, while shareholder payout policies, including share buybacks and trading on its own shares, were both material. These findings raise concerns on the actual capacity by shareholder equity to assure protection against (residual) risk and loss absorption. Customer and investor protections appear to lay with bank entity equity dynamics. These findings have implications for bank financial sustainability and resilience, company capital maintenance, and regulatory capital requirements. Further developments based upon this innovative methodology may improve on existing prudential and accounting regulations.     

The impact of bank regulation on the cost of credit: Evidence from a discontinuity in capital requirements

We study the effect on credit relationships of the Small and Medium Enterprises Supporting Factor (SME-SF), a regulatory risk weight reduction on small loans to SMEs. Employing a regression discontinuity design and matched bank-firm data from Italy, we find that a 1 percent drop in capital requirements causes an average 13 basis points reduction in the cost of credit. Moreover, with a novel measure of bank regulatory capital scarcity, we show that the drop is larger for banks facing tighter constraints. Furthermore, the drop is larger for firms with low switching costs, while the sharp assignment rule may have led to the rationing of marginal borrowers. Such findings indicate that the entire distribution of firms and banks’ characteristics plays a crucial role in determining the impact of regulatory capital changes.     

Bank pay caps,bank risk,and macroprudential regulation

This paper studies the consequences of a regulatory pay cap in proportion to assets on bank risk, bank value, and bank asset allocations. The cap is shown to lower banks’ risk and raise banks’ values by acting against a competitive externality in the labour market. The risk reduction is achieved without the possibility of reduced lending from a Tier 1 increase. The cap encourages diversification and reduces the need a bank has to focus on a limited number of asset classes. The cap can be used for Macroprudential Regulation to encourage banks to move resources away from wholesale banking to the retail banking sector. Such an intervention would be targeted: in 2009 a 20% reduction in remuneration would have been equivalent to more than 150 basis points of extra Tier 1 for UBS, for example.     

Financial networks,bank efficiency and risk-taking

Networks with a core–periphery topology are found in many financial systems across different jurisdictions. Though the theoretical and structural aspects of core–periphery networks are clear, the consequences that core–periphery structures bring for banking efficiency stand as an open question. We address this gap in the literature by providing insights as to how the structure of financial networks can affect bank efficiency. We find that core–periphery structures are cost efficient for banks, which is a characteristic that encourages the participation of banks in financial networks. On the downside, we also show that core–periphery structures are risk-taking inefficient, because they imply higher systemic risk levels in the financial system. In this way, regulators should be aware of the excessive risk inefficiency that arises in the financial system due to individual decisions made by banks in the network.     

Financial markets development,business cycles,and bank risk in South America

In this paper, we examine whether banking crises or business cycles affect the influence of financial markets development on bank risk in a sample of 37 publicly listed commercial banks in seven South American countries over a 22-year period between 1991 and 2012. Banking crises in this region offer a natural setting in which the impact of financial markets development on bank risk is examined. We find that financial markets development improves banks’ capitalization ratio and reduces their exposure to non-traditional banking activities, suggesting that financial markets development on average reduces bank risk. In addition, banking crises and business cycles appear to moderate the impact of financial markets development on bank risk. In the aftermath of banking crises, banks appear to concentrate more on their core traditional banking activities.     

Bank interconnectedness and financial stability: The role of bank capital

This paper builds a network model to study the relation between financial stability and interconnectedness among banks. In the model, banks adopt a Value-at-Risk rule to determine capital ratios. It is shown that interconnectedness may hurt financial stability by amplifying the banks’ mistakes of underestimating risk, and that interconnectedness increases systemic risk. The results in the paper suggest that financial integration may hurt financial stability, and that bank interconnectedness is more harmful when the economy turns abruptly from boom to recession. In addition, banks should be given incentives to reduce interconnectedness if systemic risk is a serious concern for regulators.