RAROC AT BANK OF AMERICA: FROM THEORY TO PRACTICE

In 1993, Bank of America's Risk and Capital Analysis Group was charged with the task of developing and instituting a single corporate-wide system to allocate capital to all the bank's activities. Since 1994, that system has been providing quarterly reports of risk-adjusted returns on capital (RAROC) for each of the bank's 37 major business units. By 1995, B of A had also developed the capability to calculate RAROC down to the level of individual products, transactions, and customer relationships. RAROC systems allocate capital for two basic reasons: (1) risk management and (2) performance evaluation. For risk management purposes, the overriding goal of allocating capital to individual business units is to determine the bank's optimal capital structure–the proportion of equity to assets that minimizes the bank's overall cost of funding. This process involves estimating how much the risk (or volatility) of each business unit contributes to the total risk of the bank, and hence to the bank's overall capital requirements. For performance evaluation purposes, RAROC systems assign capital to business units as part of a process of determining the risk-adjusted rate of return and, ultimately, the “economic profit” of each business unit. The objective in this case is to measure a business unit's contribution to shareholder value, and thus to provide a basis for effective planning, capital budgeting, and incentive compensation at the business unit level. Concerns about capital adequacy, along with the Basel risk-based capital requirements, have played some role in the growth of RAROC among commercial banks. But the most powerful impetus to bankers' use of more systematic risk measures is coming from increasingly activist institutional investors. Besides giving senior management an economic basis for evaluating the bank as a portfolio of businesses and for making resource allocation decisions that improve the bank's risk/reward profile, RAROC systems are also expected to produce better performance by holding managers accountable for the amount of investor capital they are putting at risk.     

Determinants of the capital adequacy ratio of foreign banks’ subsidiaries: The role of interbank market and regulation

This paper examines the factors influencing the capital adequacy ratio (CAR) of foreign banks. We test whether the CAR of subsidiaries and branches in developed and developing countries depends on the same factors. We use data from 310 subsidiaries and 265 branches to test the impact of the parent banks’ fundamentals on subsidiaries’ and branches’ capital ratios. We also study how the economic condition and regulatory environment in a bank's home country determine foreign banks’ CAR. Our results provide strong evidence that the CAR of subsidiaries and branches operating in developing and developed countries do not depend on the same set of explanatory factors. We also find that the regulatory framework of a parent bank's home country affects the capitalization of its foreign subsidiaries in the host countries. Finally, we show that specific variables of the parent bank have a stronger effect for foreign banks highly related to the interbank market.     

Bank capital and equity investment regulations

This paper uses an intermediation model to study the efficiency and welfare implications of both banks' minimum required capital–asset ratio and the regulation that limits, and in some countries forbids, banks' investments in the equity of nonfinancial firms. There are two sources of moral hazard in the model: one between the bank and the provider of deposit insurance, and the other between the bank and an entrepreneur who demands funds to finance an investment project. Among other things, the paper shows that capital regulation improves the bank's stability and can also be Pareto-improving. Equity regulation is never Pareto-improving and does not increase the bank's stability.     

Implications of bank regulation for loan supply and bank stability: a dynamic perspective

ABSTRACT

We show that internal funds play a particular role in the regulation of bank capital, which has not received much attention, yet. A bank's decision on loan supply and capital structure determines its immediate bankruptcy risk as well as the future availability of internal funds. These internal funds in turn determine a bank's future costs of external finance and its future vulnerability to bankruptcy risks. Using a partial equilibrium model, we study how internal funds affect these intra- and intertemporal links. Moreover, our positive analysis identifies the effects of risk-weighted capital-to-asset ratios, liquidity coverage ratios and regulatory margin calls on the dynamics of internal funds and thus loan supply and bank stability. Only regulatory margin calls or large liquidity coverage ratios achieve bank stability for all risk levels, but for large risks a bank will stop credit intermediation.     

Financial Innovation,Basel Accord III,and Bank Value

I examine how financial innovation and Basel III capital requirements in Taiwan respond differently to banking crises and market competition. My panel data set comprises data from thirty-four banks for 2000-2012. I find a significant negative relationship between derivatives and the value of a bank and significant positive relationships among the capital adequacy ratio, bank-specific variables, and the value of a bank. Larger bank size and operational diversification tend to be positively associated with a bank's value, the holding of a relatively high amount of capital requirements, and nonperforming loans that are large. The latter result may simply reflect the scale of economy and improvement of efficiency in terms of financial innovation in the banking sector.     

On the determinants of bank interest margins under credit and interest rate risks

This paper explores the determinants of optimal bank interest margins based on a simple firm-theoretical model under multiple sources of uncertainty and risk aversion. The model demonstrates how cost, regulation, credit risk and interest rate risk conditions jointly determine the optimal bank interest margin decision. We find that the bank interest margin is positively related to the bank's market power, to the operating costs, to the degree of credit risk, and to the degree of interest rate risk. An increase in the bank's equity capital has a negative effect on the spread when the bank faces little interest rate risk. The effect of rising interbank market rate on the spread is ambiguous and depends on the net position of the bank in the interbank market. Our findings provide alternative explanations for the empirical evidence concerning bank spread behavior.     

Do capital adequacy requirements reduce risks in banking?

In a dynamic framework it is shown that capital adequacy rules may increase a bank's riskiness. In addition to the standard negative effect of rents on risk attitudes of banks a further intertemporal effect has to be considered. The intuition behind the result is that under binding capital requirements an additional unit of equity tomorrow is more valuable to a bank. If raising equity is excessively costly, the only possibility to increase equity tomorrow is to increase risk today.     

Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share—as much as 20%—of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough—the authors suggest five years—to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity. The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%.     

Structural effects of asset-backed securitization

This paper analyses the potential changes in the operational structure of deposit-taking financial institutions that securitize assets. Findings indicate that banks can create an asset securitization pipeline structure that enables them to increase their return on capital. In other words, through securitization banks can expand their loan provision business without increasing their liabilities or their capital levels. Using a contingent claims model, four factors that impact on the bank's decision to securitize are highlighted and analysed: (i) the level of deposit insurance; (ii) capital adequacy requirements; (iii) insolvency risk; and, (iv) the risk of credit enhancements. Furthermore, we identify key accounting and regulatory challenges that emerge for banks from the process of asset backed securitization.     

The misconception of the option value of deposit insurance and the efficacy of non-risk-based capital requirements in the literature on bank capital regulation

This study shows how the misconception of the option value of deposit insurance by Merton (1977) and its later misuse by Keeley and Furlong (1990), among others, have led some literature supporting the adoption of binding non-risk-based capital requirements to derive incorrect conclusions about their efficacy. This study further shows that what Merton defines as the option value of deposit insurance is actually a component of a bank's limited liability option under a third-party deposit guarantee. As such, it is already included in the value of the bank's equity capital, and the flawed definition makes the Keeley–Furlong model internally incoherent.     

A STOCHASTIC SETTING TO BANK FINANCIAL PERFORMANCE FOR REFINING EFFICIENCY ESTIMATES

This study contributes to develop a framework to measure the financial performance of banks in a stochastic setting. The framework comprises several steps, the first of which is the development of a financial performance measurement model to evaluate a bank's financial performance using a set of factors from the CAMEL (Capital adequacy, Assets, Management Capability, Earning and Liquidity) system. Second, the stochastic setting of the efficiency measurement is handled using the data collection budget allocation approach, whereby Monte Carlo simulations are used to analyse additional generated data and a genetic algorithm is used to refine the accuracy of the efficiency estimates. The results show that the accuracy of the model is greatly improved using the proposed approach. In contrast to the conventional deterministic model, the proposed framework is more useful to managers in determining the bank's future financial operations to improve the overall financial soundness of the bank. Copyright © 2014 John Wiley & Sons, Ltd.     

Is bank diversification a linking channel between regulatory capital and bank value?

This study investigates the interrelationship between bank regulatory capital and bank diversification. We argue that regulatory capital might act as a substitutive mechanism of diversification to alleviate a bank's default risk. As a result, regulatory capital is likely to discourage firms from excessive diversification, which might in turn indirectly improve bank value. Using a sample of listed banks in developed countries from 2011 to 2017, we find that total regulatory capital is inversely associated with bank diversification. Narrower regulatory capital ratios only have a significant association with income-based but not with asset-based diversification. Our results also reveal an indirect effect of regulatory capital on bank value mediated by bank diversification (i.e. indirect-only mediation). Overall, our study provides novel insights into the complementarity of the institutional and strategic domains so as to understand the far-reaching implications of regulation reforms for the strategic behaviour of banking companies.     

Earnings and capital management and signaling: the use of loan-loss provisions by European banks

This paper investigates the relationship between loan-loss provisions (LLPs) and earnings management in the context of the capital adequacy of Euro Area (EA) banks versus non-EA credit institutions. This paper also examines whether LLPs signal managements’ expectations concerning future bank profits to investors. Additionally, this paper traces the role of bank regulations and creditor protection systems in explaining income smoothing. Evidence drawn from the 1996 to 2006 period indicates that LLPs do reflect changes in the expected quality of a bank's loan portfolio for both groups of banks, and that earnings management is an important determinant of LLPs for EA intermediaries, whereas non-EA credit institutions use LLPs to signal private information to outsiders. The paper also finds that higher protection of creditors’ rights significantly reduces the incentives to smooth earnings for EA banks. During the recent financial crisis, EA bank managers are much more concerned with their credit portfolio quality and do not use LLPs for discretionary purposes, whereas LLPs at non-EA banks are used to smooth income more than for the purposes of managing capital ratios or conveying private information about future performance to the market.     

Additional evidence on the information-based contagion effects of bank failures

Recent theoretical models addressed the question of the nature of bank runs and what triggers them. Two competing hypotheses emerged: pure panic and information-based contagion. This study provides additional evidence consistent with the latter hypothesis. Three observable bank characteristics are examined as proxy measures for the interim private information used by rational depositors in assessing the riskiness of a bank's long-lived assets that may trigger bank runs. The three factors are (1) the distance of the solvent banks' headquarters from the headquarters of each failed bank; (2) the size of the solvent banks; and (3) the capital ratio as a proxy for their solvency. The analysis is conducted in the context of the five large bank failures that occurred in the Southwest region of the US during the mid-1980s. Weekly abnormal returns of 33 Southwestern BHCs, in ten critical failure-related event dates are regressed on the three observable bank characteristics. Our findings suggest that distance and capital adequacy are negatively related to the magnitude of the contagion effect, whereas size is positively related.     

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.     

The bank capital channel and bank profits

This paper develops a microeconomic model of banking to highlight an endogenous loan creation process that emerges from bank profits via the capital accumulation of retained earnings and uses a simple bank capital‐loan multiplier to illustrate constraints on lending. The study also analyzes how sufficient net interest margins are important for banks to maintain lending portfolios and avoid financial fragility. The model offers support to bank capital channel (BKC) economists by illustrating how changes in interest rates may influence bank lending through the bank's internal capital accumulation growth rate and on a bank's portfolio choices.     

Bank governance,regulation and risk taking

This paper conducts the first empirical assessment of theories concerning risk taking by banks, their ownership structures, and national bank regulations. We focus on conflicts between bank managers and owners over risk, and we show that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank. Moreover, we show that the relation between bank risk and capital regulations, deposit insurance policies, and restrictions on bank activities depends critically on each bank's ownership structure, such that the actual sign of the marginal effect of regulation on risk varies with ownership concentration. These findings show that the same regulation has different effects on bank risk taking depending on the bank's corporate governance structure.     

Subordinated Debt,Market Discipline,and Bank Risk

This paper demonstrates that subordinated debt (subdebt thereafter) regulation can be an effective mechanism for disciplining banks. By reducing the chance that managers of distressed banks can take value‐destroying actions to benefit themselves, subdebt regulation may encourage banks to lower asset risk. Moreover, subdebt regulation and bank capital requirements can be complements for alleviating the banks’ moral hazard problems. To make subdebt regulation effective, regulators may need impose ceilings on the interest rates of subdebt, prohibit collusion between banks and subdebt investors, and require subdebt to convert into the issuing bank's equity when the government provides assistance to the bank.     

资本管制下商业银行战略选择对绩效的影响

以我国14家上市商业银行2004～2009年的平衡面板数据为样本,通过银行关键战略资源配置来体现银行战略选择,将银行战略问题从定性向定量转化,并通过理论建模和实证分析来研究资本管制、战略选择和绩效三者的关系。结果认为,资本管制对银行的资本充足率与绩效都存在显著直接影响;资本管制通过调整商业银行资本充足率,对绩效产生间接影响;管制压力与不同的战略资源配置的交互作用分别对资本充足率、绩效有不同的影响。     

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.