Macroprudential analysis of …nancial institutions: section 3

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Macroprudential analysis of …nancial institutions: section 3

Master 2 course

J.S. Mésonnier

Banque de France, Financial Economics Research

This version: october 2013

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Outline of part 3: regulating bank capital in a macroprudential perspective

Why do banks hold (so little) capital?

Why regulate bank capital? The macro importance of bank capital Bank capital regulation from Basel I to Basel III

A critical view of the "Basel tower"

Beyond Basel III

Mésonnier-Renne (Banque de France, Financial Economics Research)Macroprudential analysis This version: october 2013 2 / 135

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A puzzle: the high leverage of credit institutions

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Leverage and pro…tability across industries

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The capital structure decision of …rms: Modigliani & Miller (1958)

What is the cost of capital? Developing a theory of corporate investment when asset returns are uncertain.

Restrictive assumptions: perfect competition, no assymetries of information, no opportunity of arbitrage, no taxation

Firms grouped into homogenous classes of risk (correlated returns), so that the expectedrate of return on assets in each class is a constant ρ_A

Then, M&M show (by arbitrage) that the marketvalue of a …rm is independent of its capital structure:

ρ_A.V_A= ρ_A.(E+D)

As a consequence, the expectedreturn on shares can be expressed as

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The capital structure decision of …rms: Modigliani & Miller (1958)

M&M assume that the asset side of the balance sheet (projects, physical assets, loans, securities) is given: the …nancing-mix decision is separable from the investment decision

An ex-anteview on the capital structure decision, concerned with having, not raising equity (see below).

Di¤erent from pure accounting equation (book values and ex post):

ROE =ROA+ (ROA r).D/E

M&M stringent assumptions generally do not hold, but M&M should be used to discipline the analyisis: one must be precise about what deviation from idealized conditions is at work.

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Deviations from M&M and capital structure of banks

Debt is subsidized (tax deductibility of interest payments): true, but not speci…c to banks

Failure is costly: limit to leverage (applies to all …rms, but banks bene…t from implicit/explicit state guarantees)

Disciplining role of (short-term) debt and high leverage (Calomiris and Kahn, 1991, Diamond and Rajan, 2001):

Debt returns are not contingent: no reason to monitor managers.

However, with higher leverage, creditors are more exposed to losses:

incentive to better monitoring and higher required returns

Banks are "opaque": agency problems of creditors with management.

Short-term debt (like deposits) is disciplining managers because of the

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Deviations from M&M and capital structure of banks (foll’d)

Note that this can go too far: high leverage induces risk-shifting moral hazard. Managers/Shareholders prefer riskier gambles that maximize the price of their equity (call) option on bank assets (Jensen and Meckling,1976).

Intuition: suppose a project-…rm yieldingE(R), funded byE andD.

Debtholders are senior. Compare expected utilities for shareholders and debtholders if project returns either valueR=D σ orR=D+σ with equal probabilities.

Tension between run-based disciplining role of leverage and

risk-shifting incentives: basis for a "market-based capital requirement"

Debate: is the latter enough? At all times? (risk assessment through the cycle...)

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Why regulate bank capital?

General motivations

Cost of negative shocks to bank capital: empirical …ndings Bank capital and the ampli…cation of macro shocks: a DSGE approach

Bank capital and systemic risk-taking: a macro model

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Why regulate bank capital?

Banks are fragile: prone to runs (Diamond and Dybvig, 1983). High social cost of bank failures and bank crisis (Laeven and Valencia, 2008, 2010 see Table below). This cost is not internalized by bank managers/shareholders: thus need for regulation!

Deposit insurance creates adverse incentives: insured depositors do not need monitor bank managers anymore. Hence more risky decisions. Regulatory capital requirements must compensate.

[What happens when managers are not shareholders and complete contracts are not feasible? Bank capital regulation needed to enforce second best solutions on behalf of depositors. See Dewatripont and Tirole (1994), also summary in FR, chap 9.]

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Banking crises entail high social costs

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Bank leverage in a historical perspective (US case)

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Why regulate bank capital?

Note however: possible welfare costs of capital regulation (e.g. Van den Heuvel, 2010). Notably, social bene…ts of the issuance of "bank money".

See also Gorton and Metrick (2010) for an analysis of private bank bene…ts from issuing collateralized short term debt (like repos) that command money-like convenience premiums (safety + transaction services).

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Costs of bank capital shocks: empirical results

How may adverse shocks to bank capital impact lending and economic activity?

Challenge #1: disentangling loan demand and supply e¤ects

Bad economic conditions re‡ect in poorer lending opportunities, lower loan demand for investment, and deteriorated bank capital (write-o¤s).

How to deal with reverse causality?

Natural experiment: identify some truly exogenous source of capital depletion. Best exemple: Peek and Rosengreen (1997)

Exploit di¤erences in bank balance-sheets, assuming common lending opportunities: OK if di¤erences across banks hinge only on their ability to rebuild capital. Ex.: Bernanke and Lown (1991), Hancock and Wicox (1993), Berrospide and Edge (2010)

Statistical controls, e.g. lags of loans as IV or regressors in a VAR.

Recent microeconometric literature using loan-level data in a di¤-in-di¤

spirit (e.g. Jimenez et al., 2011, cf. Peydro, IJCB, 2010 for a survey).

Converging results that capital shocks matter for loan supply

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Costs of bank capital shocks: empirical results

Challenge #2: assessing the impact on economic activity

Many studies …nd that changes in capital fo some banks matter for their lending to some borrowers

Evidence of aggregate impact? What if borrowers have other sources of funding? How to control for this?

Natural experiment again: Peek and Rosengreen (2000)

Some studies use VAR frameworks, thus building on the statistical approach above. Ex.: Berrospide and Edge (2010)

Less concensus on overall economic impact of changes in bank capital

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Bank capital shocks and lending: Peek and Rosengreen (1997)

Focus on US branches of Japanese banks around the burst of the Japanese bubble (end 1980s-early 1990s)

From 1988 on, Basel I allowed Japanese banks to count their unrealized gains on common equity holdings as Tier 2 capital, thus fueling the boom

During the 80s, aggressive international expansion of Japanese banks, notably in the US (18% of US C&I loans in 1990)

Burst if the bubble (Nikkei lost 50% over 1989-1992) caused large Japanese banks to fall below the regulatory minimum of 8%

P&R use this and regress loans (DL) by Japanese branches in the US on their parent company’s capital ratio (PRBC) + controls: 1 pp decline in PRBC results in 6% in loans at the branch level Note: e¤ect is much lower for Japanese banks’subsidiaries

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Bank capital shocks and lending: Bernanke and Lown (1991)

Focus on the "credit crunch" associated with the 1990-1991 recession in the US.

Claims by observers that depletion in (book) bank capital following the burst of the real estate bubble in some states, notably in New England, interacting with the phasing-in of Basel I, caused a decline in lending that aggravated the recession (hence "capital crunch", R.

Syron).

Cross-sectional regression using state level data of loan growth during the recession on CAR in 1989 + same regression at bank level for New Jersey banks suggest strong e¤ect of lower capital ratios on lending, at least for small banks

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Bank capital shocks and lending: Bernanke and Lown (1991)

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Bank capital shocks and lending: Berrospide and Edge (2010)

Follow on methodology of Hancock and Wilcox (1993) and assume that banks adjust their leverage to changes in a predetermined target which hinges on bank characteristics:

∆K_i_,t = λ(K_i,t K_i,t) +εi,t

K_i_,t = αi+θx_i,t ₁

Loan growth is then regressed at bank level on the estimated capital surplus (K_i_,t K_i,t)/K_i,t and macro controls

Use Call report data for 140 large US BHC over 1992-2009

Find that $1 capital surplus results in $1.86 increase in loan volumes

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Bank capital shocks and activity

Peek and Rosengreen (2000) show that loan supply identi…ed in PR 1997 impacted real activity in US states where Japanese branches accounted for a signi…cant market, notably market for commercial real estate (CRE).

State level panel regressions CRE activity on lending by Japanese banks and controls, instrumenting the lending variable by the health of the relevant Japanese parent banks

Find signi…cant impact of lending by Japanese bank branches on real estate activity

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Bank capital and ampli…cation of macro shocks:

theoretical results from a DSGE model

Meh & Moran (JEDC, 2010): New Keynesian DSGE model with banking sector where bank capital solves asymmetric info problem bankers and depositors (à la Holmström Tirole, QJE 1997).

Bank capital thus determines ability of banks to attract funds and fund investment: in‡uence on business cycle through a bank capital channel of transmission.

3 types of agents: households (depositors), entrepreneurs, bankers and 3 types of goods: …nal and intermediate goods as in standard NK model + capital goods produced by entrepreneurs.

Production of capital goods is plagued by two types of moral hazard problems:

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Capital good production: shirking entrepreneurs

Entrepreneurs investi_t for a grossobservablereturn ofRi_t (success) of 0 (failure).

They privately choose among di¤erent projects with di¤erent prob of success and levels of private bene…ts:

Good guys: choose projects with probaα^g and private bene…ts 0 Bad guys: chooseα^b <α^g and private bene…tsbi_t

Ugly guys: chooseα^b and private bene…tsBi_t,B>b

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Capital good production: bank monitoring

Banks can monitor entrepreneurs to deter them from choosing projects with high-level shirking intensity.

Monitoring is costly (cost µit) and monitoring e¤ort non-observable to depositors: moral hazard problem again

Solution: banks must invest their own capital in the projects to align their private incentives to the interests of depositors

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Financing entrepreneurs: …nancial contract (1)

Entrepreneur: net worthn, project of size i, needs external …nancing i n (subscriptt here)

Bank: combines deposits d with own equity (net worth) a (with required market rates of return: r^d,r^a)

Price of capital goods in terms of …nal goods: q

One-period …nancial contract set in real terms, so that we select only equilibria where entrepreneurs must choose good projects (i.e. α^g)...

... determines investment size i, contributionsa andd, and respective (positive) shares of total return: R^e,R^b,R^h.

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Financing entrepreneurs: …nancial contract (2)

Contract aims at maximizing expected return to the entrepreneur s.t.

incentive, participations and feasability constraints:

max

fî,a,d^,Rê^,R^b^,R^hg(qα^gRêi) s.t. :

qα^gR^ei qα^bR^ei+bi qα^gR^bi µi qα^bR^bi

qα^gR^bi (1+r^a)a qα^gR^hi (1+r^d)d

a+d µi i n

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Financing entrepreneurs: …nancial contract (3)

Solving for the return shares in equilibrium, they come out as linked to severity of moral hazard problems:

R^e = b/∆α R^b = µ/∆α

R^h = R b/∆α µ/∆α

Solving for i, one gets: i = (a+n)/G, where G =1+µ+ ₁^qα₊_r^gd(R b/∆α µ/(q∆α))

1/G is leverage of project over net worth of bank and entrepreneur.

NB: constant across all contracts.

Also note that∂G/∂q<0 and∂G/∂r^d >0

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Financing entrepreneurs: …nancial contract (4)

Important to see also that …nancial contracts determines a

market-based capital adequacy ratioκ that banks have to meet and depends only on macro variables (r,q):

κ = ^a

a+d

= ^µ

µ+q∆α+₁₊^r^a_rd(R b/∆α µ/(q∆α))

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Reality check: cyclical properties of modelled CAR

After derivation of FOC, aggregation, computation of competitive equilibrium and calibration, how do the cyclical properties of

model-based CAR compare with those observed for the US economy?

Good!

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What do we learn from this model? Simulated IRFs to shocks

An active bank capital channel ampli…es the size and persistence of the e¤ects of adverse technology shocks and restrictive monetary policy shocks (compared to economy whereµ=0)

These amplifying e¤ects are dampened whenever banks have more capital ex ante (higher CAR of e.g. 20%)

"Credit crunches" matter: negative bank capital shocks (=accelerated depreciation of bank capital have strong recessionary e¤ects.

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Technology shocks and the bank capital channel

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Technology shocks and the bank capital channel: economy

with more bank capital

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Credit crunch

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Bank capital ratios in a macro model of systemic risk-taking

Martinez-Miera and Suarez (mimeo, CEMFi, 2012)

Objective: incorporate banks & systemic risk in macro analysis DSGE-style models explicit about banks do not yet have/share clear notion ofendogenous systemic risk:

Pre-crisis: Van den Heuvel, 2008; Meh-Moran, 2010

Post-crisis: Brunnermeier-Sannikov, 2011; Gertler-Karadi, 2011;

Gertler-Kiyotaki, 2010;...

In this paper, systemic risk results from banks’voluntary exposureto an infrequent & large common shock...

which is attractive to them due to standard risk-shifting incentives of levered …rms

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Main features of the model

1 Dynamic equilibrium modelin which perfectly competitive …rms need bank loans for their funding in advance of wages and working capital

2 Firms & banks make joint unobservable systemic risk-taking decision Systemic …rms fail with proba 1 ifsystemic shockoccurs (otherwise failure is iid)

Systemic …rms faillessconditionally of no shock, butmore unconditionally

3 Bank capital dynamics: capital invested in systemic loans is lost if shock realizes:

) 9“Last bank standing e¤ect” like in Perotti-Suarez (2002)

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Other features

Many simpli…cations: risk-neutral agents, no physical capital

accumulation, no money, no price rigidities, no labor market frictions ... but structural description is rich enough for calibration

Role for bank capital is di¤erent from other macro papers...

Meh-Moran’10: Monitoring incentivesa laHolmström-Tirole’97 Gertler-Kiyotaki’10: Preventing fund diversiona laHart-Moore’94 ... here it reduces bankers’systemic gambling incentives

Aggregate uncertainty is key, requiring full non-linear solution (rather than log-linearization around non-stochastic SS)

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Qualitative results

1 Strengthening capital requirements (CRs):

Reduces systemic risk taking and, hence, the losses due to systemic shocks

Reduces credit and output in normal periods (but also the size of their collapse during crises)

2 Welfare trade-o¤s produce a unique socially optimal CR [Concerns on costs of crises vs. Constrained supply of credit]

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List of endogenous variables

Marginal value of bank capitalv_t =v(e_t) 1 Fraction of systemic banks x_t =x(e_t)2 [0,1) Physical capital used by …rms k_t =k(e_t) 0 Wage rate wt =w(et) 0

ROE at non-systemic bank R0t+1 =R0(et) 1+r ROE at systemic bank if no shock R_1t¹₊^ε₁ =R₁¹ ^ε(e_t) 0

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Social welfare W as a function of capital requirement γ

2.97 2.975 2.98 2.985 2.99 2.995 3 3.005

6% 8% 10% 12% 14% 16% 18%

Capital requirement

Social welfare

Figure 1: W(γ)[max forγ =14%]

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v(e) and x(e) under low and optimal γ

0 1 2 3 4 5 6 7 8 9 10

0 0.5 1 1.5 2 2.5

Aggregate amount of bank capital (e)

Value of one unit of bank capital (v)

optimal capital requirement (14%) low capital requirement (7%)

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

0 0.5 1 1.5 2 2.5

Aggregate amount of bank capital (e)

Systemic risk taking (x)

optimal capital requirement (14%) low capital requirement (7%)

Figure 2a: v(e) Figure 2b: x(e)

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Comments on Fig. 2:

Greater scarcity of e due to higherγ implies largerv(e) Systemic risk-taking (increasing in e) is lower when γ is higher Why?

γa¤ects position and slope of v(e)

Gives greater incentives to preservee after systemic shock Further intuition (esp. on welfare trade-o¤s) requires looking at (endogenous) dynamics ofe

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Quantitative results

Optimal capital requirements: positive and large (14%) Comparison CR=7% $CR=14% (unconditional means)

Fraction of systemic loans: 71%$^24%

Loan rates increase: 4.1%$^5.6%

Macro aggregates fall: bank credit ‡ows by 21%), GDP growth by 7%

Yet, di¤erence in social welfare'+0.9% permanent consumption:

“static gains” (less risk-shifting)

“dynamic gains” (lower loss of economic activity after shock)

Fall in year-after-shock aggregates:

CR=7%!loan rate (+11.6pp), bank credit (65%), GDP (32%) CR=14%!loan rate (+2.5pp), bank credit (24%), GDP (10%)

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Take away of this model

Very signi…cant implications of capital requirements

Setting them optimally requires economic risk-management view:

static element: ine¢ cient systemic risk-taking if leverage too high = larger unconditional failure rate

dynamic element: macroeconomic e¤ects of systemic shock propagated and ampli…ed by loss of bank capital

Standard macroeconomic aggregates evaluated in the PSS (credit, GDP) give bad indication of convenience of high γ: capital requirements have “large costs” in those terms.

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Bank capital regulation in a historical perspective: overview

Focus on bank capital regulation is recent: late 1980s

1930s-1970s: stronger focus on market structure (e.g. US Glass Steagall Act), asset allocation rules, caps on interest rates (e.g. US Regulation Q)...

1970s-1980s: regulations made largely ine¤ective due to …nancial innovation, liberalization of international capital ‡ows, IT.

Basel Accord of 1988 (Basel I) introduced new harmonized minimum capital requirements for international banks. Risk weights by class (100% for C&I loans, 50% for mortgages, 0% for loans to sovereigns)

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Bank capital regulation in a historical perspective: overview

1993: proposed extension of Basel I to market risk (changes in value of trading books). Criticized by industry as imposing too bold ratios compared to predicaments of banks’quantitative models.

1996 Amendment to incorporate market risk: banks allowed to determine regulatory capital on the basis of their own risk models.

2004: Basel II Agreements (implementation started in 2006) extend this logic to credit risk also (IRB approach)

2010: New Basel III proposal (detailed below). Implementation phase runs up until 2018...

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How to regulate bank capital? Risk adjusted capital requirements

Portfolio approach of bank assets [Kareken and Wallace (1978), Crouhy and Galai (1986), Kim and Santomero (1988)]: if banks behave as portfolio managers when they choose the composition of their portfolio of assets, then regulator should use risk-related weights for the computation of the capital-to-asset ratio.

Using a mean-variance model, Kim and Santomero compare the bank’s portfolio choice before and after a solvency regulation is imposed.

They show that the solvency regulation will entail a recomposition of the risky part of the bank’s portfolio in such a way that its risk is

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How to regulate bank capital? Risk adjusted capital requirements

Rochet (1992) criticizes the Kim-Santomero approach and adds the limited liability option in the bank’s objective function.

If this option is correctly taken into account, the corrected utility functionU_LL(µ,σ²) = 1/p

2π.R_∞

µ/σu(µ+tσ)exp( t²/2)dt.is not always decreasing inσ².

Then the e¢ ciency of solvency regulations is jeopardized even more.

Even when market-based risk weights are used, it may be necessary to require an additional regulation in the form of an additional minimum capital requirement for banks (in absolute terms), independent of their size.

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Basel I: reminder

Two powerful advantages:

Level playing …eld for competition among international banks (case of Anglo-saxon banks, rise of Japanese banks in ’80s)

Simple rules: simple risk classes, RWA covered by minimum ratio of 4% Tier 1 capital (equity less goodwill) and 8% Tier 1 + Tier 2 capital.

Note: demise of reserve requirements on deposits to insure liquidity and safety of banks. Focus on liabilities side (capital) only (+LLR function of CB and ample provision of sovereign bonds as liquidity bu¤ers)

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Basel II: adjusting risk weights to …ght regulatory arbitrage

Three pillars: regulatory capital base, risk-adjustment using internal banks’models (I), supervisory oversight (II), market discipline (III) Pillar I: coping with credit risk (CR, market risk (MR) and operational risk (OR):

RWA=12.5 (OR+MR) +1.06

∑

i

w_i A_i

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Basel II capital requirements for credit risk (Pillar I): how does it work?

A menu of approaches, depending on sophistication of a banks’

activities and of its internal risk management capabilities.

Standardized approach: based on external credit ratings when available, on Basel I charge (8%)otherwise.

Internal ratings-based approach: banks assign exposure to di¤erent asset classes ; within each class, banks assign di¤erent internal rating grades / to the creditworthiness of (homogenous groups of) borrowers

This implies estimating for each borrower: one-year ahead PD, LGD, EAD, Maturity (M)

Foundation IRB approach: banks estimate only the PD and take other

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Basel II: IRB approach

Capital requirement based on VaR at 99.9% with one year horizon:

Capital required= Maximal possible loss - expected loss (already incorporated in loan pricing)

VaR computed using a one-factor Gaussian copula model of time-to-default:

Suppose large portfolio of loans, same PD, copula correlationρ then worst case default rate at 99.9% is:

WCDR =N N ¹(PD) +p_ρ.N 1(0.999) p₁

ρ

!

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Basel II: IRB approach (2)

Total portfolio loss (worts case) will then be less (at 99.9%) than:

(_∑_iEAD_i.LGD_i).WCDR

Whereas expected loss (priced in or provisioned) is:

∑iEAD_i.LGD_i.PD

Hence capital requirement is: (_∑_iEAD_i.LGD_i).(WCDR PD) cf. http://www.bis.org/publ/bcbsca05.pdf for details

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Basel II: IRB aproach for corporate, sovereign or bank exposures

Assumed correlation between copula parameter ρand PD (empirical research):

ρ = 0.12 1 e ^50PD

1 e ⁵⁰ +0.24 1 1 e ^50PD 1 e ⁵⁰ ' ^0.12. ¹ ^e ^50PD

Adjustment for Maturity (M) if longer than one year:

MA=^h¹⁺⁽_{1 1.5.b}^M ^2.5⁾^.bⁱ whereb = [0.11852 0.05478.ln(PD)]²

idea: control for changes in creditworthiness during life of loan Bottom line: total risk-weighted assets:

RWA=12.5.[EAD.LGD.(WCDR PD).MA]

Hence: required capital = 8% of RWA (half of which must be Tier 1 capital).

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Basel II IRB approach:

NB: Correlation decreases with PD (riskier loans supposed to have higher idiosyncratic risk)

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Basel II IRB: Example of capital charge computation

Bank with assets $100 mns of loans to A-rated corporations, with PD=0.1% and LGD=60% and average maturity 2.5 years.

Implies (see above): b =0.247 andMA=1.59

Tabulated Gaussian WCDR for portfolio gives: WCDR =3.4%

Capital charge under Basel II is ($ mns):

100 0.6 (0.034 0.001).1.59=39.3

NB: under Basel I would have been $100 mns, and under standardized Basel II: $50 mns

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What risk-weighting means: di¤erence between capital

adequacy and leverage ratios

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Motivations for the Basel 3 proposals

The depth and severity of the crisis were ampli…ed by weaknesses in the banking sector: excessive leverage, inadequate and low-quality capital, and insu¢ cient liquidity bu¤ers.

Ampli…cation by a procyclical deleveraging process and the interconnectedness of systemically important …nancial institutions.

Reforms aim "to improve the banking sector’s ability to absorb shocks arising from …nancial and economic stress, whatever the source, thus reducing the risk of spillover from the …nancial sector to the real economy."

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Motivation of Basel 3 (2)

To strengthen bank-level, or micro prudential, regulation, so as to raise the resilience of individual banking institutions in periods of stress.

Add a macro prudential focus, addressing system wide risks (cross-sectional correlations + procyclical ampli…cation).

Recognition that micro and macro prudential approaches to supervision are interrelated, as greater resilience at the individual bank level reduces the risk of system wide shocks.

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Reform design process

October 2009: G20 guidelines

December 2009: proposals made public

Review of comments received (close to 300 comments from bankers, academics, governments, other standard setters and prudential supervisors, and various other market participants and interested parties) and redrafting of proposals.

Validation by the Committee, then the Governors and Heads of Supervision between (July 2010 - September 2010)

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Reform highlights

stronger bank capital regulation.

new bank liquidity regulation

improvements in supervision, risk management and governance, as well as greater transparency and disclosure.

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The new enlarged framework of Basel III

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Stronger capital regulation: corrected microprudential approach (1)

Raising the qualityof capital to ensure banks are better able to absorb losses on both a going concern and a gone concern basis:

greater focus on common equity. (see Focus below).

Raising the quantityof capital.

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Focus: what is "higher-quality capital"?

What is capital? Common equity, preferred stock, unrealized gains on asset trades? Deferred tax assets, goodwill, subordinated debt? Tier 1? Tier 2? (see forms below)

Most used metric so far: Tier 1 capital = common equity + preferred stock + ...

Is it the same quality (loss absorbtion capacity)?

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What is capital? US case (FRY 9C form, 2010)

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What is capital? US case

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Higher quality capital: Preferred stock vs common equity

Easier to see in a dynamic perspective

Bank A: Asset $100, capital $6, of which common equity 100%

Bank B: Asset $100, capital $6, of which common equity $2 and preferred stock $4

Both banks lose $3 during the crisis. They want to recapitalize.

Which bank …nds it more di¢ cult to issue the missing $3 of equity (to avoid deleveraging)?

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Stronger capital regulation: corrected microprudential approach (2)

Common Equity Tier 1 (CET1) = common shares (+ associated share premium + retained earnings + some minority interests - goodwill - deferred tax assets)

Tier 1 (loss absorption on a going-concern basis) = CET1 + some perpetual preferred stocks + some CoCos + ...

Tier 2 (loss absorption on a gone-concern basis) = T1 +

subordinated debt + other preferred stocks + other CoCos + general provisions + ...

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Stronger capital regulation: new ratios

Common Equity Tier 1 (CET1) = 4.5% + 2.5% conservation bu¤er (+ countercyclical bu¤er up to 2.5% + G-SIB add-on 2%)

Tier 1 = 6%

Tier 1 + Tier 2 = 8%

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Basel III: implementation calendar

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Stronger capital regulation: new macroprudential approach

New countercyclical bu¤erto protect the banking sector from periods of excess credit growth.

Promoting the build up of capital bu¤ers in good times that can be drawn down in periods of stress

Numerous challenging implementation issues

Introducing an internationally harmonisedleverage ratio: backstop to the risk-based capital measure + aims to contain the build-up of excessive leverage in the system: proposed ratio of 3% from 2013 on.

Denominator will encompass on- and o¤-balance sheet exposures and derivatives.

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The new countercyclical capital bu¤er

A single objective: ensure that banking sector has enough capital to maintain the ‡ow of credit when the system experiences stress consecutive to a period of excess credit growth

dampening e¤ect on credit growth viewed as "positive side bene…t"

National decisions and jurisdictional reciprocity

Each jurisdiction will be able to use "judgement" to implement bu¤er add-on (see guidelines below) Upper limit common to all countries.

12-months preannouncement of add-on, immediate e¤ect of reduction during stress

Host authorities will set bu¤er add-on for exposure to counterparties in their jurisdiction. Home authorities will monitor that banks in their jurisdiction correctly calculate bu¤ers according to the geographic location of their exposures. Consequences for international banks.

Enforcement: 12 months to increase capital before restrictions on earning distributions.

A common reference guide

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The new countercyclical capital bu¤er (2)

Simple guiding variable: credit/GDP gap (extracted using a one-sided HP …lter).

Rationale: on average good predictor of banking crisis in OECD countries over the past three decades (cf. Borio, Drehman, Tstatsaronis, IJCB, 2010).

However, acknowledgement that "does not work well in all jurisdictions at all times".

"Judgement coupled with proper communication is thus an integral part of the proposal".

Step by step guide to calculating the proposed bu¤er add-on (cf.

BCBS, consultative document, July 2010, Annex 2)

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The new countercyclical capital bu¤er (3)

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The new countercyclical capital bu¤er (4)

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Countercyclical bu¤er (5): simulation for two NL banks

(A: large international bank, B: mid-sized local bank)

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Basel III: implementation calendar

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Basel III: where do we stand?

Basel III Monitoring Report (March 2014)

Data as of June 2013, 27 participating countries (voluntary basis) Study covers 227 banks

102 Group 1 banks (international bank with Tier 1 Capital> e3 bn):

very good coverage in most countries

125 Group 2 banks (others): not so good coverage

Estimates of current capital shortfall induced by full implementation of Basel III requirements

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Basel III: 2014 monitoring report (1)

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Basel III: 2014 monitoring report (2)

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Basel III: 2014 monitoring report (3)

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Basel III: 2014 monitoring report (4)

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Basel III: 2014 monitoring report (5)

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A critical view of the Basel Tower

Some unfair critics, to be …rst debunked using M&M Pending issues:

Complexity and opacity Regulatory arbitrage II and III Conceptual issues unsolved

Procyclicality: analysis using Repullo and Suarez (RFS, 2013)

Competition issues: shadow banking

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Debunking some fallacies about higher capital ratios

Cf. Admati, De Marzo, Hellwig, P‡eiderer (2011): "Fallacies, irrelevant facts and myths in the discussion of capital regulation"

Fallacy 1: equity is "idle" (confusion between the two sides of the balance sheet

“Every dollar of capital is one less dollar working in the economy”

(Steve Bartlett, Financial Services Roundtable, reported by Floyd Norris, “A Baby Step Toward Rules on Bank Risk,” New York Times, Sep. 17, 2010).

“The British Bankers’Association . . . calculated that demands by international banking regulators in Basel that they bolster their capital will require the UK’s banking industry to hold an extra £ 600bn of capital that might otherwise have been deployed as loans to businesses

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"Fallacies, irrelevant facts and myths in the discussion of capital regulation"

Fallacy 2: Increased capital requirements force banks to operate at a suboptimal scale and to restrict valuable lending and/or deposit taking

“More equity might increase the stability of banks. At the same time however, it would restrict their ability to provide loans to the rest of the economy. This reduces growth and has negative e¤ects for all.” Josef Ackermann, CEO of Deutsche Bank (November 20, 2009, interview).

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"Fallacies, irrelevant facts and myths in the discussion of capital regulation"

Fallacy 3: Increased equity requirements will hurt bank shareholders since it would lower the banks return on equity (ROE).

“Demands for Tier-1 capital ratio of 20%... could depress ROE to levels that make investment into the banking sector unattractive relative to other business sectors.” Ackermann (2010, p. 5.)

“The problem with [equity] capital is that it is expensive. If capital were cheap, banks would be extremely safe because they would hold high levels of capital, providing full protection against even extreme events. Unfortunately, the suppliers of capital ask for high returns because their role, by de…nition, is to bear the bulk of the risk from a bank’s loan book, investments and operations” Elliott (2009, p. 12).

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"Fallacies, irrelevant facts and myths in the discussion of capital regulation"

Remember that

ROE =ROA+ (ROA r).D/E

For a given capital structure, ROE does re‡ect the realized pro…tability of the bank’s assets. But when comparing banks with di¤erent capital structures, ROE cannot be used to compare their underlying pro…tability.

Higher equity capital requirements will tend to lower the bank’s ROE only in good times when ROE is high. They will raise the ROE in bad times when ROE is low. From an ex ante perspective[as in M&M], the high ROE in good times that is induced by high leverage comes at the cost of having a very low ROE in bad times.

Note: in other words, although equity has a higher required return, this does not imply that increased equity capital requirements would raise the banks’overall funding costs.

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"Fallacies, irrelevant facts and myths in the discussion of

capital regulation"

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Costs of higher steady-state capital ratios: some empirics

Little empirical evidence available

Kashyap, Stein and Hanson (2010) test that the M&M intuition holds ("conservation of risk"): if leverage is lower, the market beta of the bank and the volatility of its stock should be lower too

Regression of estimatedβandσ of a panel of US bank stocks on annual measures of book equity to book assets (see table) Gives support to M&M principle for calibration purpose.

Using the M&M logic, KSH then calibrate the e¤ects of an increase of the required CAR on loan interest rates (see table) along three scenarios. Conclude that the increase in long-run level of interest rate on loans would be very small (below 45 bp for an increase in the capital requirement by 10 pp.)

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Kashyap, Stein and Hanson (2010)

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Kashyap, Stein and Hanson (2010)

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What are the e¤ects of heightened capital requirements:

short run costs

Stock/Balance sheet costs of holding more equity vs ‡ow costs of increasing capital

Theory for balance sheet costs: see previous section on M&M

Theory for ‡ow costs: mainly lemon problem mentioned by Myers and Majluf (1984) due eg to opacity of relationship lending

Note: association between stocks issues and price declines well documented empirically

Theory implies that …rms are not adverse to high capital ratio if can accumulate it over time by retained earnings

Empirical evidence con…rm that ‡ow costs are contained (but potentially higher in crisis times!)

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The tower of Basel: increasing complexity

"With hindsight, a regulatory rubicon had been crossed [in 1996]. This was not so much the use of risk models as the blurring of the distinction between commercial and regulatory risk judgements. The acceptance of banks’own models meant the baton had been passed. The regulatory backstop had been lifted, replaced by a complex, commercial judgement.

The Basel regime became, if not self-regulating, then self-calibrating.

A revised Basel Accord, Basel II, was agreed in 2004. It followed closely in the footsteps of the trading book amendment. Internal risk models were allowed as a means of calibrating credit risk. Indeed, not so much

permitted as actively encouraged, with internal models designed to deliver lower capital charges. By design, Basel II served as an incentive device for banks to upgrade their risk management technology. (...)That meant greater detail and complexity." (Andrew Haldane, Jackson Hole Speech, 2012)

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The tower of Basel: increasing complexity

Basel I: 30 pages

Basel II: 347 pages Basel III: 616 pages...

This but understates complexity and opacity: parameter space of a large bank’s banking + trading books probably dimension of several millions (Haldane, 2012)

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The tower of Basel: increasing complexity

Basel I: 30 pages Basel II: 347 pages

Basel III: 616 pages...

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The tower of Basel: increasing complexity

Basel I: 30 pages Basel II: 347 pages Basel III: 616 pages...

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The tower of Basel: increasing complexity

Basel I: 30 pages Basel II: 347 pages Basel III: 616 pages...

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The tower of Basel: increasing complexity

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The tower of Basel: increasing complexity (2)

Do not forget the legislative blanket that translates non-statutory Basel rules into national legislations:

US: Dodd-Frank Act of 2010 = 848 pages (20 times more than Glass Steagall Act) + rule-making book set up by regulatory agencies (400 pieces) = 8,843 pages at mid 2012 (up to probably 25,000 if same proportions maintained)

EU: a dozen of directives and associated rule-books, making up around 2,000 pages in mid 2012 (up to 60,000 when completed?)

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The tower of Basel: increasing costs

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The tower of Basel: reporting burden

Reporting burden for a large bank:

UK: 1974: some 150 entries, 2012: some 7,500 entries US: 1930: some 80 entries, 2012: 2,271 Excel columns Maintenance costs:

UK: compliance with Basel III reporting would imply 200 full-time jobs for a European mid-sized bank (McKinsey, 2010)

US: compliance with DFA would imply some 1000 full-time job for large bank (Fin. Serv. Committee, 2010)

How much is this investment worth in terms of averting future …nancial crises?

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Horse race: complex RW vs simple capital rules

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Horse race: complex RW vs simple capital rules

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Basel II did not stop regulatory arbitrage

The declining trend in RWA

Micro evidence on arbitrage associated with the implementation of IRB models (Mariathasan and Merrouche, 2013)

Analysis of risk-weighted assets for market risk

An example about capital arbitrage and promise shifting using CDS (Blundell-Wignall and Atkeson, OECD Jl, 2010)

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Basel II did not stop regulatory arbitrage (2)

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Basel II did not stop regulatory arbitrage (3)

Micro evidence on arbitrage associated with the implementation of IRB models (Mariathasan and Merrouche, 2013) using:

115 banks that have been approved for IRB adoption 21 OECD countries

annual balance sheet data, 2004-10 (Bankscope)

Idea: contrast ex post banks that eventually failed and banks that did not

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Basel II did not stop regulatory arbitrage (3)

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Basel II did not stop regulatory arbitrage (3)

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Basel II did not stop regulatory arbitrage (3)

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Variation across banks of computed RWA for market risk (mRWA)

Cf. Regulatory consistency assessment program, BCBS, January 2013.

Objective: assessing potential for heterogeneity of mRWA across banks + highlight role of aspects of Basel rules

Sample of 16 global banks. Observation period includes recent Basel 2.5 changes.

Two joint exercises: analysis of published reports on mRWA + hypothetical test portfolio exercise coordinated by BCBS

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Variation of mRWA: main …ndings/public reports

Large variation in average published mRWAs for trading books, only partially correlated with size/composition of trading positions.

Average rWA ranging from 10% to 80% (mostly in 15%-45% bucket) Sizeable share of heterogeneity due to supervisory factors (country or bank levels), eg netting of derivative positions =>debate "accuracy"

of rules vs common level playing-…eld!

Impact of modelling choices by banks (notably degree on reliance on internal models ranging from 10% to 80%)

Overall, insu¢ cient quality of disclosures (opacity for investors)

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Variation of mRWA: main …ndings/public reports

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Variation of mRWA: main …ndings/public reports

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Variation of mRWA: reliance on internal models

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Variation of mRWA: reliance on internal models

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Variation of mRWA: main …ndings/test portfolio exercise

BCBS designd 26 dummy portfolios (covering all major risk factors, made of vanilla products mainly) for banks to compute associated IRB metrics (VaR, SVaR, IRC) over 20 trading days

Variation of results largely due to banks’model choices

Higher for new, more complex IRC (incremental risk charges) models than for VaR and Stressed VaR

Ex. of choices: length of data period used for calibration, aggregation approaches, scaling factors (from 1-day to n-day risk estimates), calibration of transition martices etc.

Variations caused by di¤erences in supervisory multipliers applied to raw output of models (from 3 to 5.5), explaining about 25% of total

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Variation of mRWA: test exercise results for most diversi…ed PTF

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Variation of mRWA: test exercise results for most

diversi…ed PTF

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Variation of mRWA: test exercise results (VaR approach)

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Capital arbitrage and promise shifting using CDS

Still massive incentives to use "complete market techniques"

(shorting credit by buying CDS) to avoid capital charges and reduce tax burdens for clients, thereby maximizing returns.

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Capital arbitrage and promise shifting using CDS: …ctive example

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Conceptual de…cits of Basel capital regulation

See Martin Hellwig (2010, "Business as usual?"): A lack of

systematic analysis by the BCBS of why previous regulation failed and how the proposed regulation will succeed in preventing another crisis.

However, Basel regulations have implied a tremendous amount of work and sophistications.

Lots of even unasked questions:

Why could major banks manage their risks and equity in a way that contributed to the crisis?

Why was bank capital so low that doubts about sovency arouse so rapidly after the onset of the crisis (and interbank market froze)?

What assurance do we have that, would Basel 3 …xes have been

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Conceptual de…cits of capital regulation

"Regulatory capture by sophistication" (Hellwig): the successive versions of Basel all strived to improve risk calibration of capital requirements ("fascination" for model based approaches)

Root of the problem may not be de…ciencies in risk modelling but ratherincentives of bank managers to "economize on equity" to increase "shareholder value" in the short-run. High leverage is the quickest way to achieve it.

Basel has too much focused on risk calibration andneglected the issue of governance: regulation is needed for bankers to internalize large externalities of bank risk taking

discrepancy between private interests of bank managers and public interest in …nancial stability