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Master’s Thesis Author: Michal Zajicek
Academic Supervisor: Anders Grosen
MSc Finance & International Business
Department of Business Studies
Assessment of Basel III capital requirements and their impact on
financial sector in Slovakia
Aarhus School of Business, Aarhus University
2011
2
Acknowledgements
To Anders Grosen
And to Jana Taskova
Michal Zajicek
August, 2011
3
ABSTRACT
The purpose of this paper is to investigate the potential impact of increased capital requirements
on lending spreads charged by banks in the Slovak financial sector. The results yield a 17bp
increase in lending spread for a 1 pp increase in capital ratio. Given the characteristics of the
Slovak financial environment, it has capacity to absorb this increase given the transition period
is long enough.
KEYWORDS: BASEL II, BASEL III, Capital requirements, lending, bank, information
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Introduction
The aim of this paper is to illustrate the need for regulation in the financial industry,
show the significance of the new Basel III capital requirements in terms of increased
quality and quantity of regulatory capital and to illustrate the impact of Basel III capital
requirements on the banks in Slovakia.
Relevance of the subject area
The importance of banks in economy and in financial system is demonstrated by how
savings of the surplus units are channeled into productive activities of the deficit units.
This shows a clear effect on the economic activity and growth.1 In the theory of the
transmission channels of monetary policy, bank lending channel shows how the role of
bank credit can augment monetary policy actions, depending on the relative importance
of credit supplied by banks to economy. Part of the bank lending channel is related to
banks‘ capital positions and their influence on availability of credit. The banks’capital
positions are then subject to minimum regulatory requirements and credit-ratings based
target ratios.2 This provides a link how capital requirements can influence the amount of
credit in the economy and subsequently the growth of GDP.The central role of banks in
economy was also nicely demonstrated by the recent financial and economic crisis,
where interlinkages among banks themselves and between banks and financial markets
became very clear.3
1 Allen, Franklin & Carletti, Elena. (2010). Chapter 2: The roles of banks in financial systems. In: Berger, Allen N.; Molyneux, Philip; & Wilson, John O. S.: The Oxford Handbook of Banking, pp. 37-57. Oxford: Oxford University Press
2 European Central Bank (2008b), "The role of banks in the monetary policytransmission mechanism", Monthly Bulletin, August
3 Shyamala Gopinath: Centrality of banks in the financial system
5
The dynamics of the recent crisis highlighted the areas of financial system that need to
be revised and require an improvement in their design.4 The centrality of banks in the
recent financial and economic crisis demonstrated the need for more efficient regulation
of banking industry. Based on the continuing work in the field of financial system
regulation and as a response to the crisis, Basel Committee on Banking Supervision
(BCBS) issued a number of documents proposing the establishment of a new regulatory
capital and liquidity regime. The Committee’s package of reforms was fully endorsed
by the Group of Governors and Heads of Supervision, the oversight body of BCBS, at
its September 2010 meeting. As noted by top representatives from the supervisory
environment, the package of reforms will mean a fundamental strenghtening of global
capital standards.5
A wide range of criticism of the currently-in-effect regulatory framework of Basel II
standards has arrised to argue about its weaknesses and their potential causal and
augmenting effect during the years of recent crisis. Basel III regulatory initiative is
a further attempt to narrow the gap that provides room for banks’missbehavior and
makes the financial system fragile. Basel III is aiming to eliminate the opportunities for
missbehavior that occured during the crisis.
Purpose of the project
While the rationale for regulating the banking industry has quite solid theoretical logic,
there are many studies that provide evidence of empirical inconsistencies on the
efficiency of bank regulation as well as works that propose alternative design of
Inaugural address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India, at the 12th Fixed Income Money Market and Derivatives Association-Primary Dealers Association of India (FIMMDA-PDAI) Annual Conference, Udaipur, 8 January 2011.
4 BCBS (October 2010); The Basel Committee’s response to the financial crisis: report to the G20
5 The Basel Committee on Banking Supervision is a committee of banking supervisory authorities which was established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. It usually meets at the Bank for International Settlements (BIS) in Basel, Switzerland, where its permanent Secretariat is located.
6
regulation or its complete elimination.6 It is not the aim of this paper to assess the idea
of regulation from fundamental point of view, nor to criticise or propose alternative
design of regulation. Rather this paper aims at assessing the proposed Basel III
measures from the grounds of widely accepted regulatory logic currently in practice.
The aim is to show how Basel III capital requirements fit in the current regulatory
framework and how these measures will strenghten the current regime of regulation.
The banking industry, regulatory environment, and consultancy firms, among others,
have so far produced a number of studies for assessing the potential impact of the new
Basel III increased requirements. 7 These impact studies provide an overview of the
potential benefits and costs of Basel III as well as estimates of their quantification. The
benefits are stemming mainly from reduction in the costs associated with banking
crises. Another source of benefit of increased resilience of banks is its potential to
decrease the volatility of output. On the other hand, the source of costs is represented
by increased price of financial intermediation in the form of higher lending spreads
banks will require to maintain their profitability. Assuming that the costs associated
with being required to hold higher portions of equity capital will be passed through by
banks directly on their customers (borrowers). This would then potentially lead to
a decrease in availability of credit and would eventually translate into slower output
growth.
This is the widely accepted point of view for assessing the benefits and costs of
introducing increased capital requirements. While it is expected, that the reactions of
banks to recover the increased cost of funding outlined in the papers assessing the
impact are likely to occur, there might be a misconception about the grounds this kind
6 See for example: Levine, Ross; (2005); Bank Regulation and Supervision; in NBER Reporter: Research Summary Fall 2005; available at: http://www.nber.org/reporter/fall05/levine.html#N_*_; and Dowd, Kevin; (1996): The Case for Financial Laissez-Faire; The Economic Journal Vol. 106, No. 436, pp. 679-687 7 For example: BCBS (2010) “An assessment of the long-term economic impact of stronger capital and liquidity requirements.” (August). Macroeconomic Assessment Group (2010) “Interim Report – Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements.” (August). Institute of International Finance (2010): Interim Report on the Cumulative Impact of Proposed Changes in the Banking Regulatory Framework. Härle, Heuser, Pfetsch, Poppensieker (2010): Basel III-What the draft proposals might mean for European banking; in: Banking & Securities; McKinsey & Company; available at: http://ec.europa.eu/internal_market/bank/docs/gebi/mckinsey_en.pdf
7
of understanding is based on, as suggested by Admati, et al. (2010)8. This paper will
provide theoretical arguments for this possible missconception.
In this paper, the arguments for how costly the Basel III implementation may be, will be
assessed from a theoretical ground, focusing especially on the costliness of bank capital.
Also I will make an attempt to demonstrate the soundess of the increased quality and
quantity of capital to provide an argument for the benefits of Basel III requirements.
Since the Basel III framework will be also implemented into legislature in Slovakia, to
conclude the whole assessment, I will illustrate the position, or readiness of banks
operating in Slovakia facing the implementation of Basel III. The assessment part will
serve two purposes – to illustrate the distance between current and proposed levels of
capital of banks in Slovakia and to discuss the methodology used to quantify the impact
of incresed capital requirements in light of the theoretical foundation provided in
preceding parts of the paper.
Problem formulation and methodology
This paper aims at assessing the following questions:
1. Is the argument that equity is costly relevant?
2. Is the claim that Basel III means a significant improvement in strenghtening the
resilience of banks justified?
3. What is the nature of results the methodology used for mapping increased
capital requirements into lending spreads will yield?
4. What is the potential impact of Basel III on the banks in Slovakia?
Arguments for answering the above outlined questions will be provided in this paper
structured as follows.
Part 1 - International Financial Regulation
8 Admati, Anat R., DeMarzo, Peter M., Hellwig, Martin F. and Pfleiderer, Paul C., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive (October 29, 2010). Rock Center for Corporate Governance at Stanford University Working Paper No. 86 ; MPI Collective Goods Preprint, No. 2010/42. Available at SSRN: http://ssrn.com/abstract=1669704
8
In this part, the need for regulation in the financial industry will be discussed. I will
provide a picture about how the core characteristics of bank’s function as a financial
itermediary gives rise to behavior that needs to be regulated.
To argue for the neccessity of regulation in the banking industry I will first position the
arguments for regulation arising from market imperfections. These imperfections of
financial markets give rise to intermediation where one type of a financial intermediary
is a bank. Further, the functions and characteristics of banking business will be outlined
and the subsequent problems arising from these characteristics will be discussed. The
literature used for this topic will include, but will not be limited to: Merton, Bodie
(2000); Allen, Carletti (2010); Heffernan (2005); Brunnemeier, Goodhart et. al (2009);
Freixas, Santomero (2003).
Further on, the global regulatory measures introduced by the Bank for International
Settlements and its Basel Committee for Banking Supervision, commonly known as
Basel II9 will be introduced, with a focus on credit risk and its measurement for
regulatory purposes. The need for revision of Basel II due to its adverse impact on
banks during crisis will be discussed and subsequently I will provide an explanation on
how the new Basel III addresses these shortcomings.1011To conclude the regulatory
framework part I will outline the increased regulatory requirements pronounced in the
Basel III document „A global regulatory framework for more resilient banks and
banking systems“.
Part 2 – Benefits and costs of Basel III
This part of thesis will focus on the benefits and costs of increased capital requirements.
From the widely assumed arguments that banks will be forced to pass the costs
associated with the required increased in the level of the most expensive source of
funding – common equity- the idea of the cost of equity will be discussed. According to 9 BCBS( June 2006): International Convergence of Capital Measurement and Capital Standards A Revised Framework, Comprehensive Version 10 BCBS (October 2010); The Basel Committee’s response to the financial crisis: report to the G20 11 BCBS (December 2010): Basel III: A global regulatory framework for more resilient banks and banking systems
9
Modigliani and Miller12, in a an ideal world, wihere no tax deductibility of debt exists
and all information is instatntly available to everybody, the value of a firm is
independent of its capital structure. However in real world, an optimal capital structure
can be achieved to maximize the value of a firm, this is due to the deviations from the
ideal world. The environment banks operate in gives rise to some additional features of
behavior that need to be taken into account such as the effect of deposit insurance.13
Which slightly alters the application of Modigliani and Miller’s theory on the capital
structure of banks, nevertheless, I will explain how the ratio of equity to assets affects
the relative riskiness of bank’s sources of funding. The arguments used here will follow
the statements presented in Admati, et al. (2010).
Turning to the side of benefits, I will explain why the common equity element of
regulatory requirements is the soundest part that can ensure that banks are able to better
withstand potential adverse events. To show the soundness of the Basel III capital
requirements, I will discuss the types and roles of different components of regulatory
bank capital. The quality of common equity will be discussed in the light of bank capital
management and risk management practices. For arguments in in this part of the paper,
I will use, among others, the following literature: Mishkin (1992), Hull (2007), Mejstrik
et al. (2009).
Part 3 - The potential impact of Basel III capital requirements on banks in
Slovakia and its quantification
The impact assessment on the banks in Slovakia will be undertaken based on the model
used in King (2010)14. The model uses actual balance sheet data of banks to calibrate
the impact of increased capital requirements. Based on modified Modigliani-Miller
analysis, where the weighted average cost of capital does not change for different
12 Modigliani, Franco and Merton H. Miller, (1958), “The Cost of Capital, Corporation Finance, and the Theory of Investment” American Economic Review, 48, 261-297.
13 Santos, João A. C., Bank Capital Regulation in Contemporary Banking Theory: A Review of the Literature (April 2000). BIS Working Paper No. 90. Available at SSRN: http://ssrn.com/abstract=248314 14 King, Michael R., Mapping Capital and Liquidity Requirements to Bank Lending Spreads (November 1, 2010). BIS Working Paper No. 324. Available at SSRN: http://ssrn.com/abstract=1716884
10
capital structure choices, the model assumes, that banks respond to the fall in return on
equity (ROE) by raising the lending spread charged on loans. The model therefore
quantifies the increase in lending spread required to maintain the level of ROE and also
assumes that the cost of liabilities remains unchanged (King 2010).
These assumptions will be discussed from the theoretical basis outlined by preceding
parts of this paper focused on the cost of equity. Further discussion of the nature of the
results that this model yields will be based on the constraints imposed on bank loan
pricing decisions.
Balance sheet data of banks operating on the Slovak market will be used to determine
the distance between their current levels of capital and the required increased levels of
capital imposed by the Basel III framework. The rest of the discussion will be related to
the options that banks have to bring their capital ratios to required levels, taking into
account the nature of slovak economic, financial, and banking environment as well as
the discussion of the model used to quantify the increase in lending spread.
International Regulatory Framework
11
The process of chanelling funds from deficit units to surplus units in the financial
system can materialize in two ways, the first is through financial markets (directly) and
the second is through banks and other financial intermediaries (indirectly).15 Thus, in
many aspects,the availability of these two types of fund channeling puts the financial
markets and financial intermediaries in position of competing against each other in the
course of funds allocation.
Across countries, there are differences in the design of financial system which lead to
a question, whether these can be linked to efficiency. Levine (1997) argues with
evidence that more developed financial system is not just a result of economic growth,
but that it can be a good predictor and facilitator of it. Differences in legal and political
traditions as well as natural resource endowments may all influence the structure and
development of financial environment. It is however hard to reconcile the question
whether either institutional structure – bank based or market based - dominates in
facilitating economic growth. It then follows that the preferential choice of funding
channel made by deficit units may be motivated by their own characteristics, position
and intentions, therefore suggesting that each of the two types of funding channels have
their pros and cons, or in other words „intermediated financial contract markets emerge
in conjunction with a direct financial contract market, rather than in place of it,“
(Seward 1990, p. 371).
Merton explains financial markets and institutions in a dynamic perspective as
complementaries, reinforcing each other on the road to efficiency. Markets are a more
efficient alternative when the products have standardized terms, can serve a large
number of customers and the assessment of their price is well understood.
Intermediaries, on the other hand, are better capable of handling products which are
highly customized and/or contain fundamental information asymmetries (Merton 1995,
p. 26).
Existence and roles of intermediaries in the financial system
15 Allen & Carletti (2010), p. 37
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As noted by Freixas & Santomero (2003), the first logical step before any discussion
about banks and banking regulation takes place is to explore the reasons for the mere
existence of these institutions.
Literature, so far, has provided many explanations for the existence of financial
intermediation from the perspective of overcoming market frictions. Researchers look at
this problem from many different positions, taking into account bank’s functions. The
different perspectives of approaching to this question causes, that the ideas given as to
justify the existence of banks can be aligned under two logical bases.
Santos (2001) in his review of banking literature states that in a world with complete
and frictionless markets, there would be no need for financial intermediaries, because
investors and borrowers would be able to achieve efficient risk allocation on their own.
Earlier theories of financial intermediation emphasize the role of banks overcoming
frictions that result from transaction cost, whereas contemporary theories state that these
frictions arise instead from asymmetric information (Santos 2001, p. 3).
Akerlof (1970) in his famous „lemons“ problem showed how quality and uncertainty
can be detrimental to the exchange between transacting parties. Increase in price will
result in lower overall quality, buyers will anticipate this and as a consequence, no
market will exist at all. Akerlof then concludes that in reality, many institutions arise to
counteract these effects of quality uncertainty.
To provide a rationale for intermediation, Ramakrishnan & Thakor (1984) and Leland
& Pyle (1977) show, how adverse selection problem can be efficiently overcome by
production of information by intermediaries. When production of information is costly,
however, two problems arise. The first one is due to appropriability of returns from the
production of information given its nature of a „public good“. The second being
associated with reliability of the information16.
Leland & Pyle (1972) explain how a bank has the necessary characteristics to represent
a type of intermediary who can efficiently produce information. Production of
16 Ramakrishnan & Thakor focus on the explanation of existence of rating agencies as „diversified information brokers“. Firms that exceed the cross sectional average value will have an incentive to purchase certification of their value from the information producer. By this, the problem of information as a „public good“ is avoided. The reliability is achieved through diversification, since incentives to produce unreliable information diminish as the number of information producers grows with size of the coalition.
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information about individuals is beneficial to the bank if it achieves economies of scale
in doing so. The problem of appropriability of returns is eliminated by the bank if it
buys and holds the assets about on which it has produced the information – this is now
captured as a private good in the returns on the bank’s portfolio. The organizers‘
willingness to invest (investing their own wealth in assets about which it has special
knowledge) in their firm’s equity then signals the quality/reliability of information – by
putting their own capital at risk they signal a commitment to monitor the returns17.
The second aspect of asymmetric information is that of incentive problems caused by
separation of ownership and control after a transaction is made. In case of a debt
contract18, the borrower has incentives to substitute assets or a project for more risky
ones than those, which were underlying the loan approval (Myers 1977). Additionally,
the lender might be unable to observe the true return realized by the borrower. In both
cases, the lenders need to monitor the borrowers. Some of the adverse incentives can be
mitigated by imposing restrictive covenants into the loan contract, but these are costly
to enforce (Smith & Warner 1979).
In his well cited model, Diamond (1984) assumes the existence of information
technology allowing costly monitoring of the realization of borrower’s output.
Delegating this monitoring activity to a single entity eliminates the duplication of
monitoring costs and the free-rider problem present among individual lenders observing
each others‘ actions. He further stresses the role of diversification in the context of
avoiding the problem of needing to „monitor the monitor“. As the size of intermediary
(and its diversification) increases, it can achieve the market return on its loans with
certainty. If the investors (depositors) do not receive this return, they know that
monitoring was not undertaken properly and will impose non-pecuniary penalties19
upon the intermediary.
17 Banks are however not able to eliminate the problems of adverse selection and moral hazard completely. The screening mechanisms – such as the interest rate a bank charges on its loans can affect the average risk profile of the borrowers as a result of residual imperfect information after the evaluation of loan applications. This can give rise to „credit rationing“ according to Stiglitz & Weiss (1981). 18 In the strand of literature on contracting under „costly state verification“ the standard debt contract is derived as the optimal incentive contract under certain conditions of costly monitoring. Lacker (1991) shows that contingent payment schedule coupled with collateral mitigate the incentives problem when lender is uncertain about borrower’s future resources. 19 e.g. in forms of bankruptcy costs or loss of reputation.
14
Benston & Smith (1976) represent an earlier view on the existence of intermediaries.
The bank’s specialization gives it a comparative cost advantage in acquiring
information about borrowers‘ ability to repay debts, in monitoring costly covenants and
in processing documents. By specializing in these activities, banks can develop
standardized forms and procedures, which bring scale efficiencies. Information received
about a consumer also has a potential to be reused in scope – for example in processing
other consumers in the same industry. The authors further argue, that important, detailed
information about borrowers‘ financial condition can be obtained at much lower cost.
This fact is also recognized by Fama (1985), who states that since borrowers usually
maintain deposits at the same bank which they obtain credit from, the bank is allowed to
assess the risks of loans and monitor them at lower cost than other lenders20.
Diamond & Dybvig (1983) contain one aspect of liquidity provision. They show that
when bank depositors have unobservable, random consumption needs, banks issuing
demand deposits can provide superior risk sharing among them. As they further note:
„banks are able to transform illiquid assets by offering liabilities that have a smoother
pattern of returns over time, than the illiquid assets offer“.
Another aspect of liquidity is shown by Lacker & Wineberg (2003), who stress the
uniqueness of banks in issuance of payment instrument liabilities. This rationale for
banks can be related all the way to the reason why money was created as a means of
exchange and payment. Gorton & Winton (2002) present an overview of this aspect of
bank function. Banks act as a central clearing location, which facilitates trade between
agents located in different places. Thus eliminating the costs of barter trade and
providing liquidity by offsetting requested payments. Another important property of
banks arises due to their diversified portfolio - banks are suited for providing riskless
debt securities (deposits) which can act as a medium of exchange. In yet another way,
banks can provide a line of credit to a firm that can be drawn to the extent, the firm
experiences an unexpected liquidity need, and thus allows the firm to transfer value
across time.
Campbell & Kracaw (1980) argue that neither of the explanations – asymmetric
information, and transaction costs stand alone as satisfactory in motivating the existence
20 This implies there may also be benefits for both parties from this „relationship lending“ as discussed in Berger & Udell (1995).
15
of intermediaries, but are rather complementary. Emergence of intermediaries is
profitable, when they can jointly produce information and also offer other - liquidity,
transaction, and insurance services. Campbell & Kracaw thus link the synergies of
banks producing information and their role in provision of liquidity and facilitation of
payments and transactions.
Intermediaries are efficient in mitigating ex-ante and ex-post information asymmetries.
The nature of bank liabilities has value since they act as a medium of exchange and
payment. Banks create liquidity and provide monitoring services thanks to
diversification. Information production makes funds available to flow to borrowers who
would be unable to directly access the market either due to lack of their own funds21 or
insufficient reputation22. The bank obtains proprietary information about the borrower,
which it can reuse in a way beneficial for both parties23.
The dynamic perspective also explains that relative importance of banks‘ roles and
functions changes over time. Allen & Santomero (1996) account for the complexity of
large financial institutions which engage in a range of interest and non-interest bearing
activities24. New products brought by securitization, derivative instruments, and shift
from holding to originating-and-distributing of loans stress the role of intermediaries in
risk management services and reduction of participation costs to uninformed investors.
Services provided by banks and risks involved
Bhattacharya & Thakor (1992) provide an overview of services offered by financial
intermediaries. Nondepository intermediaries often specialize in certain services, but
banks have traditionally provided virtually all of these services. In the brokerage line,
these include: transaction services, financial advice, screening and certification,
origination, issuance. Whereas qualitative transformation services include: maturity
transformation, asset divisibility, liquidity transformation and credit risk.
21 Repullo & Suarez 1998 22 Diamond 1991 23 Boot (2000) p. 10 24 Besides traditional deposit taking and provision of credit, to financial innovation and engineering, advisory services, and proprietary trading, i.e. trading on their own account as opposed to being their customers‘ broker.
16
Along the classes of risks that all, i.e. non financial and financial companies are
subjected to, like legal, business and market risk, the services of asset transformation
mean a particular set of risks is accentuated for banks.
Liquidity transformation - While other sectors of economy are also exposed to liquidity
risk - the ability to fund increases in assets and meet obligations as they come due25 and
is crucial for the bank to remain viable due to the nature of their assets and liabilities. To
be able to extend loans, which are usually individual arrangements containing publicly
unobservable borrower-specific information, banks issue deposits which are payable on
demand. Thus if a bank experiences large unexpected cash withdrawals, it can end up
being forced to insolvency. In case of the banking industry, liquidity risk can lead to
a major systemic problem.
The reason why banks can offer liquidity transformation service is that they are able to
diversify a large portion of risk of their portfolio, however not all of it26. Liquidity is
defined as the ability to fund increases in assets and meet obligations as they come due
and is crucial for the bank to remain viable27. As will be further discussed, due to
imperfect information about the quality of banks‘ assets (loans) giving rise to asset
liquidity risk, depositors may take actions that force banks to early liquidation of assets,
accentuating the funding liquidity risk, which can eventually force the bank into
distress.
Maturity transformation - Another mismatch between bank’s assets and liabilities lies in
the term until maturity. Long term loans financed by short term deposits expose a bank
to interest rate risk.
Risk transformation (credit risk) - The core business of banks is to make loans to
customers. Service of lending means banks hold assets that are subject to credit risk.
Credit risk is the risk of losses owing to the fact, that counterparties may be unwilling or
unable to fulfill their contractual obligations (Jorion 2007, p. 24). Credit risks are
traditionally managed by ensuring that the portfolio is well diversified, which reduces
nonsystematic risk, but does not eliminate systematic risk (Hull 2007, p. 19).
25 Sound Practices for Managing Liquidity in Banking Organisations, BCBS, February 2000. http://www.bis.org/publ/bcbs69.htm 26 Saunders & Cornett (2006), Chapter 1, p. 7 27 Sound Practices for Managing Liquidity in Banking Organisations, BCBS, February 2000. http://www.bis.org/publ/bcbs69.htm
17
Regulation of banking
It is difficult to draw a clear cut picture of where one type of regulatory instrument starts
to be justified and where its application ends. It is also the case, that it may be beneficial
for mitigating one issue while giving a rise to another one. Rationale for regulation of
banking industry lies first in the issues that are specific to the banking environment; and
second due to general market imperfections.
Llewellyn (1999) states, there are three objectives (goals) of regulation in the financial
industry:
- To sustain systemic stability.
- To maintain safety and soundness of financial institutions.
- To protect the consumer.
Freixas and Rochet28 in their microeconomic analysis of banking discuss the safety and
soundness regulation of banks. In general, public regulation is justified by market
failures that come from market power, externalities, or asymmetric information between
buyers and sellers. Banks arise to overcome problems of asymmetric information,
however it is not ensured that they can completely solve this problem, and may even
lead to new market failures. The two main market failures in the banking industry are: i)
the fact that depositors are generally not in the position to monitor the bank’s
management – they need a representative; and ii) the fragility of banks because of their
illiquid assets and liquid liabilities – systemic risk.
Depositors‘ representative
The concern that depositors are not armed to monitor the management of their banks is
approached by Dewatripont and Tirole (1993) who build on the corporate governance
problem created by the separation of ownership and management.
28 Freixas and Rochet (1997)
18
Given the payoff structure of debt and equity securities29, the managers should be
rewarded by low interference by outsiders when performing well and conversely, should
be punished by substantial outside involvement when the performance is poor. Their
model assumes some verifiable bank performance measures that determine the threshold
when the control is taken away from equity owners and shifted to debt-holders.
Moreover, by keeping assets and liabilities unchanged, the mere new information about
existing loans gives the equity holders an incentive to gamble for resurrection –
managers and shareholders of decapitalized banks benefit from undertaking high-risk,
high-yield negative NPV investments at the expense of creditors – if successful, this
may keep them in business and capture rents, while on the downside, their loss is
limited.
The above mentioned thus demonstrates the limitations of a free banking sector because
equity holders are biased in favor of managers and can be only relied upon in good
times. When bank performs badly, to set the threshold, monitor and intervene, a public
agency (such as FDIC in US) should act on behalf of the small depositors, who have
neither the incentive, nor the information or competence to do so30.
Systemic risk and cost of bank failure
Diamond & Dybvig with their explanation for existence of banks stemming from
provision of liquidity risk insurance at the same time recognize that this function makes
banks instable. The authors state that „uninsured demand deposit contracts are able to
provide liquidity but leave banks vulnerable to runs“ (Diamond & Dybvig 1983, p.402).
Thus the liquidity insurance that banks provide makes these institutions fragile. Along
with pure panic runs, where withdrawals are random events based on depositors‘
consumption preferences, Jacklin and Bhattacharya model the existence of information-
based runs31. Interim information might be observed about bad performance of bank’s
assets, which will lead depositors to withdraw their money. While a bank run in both
29 Because of limited liability, the payoff function of the holders of equity is convex, which brings tendency to favor risky decisions. On the other hand, the payoff function to debt holders is concave indicating more risk aversion. 30 Dewatripont, M., and J. Tirole. 1993. Efficient governance structure: Implications for banking regulation. In Capital markets and financial intermediation, ed. C. Mayer and X. Vives. Cambridge: Cambridge University Press. 31 Jacklin, C. and S. Bhattacharya (1988): “Distinguishing Panics and Information–Based Bank Runs: Welfare and Policy Implications,” Journal of Political Economy 96, 568–592.
19
above mentioned settings could be a beneficial source of discipline on banks, the
reasons why bank failure is seen to be undesirable is due to much larger costs it can
impose on the financial system, which can also spread into the real sector (Jacklin &
Bhattacharya 1988).
The U.S. experience of bank failures during the 1930’s lead to a decision that
widespread loss of confidence in banks needs to be prevented. Following the years of
Great Depression, retail depositors‘ confidence in the stability of the banking system,
and that they receive their money has been guaranteed by a state deposit insurance
scheme. Since then, many advanced countries adopted similar explicit guarantee
schemes following their own experience of banking crises (Demirgüç-Kunt & Kane
2002)32.
In principle, if depositors redeposit their money from a suspected bank to another one,
interbank market could well satisfy the shortage of liquidity in the troubled institution33.
In case, depositors redeem their holdings for cash, liquidity needs to come from an
outside source – central bank. The ideas that a central bank act as a source of last resort
lending to troubled banks dates to early nineteenth century. The central bank is thought
to be a useful correction of some of the frictions in interbank market, because the ability
of interbank lending to remedy liquidity problems severely depends on the
completeness of information banks have about each other. Interbank market may
become more cautious during a crisis because participating institutions may not have
the capacity or willingness to lend to each other. Possible reasons are the inability to
distinguish between an illiquid and an insolvent institution or when banks are not
certain about their own funding needs for the immediate future (Freixas et al. 1999).
As the experience showed, runs by depositors are not the only source of bank’s balance
sheet fragility. The failure of Continental Illinois bank began when its short-term
wholesale funding 34. A recent example of a „modern bank run“ is the dry-up of
interbank and money market funding that lead the U.K savings and mortgage bank
32 Some of the alternative proposals to ensure the stability of banking system include - narrow banking; all-equity funded banks; suspension of convertibility. 33 Provided the interbank market is functioning well. 34 Chapter 4 - Continental Illinois National Bank and Trust Company. Available at: http://www.fdic.gov/bank/historical/managing/history2-04.pdf
20
Northern Rock to dependent on the assistance of central bank and subsequently
nationalized (Shin 2008). For the U.S., Bear Sterns experienced a run, when its short-
term funds provided by hedge funds was not rolled over in March 2008 (Brunnermeier
2009).
Contagion is a major concern for regulation since the primary objective is to preserve
the whole system’s stability and confidence. The high degree of interconnectedness
among the financial institutions and consequences for the whole system are also taken
as a distinguishing nature that makes a failure of one bank causing high cost to society
in contrast to a failure of a non-financial firm (Crockett 1996).
Crockett identifies three channels of contagion through which a failure of one large or
a number of small banks can spread: interbank market; over-the-counter derivatives
transactions; and the payments and settlements system. Within this network, banks hold
interlocking claims, where a failure of a counterparty to fulfill its obligations can have
direct knock-on (or domino) effects on other banks. Stability of payments and
settlement systems and smooth functioning of interbank market is thus vulnerable.
The threat of instability in case of a large bank’s failure was a rationale for the „Too-
Big-To-Fail“ doctrine35 where a government bailout of the troubled bank seeks to avoid
the high systemic cost of failure.
Leverage and cost to society
Banks have systematically the highest leverage of firms in any industry36. Since this is
so, even a small decrease in asset value can lead to distress and potential insolvency,
and can lead to severe consequences, particularly when the financial system is deeply
interconnected37. This is one of the facts that bring higher concern about a failure of
a bank as opposed to a non-financial company.
When a bank experiences liquidity problems it can best rely on meeting the shortage by
selling its liquid assets, which are easily marketable and without depressing the price.
On the contrary, when forced to sell its loans to borrowers, much of their value may be
35 Goodhart & Huang 1999; alternatively: Too-Interconnected-To-Fail 36 Berger et al. (1995), p. 394 37 Admati, et al. (2010), p. 1
21
lost for the lemons premium that may be requested by buyers, because of the specific
information those loans contain. Moreover the projects financed by bank loans are most
valuable while being going-concern because they require specific human capital to
create value38. Forced liquidation of long term loans to borrowers can thus rapidly bite
off the capital base of a bank.
As discussed above, diversified financial institutions remain vulnerable to systematic
shock. Given the high leverage and wide maturity mismatch between assets and
liabilities, the financial industry can quickly get into trouble when a general adverse
shock affects the assets. Deleveraging, higher margin requirements and forced asset
sales can put a strong pressure on the asset markets causing drop in market liquidity39
and depressing the price of assets, so srinking the balance sheet becomes very costly.
The combination of market liquidity and funding liquidity deterioration can quickly tilt
highly leveraged institutions toward the brink of insolvency (Brunnermeier 2009).
Besides the fragility of leverage, there are costs to society from liquidating loans to
borrowers. As discussed previously, the monitoring effort and costs that banks incur in
course of lending create relationships with borrowers. If their credit is cut-off, the bank-
dependent borrowers will incur cost of finding a new lender and re-establishing
a relationship, for the lender will need to replicate the screening and monitoring costs
(Bernanke & Gertler 1995). Thus when a bank fails, customers are facing the very
imperfections the bank was supposed to solve.
SAFETY NET AND MORAL HAZARD
The notion of inherent subsidizing of risk taking behavior by charging a flat deposit
insurance premium was modeled by Merton (1977). In his paper, he uses the formula
for option pricing developed by Black & Scholes to derive the actuarially fair risk
premium of deposit insurance40. In this setting, the flat premium paid to the insurer
38 James 1991 reports substantial loss in value of gone-concern bank 39 Market liquidity is low, when it is difficult to raise money by selling the asset. (Brunnermeier 2009, p. 92) 40 The price of deposit insurance can be thought of as an option premium paid for a put option on the value of bank’s assets, where the strike price is equal to the promised value of deposits at maturity. By construction of the Black-Scholes pricing formula, the value of the premium then increases both with deposits-to-assets ratio (leverage) and the volatility of the banks assets (the measure of risk) when holding time to maturity fixed.
22
becomes more valuable, the more risky the bank’s assets are and the higher leverage it
takes, which gives rise to moral hazard41.
By making the deposits informationally insensitive, the depositors will have no need to
monitor the banks’ performance. Based on this fact, the bank managers are given
incentives to take excessive risks.
The original proposal, that emergency lending be done at a penalty rate to prevent banks
for seeking this support, is questioned on the grounds that it may aggravate the situation
of the already fragile bank (Crockett 1996, Freixas et al. 1999). Higher rate paid for
emergency support may induce the managers of troubled institution to pursue more
risky strategy – gamble for resurrection. Moreover the announcement of last resort
support could be associated with a negative stigma and market’s reaction of further
withdrawals of funds.
These undesired consequences however give rise to moral hazard stemming from
expectation of cheap support. In case of an emergency injection of risk capital, the
incentives are even more distorted since risk-taking institution might be deemed as
insured against all types of risk (not only the liquidity risk). Firstly it gives the managers
and shareholders incentives to maximize the implicit subsidy, and secondly, it reduces
the incentives for uninsured creditors to monitor the institution (Freixas et al. 1999).
From Basel II to Basel III
The first attempt to set risk-based internationally harmonized capital standards was the
1988 Basel Accord. The motives behind its introduction were to boost the low capital
ratios of internationally active banks and to reduce competitive inequalities42. The
requirement defined a minimum capital ratio for credit risk-weighted assets, where the
41 Merton (1977) 42 Jackson, et al. 1999
23
risk weights were based on four institutional categories ranging from 0% for claims
deemed the safest to 100% for risky ones43.
Total regulatory capitalRisk Weighted Assets ≥ 8% (1)
As the progress in financial industry continued, banks were increasingly relying on off-
balance sheet activities, while also being more engaged in trading. The first Accord was
therefore criticized for being too crude and failing to incorporate other risks that banks
face, as well as for the fact that banks already found ways for regulatory capital
arbitrage44. The original Accord was amended in June 1996 to include a capital charge
for market risk and in June 1999, a first consultative proposal was published for a major
revision of the 1988 Accord. The agreed text of „Basel II“ framework was published in
June 2004, with implementation beginning from 2007 and reaching its full in year 2009.
The structure of Basel II consists of three mutually reinforcing pillars. Pillar 1 - sets the
regulatory capital minima for three types of risk – credit, market, and operational. The
pillar 2 – supervisory review process serves to ensure that banks develop sound risk
management practices. The 3rd pillar – market discipline, recognizes that increased
transparency will lead to better understanding by market participants whether banks‘
capital position is adequate to its risk profile.
Basel II credit risk
Basel II provides an option to choose between two approaches to determine capital for
credit risk i) standardized and ii) internal ratings based. Using the standardized
approach, banks rely on credit ratings of external agencies to determine risk weights for
different classes of their claims, similar to the first Accord, except the focus is on risk
profile within each of the classes45. In addition, the Framework also allows for a limited
degree of national discretion in the way in which each of these options may be applied,
to adapt the standards to different conditions of national markets46.
43 For example: 0% - cash, OECD governments, Central banks;20% - multilateral development banks, banks in OECD countries; 50% - secured residential mortgage loans; 100% - claims on private sector and non OECD countries 44 Extensive use of securitisation 45 Sovereigns, public sector entities, banks, corporates, securities firms, etc. 46 This is also subject to criticism especially regarding definitions of capital, since deviations on national level undermine the idea of level-playing-field and give scope to regulatory arbitrage.
24
Internal ratings based approach
The IRB approach, which is subject to an explicit approval of the bank’s supervisor,
would allow banks to use their internal rating systems for credit risk. Under the IRB
approach, two alternatives are possible: the foundation and advanced. Under the
foundation approach, banks only use their models to estimate the probability of default
(PD), whereas under the advanced approach, bank can rely on its own estimates for all
parameters.
Foundation and advanced approaches
Basel II Credit risk
Corporate,
Sovereign,
Banks, Eligible
purchased
corporate
receivables
Retail and
Eligible
purchased
retail
receivables47
Equity
Advanced
IRB
Bank's
internal
estimates
PD, LGD,
EAD, M
PD, LGD,
EAD, M
PD/LGD
approach
Market
based
approach Foundational
IRB
Bank's
internal
estimates
PD
Supervisory
estimates LGD, EAD, M
The model underlying this approach is the one-factor Gaussian copula model of time to
default. Equation 2 presents the calculation of capital requirement for corporate,
sovereign and bank exposure.
퐾 = 퐿퐺퐷 × 푁 ×퐺(푃퐷) + √푅 퐺(0,999)
√1 − 푅− (푃퐷 × 퐿퐺퐷)
×(1 + (푀 − 2,5)푏)
(1 − 1,5푏) (2)
47 Once the bank meets the criteria for using the IRB approach, there is no distinction for calculating exposures for the retail class, the bank uses its own estimates for all risk components.
25
Where K denotes the capital requirement for defaulted exposure, that is equal to the
greater of zero and the difference between its LGD and estimate of expected loss. R
denotes the correlation parameter, N (x) is the cumulative distribution function and and
G(z) is its inverse. The expected loss is subtracted from the worst case loss, since it
should be covered by the loan’s price and corresponding provisions. The capital then
covers the unexpected portion of loss. The last term represents adjustment for maturity.
R, the parameter for correlation can take maximum of 24% and is decreasing in the size
of borrower’s turnover and probability of default, reaching a minimum of 12%. The
idea here is that the borrowers‘ with high probability of default will be less susceptible
to common risk factor. Similarly, the small borrowers‘ default probabilities will exhibit
higher vulnerability to market conditions. Risk weighted assets are then arrived at by
multiplying the unexpected loss by EAD and a factor of 12.5 to arrive at an 8% capital
ratio.
The events that precipitated in the recent crisis were accompanied by excessive funding
maturity mismatch. High amounts of leverage and on and off balance sheet risk taking.
As a response to these events, in December 2009, the Basel Committee on Banking
Supervision (BCBS) published two consultative documents that propose increasing the
quantity while improving the quality regulatory capital and reducing funding and
maturity mismatches between bank assets and bank liabilities (BCBS, 2009a,b).
Financial institutions, while showing sufficient capitalization, did not have sufficient
amount of loss absorbing capital. The new proposal increases quality and quantity of the
capital base. It further enhances risk coverage for trading book and securitization
exposures, and resecuritizations in both the banking and trading book. Increasing capital
requirements for counterparty credit exposures arising from derivative, repo and
securities financing to reduce interconnectedness by favoring central counterparties.
A simple leverage ratio of 3% Tier 1 capital to total assets will be introduced48. To
contain excessive buildup of on- and off- balance sheet leverage to mitigate the
deleveraging feedback loop. Included will be a 100% credit conversion factor for
recognizing off-balance sheet sources of leverage49.
48 Also after all deductions. 49 Such as commitments (including liquidity facilities), direct credit substitutes, acceptances, letters of credit, etc.
26
To mitigate procyclicality, Basel III introduces less procyclical forward looking
provisioning, capital conservation buffer and countercyclical capital buffer.
Capital conservation buffer is one of the elements introduced to mitigate adverse effects
of deleveraging, it will consist of 2.5% Common Equity Tier 1 (CET 1) above the
regulatory requirement when fully phased-in. Banks will be required to hold buffers
above the regulatory minimum during good times, so they can draw the buffers down to
support their operations through period of stress. When the value of conservation buffer
falls within the range of 0-2.5%, constraints on distributions50 will be imposed. The
percentage of earnings required to be conserved will grow as the buffer approaches the
minimum.
The countercyclical buffer will be imposed by national authorities, when they judge that
excess credit growth is associated with a buildup of system-wide risk, and will be
released, when the situation dissipates or materializes. Its maximum amount will be
2.5% of RWA, will consist of CET1 and will be in excess of capital conservation
buffer.
Basel III will introduce two liquidity measures. The liquidity coverage ratio -LCR- high
quality liquid assets that can be converted to cash to be able to meet liquidity needs over
a 30-day stress horizon. Stock of these assets must be equal to or exceed net cash
outflows under such stress-scenario. And the net stable funding ratio -NSFR- for
medium and long term funding, a minimum amount of available stable funding that can
consist of capital, preferred stock and liabilities with a maturity of at least 1 year . The
required amount will be set based on the characteristics of liquidity risk profiles of
institutions assets, off-balance sheet exposures and selected activities.
The implementation of Basel III will begin in 01/2013 and the requirements are to be
phased-in gradually, with full requirements being in force in January 2019. The gradual
portions of Common Equity Tier 1, Additional Tier 1, Tier 2, and Capital conservation
buffer will mandatory at the beginning of each year, as shown in Figure 1 below. The
Countercyclical capital buffer
50 Such as dividends and share buybacks, payments on Tier 1 instruments, and bonus payments to staff.
27
Figure 1:
Basel III requirements - Amount, definition and loss absorbency of capital
The new Basel requirements will represent a significant change in regulatory regime.
The impact studies undertaken bu BIS and CEBS demonstrate that at the end of year
2009 the largest banks would be lacking about 40% of the capital under new
requirements. This is a significant distance, representing about
Common equity Tier 1
Common equity Tier 1 (CET 1) can comprise of common equity, retained earnings and
disclosed reserves. Equity represents unlimited residual claim on assets, while
distributions can only be paid to equity holders after all obligations and payments to
more senior creditors are satisfied. Common equity is therefore the highest quality
component with and highest loss absorbency. It is perpetual and never repaid outside
liquidation (aside from stock repurchases), and has the attribute of „patient money“
3,5% 4% 4,5% 5,125% 5,75% 6,375% 7%1%
1,5%1,5%
1,5%1,5%
1,5%1,5%
3,5%2,5% 2%
2%2%
2%2%
0,0%1,0%2,0%3,0%4,0%5,0%6,0%7,0%8,0%9,0%
10,0%11,0%
2013 2014 2015 2016 2017 2018 2019
Basel III Phasing in period 2013-2019common equity Tier 1 (incl conservation buffer Aditional Tier 1 Tier 2
28
(Berger, Herring, Szego, 1995) In contrast to Additional Tier 1 (AT 1) instruments, on
the balance sheet, it must be classified as equity, not as a liability.
Unlike Basel II, which allowed the regulatory adjustments to be deducted from the
entire Tier 1 layer, under the new regime, the vast majority of deductions will be made
from CET 1. The results of Comprehensive Quantitative Impact Study undertaken by
CEBS51 at the end of 2009, showed that the major portions of deductions under Basel
III would come from goodwill, deferred tax assets, holdings of other financial
institutions, and other intangibles.52 Main features of the regulatory Tiers under Basel
III are summarized in Table 2:
Table 2 -
Characteristics of
regulatory
capital
instruments
Common equity
Tier 1 Additional Tier 1 Tier 2
Subordination most subordinated subordinated to Tier
2
subordinated to
depositors and
general creditors
Loss absorbency going concern
going concern,
specified trigger
point
gone concern,
repayment before
CET 1 and AT 1
Maturity perpetual perpetual, callable
after a minimum of minimum 5 years
51 Committe of European Banking Supervisors, now European Banking Authority, is the EU wide supervisory authority responsible for coordination of financial supervision and develops technical standards for implementing Capital Requirements Directives 52 CEBS (2010)
29
5 years
Distributions no obligation to
distribute
cancellable - not
triggering default
non-payment
constitutes default
Additional Tier 1
The instruments qualifying for inclusion into Additional Tier 1 (AT 1) must satisfy loss
absorbency on a going-concern basis. This layer can however be formed by hybrid
securities, those having equity and debt-like characteristics. If recognized as a liability,
the instruments must have a specified trigger point to ensure loss absorbency by either
being converted to common shares, or having a write-down mechanism of loss
allocation. This feature is meant to ensure that the instruments take losses before
a public sector capital injection is made.
Requirement of being perpetual remains, however, the instruments can include an
option to be called. The call can be exercised only after a minimum of five years,
subject to meeting the minimum requirements, this specification is also shared with Tier
2 instruments.
Tier 2
Insturments representing the Tier 2 portion can consist of debt that is subordinated to
depositors and general creditors, and the objective is to provide loss absorbency on
a gone-concern basis. Failure to make payment constitutes default and in the even of
bankruptcy, claims of Tier 2 holders are satisfied before those of CET 1 and AT 1.
Inclusion of this Tier 2 is advocated on the premises that spreads on uninsured debt
have the potential to be an indicator of bank’s risk taking and thus a source of market
discipline. Similarly as the conversion feature in AT1, Tier 2 subordinated debt is useful
to protect governments from losses in the event of liquidation (Carey, 2002).
To achieve the goals of public policy, instruments, that qualify for inclusion in
regulatory capital should satisfy three main characteristics (Berger, Herring & Segö,
30
1995, p. 408). First, the claims should be junior to those of deposit insurer and absorb
losses before insurance fund. Second, as stated above, it should provide a stable source
of funding during a possible panic run by other creditors. Lastly, the instrument should
reduce the bank’s moral hazard incentives to undertake excessive portfolio or leverage
risk. Common equity satisfies the first two objectives, but only partly the third one. The
leverage risk is reduced as higher amount of equity is required, theoretical results on
whether it reduces portfolio risk are divergent. These will be discussed later in this
section.
Empirical evidence from the recent financial crisis sheds light on the quality of „tiers“.
Demirguc-Kunt et al. (2010) study the relationship between different capitalization
measures and stock price returns for a sample of 381 banks over the period before and
during the recent crisis. Until Q2 2007, which is the time of the crisis dummy, the
coefficient for capital is small and marginally significant, while during the crisis period
spanning between Q3 2007 and Q1 2009, their results show the strongest positive
relationship for common equity, Tier1, and tangible common equity. Their results are
most pronounced for a subsample of large banks53 and for ratios to total assets as
opposed to RWA.54
The above study provides clear cut evidence for what investors in the market deem as
highest quality. The issues with tangibility were earlier most pronounced for Japanese
banks, which became heavily reliant on deffered tax assets55 in 1998. Skinner (2005)
ascribes the decision for including these assets into capital to regulatory fobearance56 of
government authorities to prevent the weakest banks from failing subsequent to the
burst of stock market and real estate bubble in 1990.
Subsequently to the new proposal, two impact studies were undertaken by BIS and
CEBS at the end of 2009 to measure the difference between banks‘ actual capital ratios
53 Total assets more than $ 50 billion 54 The authors assign this effect to a possibility that large banks have more opportunities to engage in regulatory arbitrage, that blurred the information content of RWA. 55 Deferred tax assets (DTAs) represent operating loss, tax credit or other carry forwards. These items require significant portion of subjective judgement made by managers. Moreover, DTAs are only economically meaningfull if a firm remains going concern, in case of bankruptcy, they are lost. (Skinner, Miller 1998) 56 Regulatory forbearance is reluctancy to wind up a bank in
31
and the Basel III proposals. The impact studies are focused on Group 1 banks (Tier 1
capital in excess of EUR 3 bil.) and Group 2 banks (all other banks). The shortfall of
common equity Tier1 resulting from new proposed increases, definitions, and
deductions was roughly 50% for Group 1 banks and 30% for Group 2 banks and was
mainly due to deductions. Tier 1 ratios showed a shortfall of about 30% for the group of
large banks and was mainly attributable to eligibility of instruments.
Market discipline
Regarding the effectiveness of market discipline, the usual argument goes, that
explicitly as well as implicitly insured depositors do not have incentives to monitor and
thus the institutions will not be disciplined for the risks it takes. Flannery (1998)
reviews the empirical evidence on monitoring of US banking firms. They conclude, that
bank share prices react promptly to new information, and bank liability holders behave
rationally. Large certificates of deposits reflect bank risks even in the presence of
government guarantees. This is contrary to the experience from recent crisis, where the
case of Lehman bankruptcy is put forward as the ultimate evidence of investors being
complacent or uninformed about the true risks. However, as stated in Levy-Yeyati et al.
(2007) while bank fundamentals may be useful indicators of bank health during calm
times, they tend to fail in capturing macroeconomic risk in a run-up to a crisis and may
be slow in responding, once the risks materialize.
Economic capital
Economic capital (or risk capital) is defined as the amount of capital a bank needs to
absorb losses over a certain time horizon with a certain confidence interval – a VaR
concept (Hull, 2007, p. 366). As Basel II IRB approach uses this concept in order to
„allign“ regulatory capital with the economic one, the amount of economic capital is
defined as difference between the actual worst case losses and expected losses.
Figure 1 shows, that economic capital will include risk that is specific to the bank and is
not covered by regulatory capital. To arrive at an institution-wide risk capital,
32
unexpected losses for non-business risk and business risk are aggregated. The time
horizon is usually set to one year, which corresponds to notion that bank is able to
recapitalize within this time period. The confidence level is subject to each bank’s
objective. As noted by Hull, a common objective for banks is to obtain a desired credit
rating.
Figure 1:
Source: Hull (2007)
Distinction between regulatory and economic capital and associated issues
The two concepts reflect the needs of different primary stakeholders. For economic
capital, the primary stakeholders are the bank’s shareholders whose objective is to
maximize their wealth. Whereas for regulatory capital, the primary stakeholders are the
bank’s depositors and their objective is to minimize the possibility of loss (Allen 2006,
p. 45).
Elizalde & Repullo (2006) analyze the differences between the two concepts of capital
in the context of the single risk factor IRB model of Basel II, where the level of capital
is chosen by shareholders in order to maximize their wealth. In this context, they show,
that economic and regulatory capital do not depend on the same variables. The former
depends on the cost of capital and on intermediation margin. They show, that economic
capital is higher that regulatory capital only when cost of capital is low. Intermediation
margin substitutes for capital in incompetitive loan market and thus drives economic
Total risk
Non-business risk (regulatory capital)
*Credit risk
*Market risk
*Operational risk
Business risk (no regulatory capital)
*Risk from strategic decisions
*Reputation risk
33
capital low. They advocate regulations of prompt corrective action type, which mandate
progressive penalties as capital ratios deteriorate.
Carey 2002 argues, that allowing subordinated debt to be included in the amount of
capital required to achieve desired degree of solvency may render the amount of capital
insufficient to satisfy the social planner’s goal.
A critical point is made by Kupiec (2004). Using Merton’s option pricing framework
and assuming wealth maximizing shareholders, the author shows, that IRB capital
requirements do not eliminate incentives created by mispriced safety net. The interest
rate subsidy that is captured by the IRB models differs among investments with
different risk profiles making it possible for the bank to meet the regulatory solvency
rate with less capital than would otherwise be adequate for an uninsured institution. The
assets for which the subsidy is most pronounced have low volatility and high risk
premium.
Bank capital, risk taking and unintended consequences
The large theoretical literature predicting behavior of banks under capital restrictions
yields divergent conclusions. VanHoose (2007) surveys the field of theoretical
predictions. The different approaches study: i) capital constrained portfolio selection; ii)
incentives to take risk; iii) capital and demandable debt as mitigation of moral hazard;
iv) influence of capital regulation on bank lending and monitoring choices; v) capital
regulation and adverse selection of borrowers, extended for heterogenous banks.
VanHoose makes following conclusions:
- Immediate effects of capital constraining standards are reduction in lending and
increased market loan rates
- Longer term effect of capital regulation leads to increase in capital ratios, with
an ambiguous effect on amount of lending
34
Capital regulation can thus protec depositors and depsit insurers from losses in the event
of bank failures. The divergence of literature is rooted in the marginal choice of the
bank in question. Capital cushion may cease to achieve its objective if banks choose to
take higer risks or reduce screening and monitoring. An agreement rests in tying the
capital requirement to asset risk, but not in how many banks will become less risky.
Capital regulation might need to be complemented with other policy instruments, such
as supervision or market discipline.
Jackson et al. (1999) undertake a survey of empirical studies on the performance of
capital requirements. They make several observations. Capital ratios seem to induce
banks to hold higher capital levels. Banks adjust their balance sheets depending on the
stage of the business cycle and banks‘ capitalization. In times, when it is costly to raise
equity, banks change the composition or level of lending. For the question, whether
higher requirements lead to higher risk taking, they conclude, that no reliable evidence
can be forwarded. Finally, they find there was significant securitisation-related capital
arbitrage in Canada, Europe and Japan.
Capital Structure and Cost of Equity
In this section, the cost of equity in relation to capital structure will be discussed. The
classical finance theory of irrelevance of capital structure on firm value and investment
choices presented by Modigliani and Miller is hardly applicable to banks when one
takes a look at the theoretical underpinnings of the mere existence of banks. There are
also features, that may make banks „special“ such as the presence of government
guarantees and the regulatory constraints applied to their capital structure. This would
all suggest, there is no merit in studying banks‘ capital structures because, they are just
unique in every aspect. Below, the standard theories of deviations from the perfect
worls are presented and applied on the banking firms, it turns out, that there might be
much more similarities between banks and non financial firms, as well as a fact that
banks might be subject to the same mechanics. From this analysis, the costliness of
equity will be discussed to prepare for an analysis for the methodological part of this
paper.
35
While existence of banks lacks any justification in a world without frictions, several
authors posit that Modigliani & Miller needs to be the starting point for analysis of bank
capital structure choices.
In formulating their famous propositions, Modgliani and Miller (1958), henceforth M-
M, showed that in a world without frictions, where all investors have full access to
information and price risk rationally, the way how a firm is financed does not create
value. Their Proposition I states that: „the average cost of capital to any firm is
independent of its capital structure and is equal to the capitalization rate of a pure equity
stream of its class.“ (M-M, 1958, p. 268). Proposition II: „the expected yield of a share
of stock is equal to the appropriate capitalization rate (Re) for pure equity stream in the
class, plus a premium related to financial risk equal to the debt-to-equity ratio times the
spread between (Re) and (Interest rate charged on debt) (M-M, 1958, p. 271).
The frictions of the real world then allow for the value of the firm to be determined by
its capital structure choices – an optimal amount of leverage. There may be costs to
holding too much as well as too little equity. Moreover, there may be costs associated
with raising, rather than holding equity. There are also factors that are specific for banks
that need to be taken into account when analyzing their capital structure choices. The
sources of these costs are discussed below.
General theories of capital structure choice
The tradeoff theory states that there are offsetting effects from leverage (see e.g.
Bradley 1984). The existence of corporate tax rate makes leverage favorable because
the interest payments on debt are tax deductible, so maximizing leverage adds to the
value of the firm. The other side of the coin is that raising leverage increases the
probability of bankruptcy. Thus firms will optimize the amount of leverage up to
a point, where the marginal benefit of tax shield equals the marginal cost of rising
probability of bankruptcy.
Separation of ownership and control and asymmetric information give rise to agency
costs, where conflicts of interest arise between contracting parties – the conflict between
principal and agent. According to Jensen&Meckling (1976), if the owner-managers
have only a small stake in the firm, they migh be pursuing their own interests (for
example by perquisites consumption and empire building) instead of maximizing
shareholder value. Jensen & Meckling additionally show, how a conflict of interest
36
exists between shareholders and creditors, stemming from the variable and fixed payoff
to shareholders and debt-holders, respectively. Shareholders benefit from investing in
riskier projects, gaining if the gamble succeeds, but this is detrimental to the debt-
holders, who bear the cost of increased probability of bankruptcy, in turn the
debtholders will demand a premium for this possibility and the ultimate cost is born by
the shareholders. Similar insights to the shareholder-creditor conflict are presented in
Myers (1977), the author adds the possibility of underinvestment. When the firm is near
bankruptcy, shareholders lack incentives to contribute new equity, thus giving up value-
increasing investments in anticipation that the benefits would accrue to creditors.
The above theories are concerned with the reason, why holding equity might be costly.
The insight into why raising equity might turn out to be costly and make firms seek
other sources of funding to undertake investments is given by Myers (1984) and
Myers&Majluf (1984). The authors suggest, that since managers hold inside
information about the firm’s state and prospects, the investors will regard the equity
issuance to be made exactly when the shares are overvalued. Investors will thus demand
a „lemon“ premium and will be only willing to purchase the issue for a discounted
price. This theory suggests, that firms will first choose to fund projects with funds that
are least informationally costly, yielding a „pecking-order“ theory, where the firm first
uses internally generated funds, then issues debt, and chooses to issue equity only when
previous sources cannot be used anymore.
Bank-specific features
Merton Miller, in his response to the question, whether the M-M theorem applies to
banks, stated: „The government payment guarantees for bank demand deposits, found
on no other corporate securities, will surely affect the cost of capital from this source.“
(Miller, 1995, p. 485).
Thus the presence of (underpriced) government safety net poses an addition to the
above outlined theories that might determine an optimal capital ratio. The market capital
„requirements“ as Berger (1995) calls them, will take account of these guarantees,
demanding a lower risk premium on their securities and leaving the bank to attain
a higher than normal leverage. Banks can be insulated from potential market discipline.
Apart from insured creditors, also those that are not explicitly insured may perceive
37
themselves to have a de-facto guarantee. This would allow banks to increase their
leverage without suffering by having to pay higher interest rate on its liabilities.
Empirical evidence on capital structure theories for non-financial firms is vast and
evolving, producing a long list of factors that could be meaningful in determining
a pattern of firms‘ capital structure choices. Frank & Goyal (2007) make an attempt to
test overarchingly the performance of six „core“ factors out of 19, that are most
frequently associated with choices of leverage. The core factors include i) industry
median leverage; ii) market-to-book assets ratio; iii) proportion of tangible assets; iv)
profitability; v) firm size; and vi) expected inflation. Their conclusion goes, that
although these factors are significant on a standalone basis, when interpreted jointly,
they posit weaknesses in following the theoretical link between one another.
A recent study by Gropp and Heider (2010) seeks to apply the standard factors on
banks. The authors study a sample of 100 large publicly traded banks and bank holding
companies in the US and Europe over the period between 1991 and 2004. Their findings
indicate, that neither deposit insurance, nor capital requirements can explain the capital
structure of banks. Gropp & Heider conclude, that banks in their sample seem to
optimize their capital structure much like non-financial firms.
A rather alternative approach to test, whether bank capital matters was undertaken by
Mehran & Thakor (2009) they develop a model that predicts bank capital to be
positively correlated in the cross section, and test it using mergers and acquisitions data.
They find, that target bank’s equity has a significant positive relationship to the amount
of its capital. Thus concluding that higher levels of capital are cross-sectionally
correlated with higher bank values.
As a response to the argument of costliness of equity, there are two studies that examine
to what extent does the M-M principle of conservation of risk hold for banks.
Specifically, the theory would suggest, that if the bank’s ratio of equity to assets is
doubled, and if underlying riskiness of the assets does not change, its beta coefficient
should fall by one half.
Miles, Yang and Marcheggiano (2011) approach this question by examining six large
publicly traded banks in UK over the period between 1992-2010 using CAPM to
decompose asset betas into equity betas and assuming the debt is riskless. They regress
38
half-yearly betas to get an estimate of how leverage ratio impacts the correlation
between market returns and bank equity returns. Results yield higly significant positive
relationship between leverage and equity betas. The authors then use the inputs to
compute weighted average cost of capital (WACC) assuming risk-free rate and risk
premium to be equal to 5%. The resulting WACC shows that a 45% M-M offsetting
effect is present.57 The authors then also estimate the regression in log specification, and
for the third case, without assuming that CAPM holds, they regress earnings-to-price
ratio (as a proxy for required returns on equity) on leverage. The two subsequent
estimates yield a WACC with 75% and 100% M-M offsetting effect, respectively.
A study by Kashyap, Stein and Hanson (2010) undertakes a similar investigation of
large US publicly traded banking firms with assets exceeding $10billon. They estimate
market betas and return volatilities using monthly regressions. Both of the regressions
yield statistically significant results satisfying the prediction that betas and volatilities
decrease as the ratio of equity to assets increases. The M-M principle of conservation of
risk is present to about two thirds.58
The results are clearly divergent. It can be the case, that capital is costly for banks to
hold, conversely it can increase the value. The third possibility is that the frictions,
while no reason to claim that they are not present in the real world, do allow the
classical theories to hold to a limited extent. It could then well be the case, that raising
equity is much more costly than just holding it, and holding lowest possible portions of
equity increases the returns, but at the expense of increased risk.
Loan Pricing
To evaluate the model that will be used for quantifying the impact of Basel III in the
following section of this paper, since it has implications for an increase in loan prices,
this sections will look at what factors come in the decision process when evaluating the
rate to be chaged on aloan. There are also aspects of the environment that determine the
feasibility of loan pricing choices.
57 Meaning that the WACC rose only 55% of the magnitude if there was no M-M offset. 58 Using the estimated coefficients, when doubling the equity-to-assets ratio, beta falls by 0.32 as opposed to a fall of 0.5 if the M-M held exactly.
39
Decision to extend a loan involves taking various factors into account. In Saunders &
Cornett (2006, p. 297) a traditional return on assets approach is presented to arrive at a
contractually promissed return on a loan. The return will be affected by cost of funding
the loan, any fees related to the loan (e.g. for administrative expenses), borrower’s
credit risk premium, collateral backing the loan, and other non price items.
Although the parameters are all important, the component measuring risk is of particular
significance for bank’s decision process.
Hasan & Zazzara (2006) divide the risk-adjusted pricing into ‘technical‘ and
‘commercial‘ portions. Their focus is on technical pricing – to reflect the riskiness of
the loan, cost of expected and unexpected losses needs to be covered. The authors
employ a risk-neutral approach59 to express spread charged for the expected loss and
utilize the Basel II IRB formula for spread to cover unexpected loss. Where the risk-
adjusted spread is equal to (equation 3)60:
푆푝푟푒푎푑 = ×( ) − 1 − 푟 + 퐵2 × 푅푂퐸 (X)
The first term represents spread for expected loss and the second term is the IRB capital
requirement (B2) multiplied by the return on equity. The authors highlight the need to
properly account for regulatory capital constituting a risk-sensitive component of cost.
This is also the approach promoted by regulators, since it seeks to properly price the
total risk that a loan bring to its holder.
As pointed out by Stiglitz & Weiss (1981), however, under assymmetric information,
the interest charge reflecting risk might itself determine the average quality of
borrowers. Increased interest rate might lead to adverse selection of borrowers, because
those willing to borrow at high rates perceive their probability of repayingthe loan to be
low. Similarly, the borrowers might undertake projects with same expected returns but
much higher variance as a response to change in rates. The authors thus explain, why
banks ration credit among identical applicants. It is sometimes optimal for a bank to
extend only a limited amount of loans even if it has a capacity for more.
59 Under risk-neutrality, investors are indifferent between a risk-free investment and a risky investment with the same expected value. 60 For simplicity, only one period is assumed here
40
Thus, the interest rate might not deliver the desired expected return to a bank. When
setting the loan terms, a common remedy is to limit the loan-to-value ratio or require
collateral to secure the repayment.
The price of a loan must also take into account the industry environment. Ruthenberg &
Landskroner (2007) present a loan pricing model taking into account banking industry,
that is characterized by imperfect competition. They examine the loan pricing
implications of the two approaches under Basel II- the standardized and IRB. The banks
are assumed to be risk neutral and maximize their expected profits with respect to their
decision variables – amount of loans extended and deposits. In their setting, the interest
rate on loans is determined by five parameters. The first one represents risk premium
expressed as a yield differential that takes into account borrowers‘ probability of
defaulting. Second term represents market structure, taking into account the Herfindahl-
Hirschman index of concentration in the loan market (bank’s market power) and the
elasticity of deman for loans. Next two terms are the risk-free rate and cost of rising
debt in the secondary market. The last component is given by the sensitivity of required
capital to changes in loans extended (or marginal capital requirement) multiplied by the
cost of equity capital. The authors test their model in context of Israeli loan market and
show that low risk customers will get a more favorable loan terms when choosing to
borrow from an IRB using bank. Higher risk customers, on the other hand will be better
of, when applying for a loan from bank that uses standardized approach to credit risk.
Taken from the other side, the larger, more sophisticated banks, that use IRB approach,
will experience an inflow of low risk borrowers, whereas the less advance banks, using
standardized approach, will end up holding a riskier portfolio.
Repullo & Suarez 2004 examine Basel II loan pricing in context of perfectly
competitive market for business loans. They assume risk neutral bank shareholders. The
competitive equilibrium interest rate is such, that makes each loan’s contribution to the
expected discounted value of shareholders’ final payoff equal to the initial equity
contribution that is required for the loan. The equity contribution is determined by IRB
capital requirement. Similarly to Ruthenberg & Landskroner, they come to a conclusion
that banks adopting the IRB approach will specialize in making loans to less risky
borrowers.
41
For analyzing the potential reactions of banks to increased capital requirements, thus
several factors will need to be taken into account. The market environment, which will
determine the capacity tocharge higher rates and not loosing business to the
competition. The constraint given by deterring the low risk borrowers from applying,
when the interest rate is high enough so that mostly opportunistic projects will seek
financing. And lastly the amount of equity that will need to back the loan.
The next section turns to the impact assessment and will try to discuss these factors in
the analysis.
Impact Assessment of the Basel III Proposal
In this section, the accounting identities and neccessary equations will be presented and
discussed. Following through data description, I will explain, how the stylized balance
sheet and income statement were constructed. The final step of the methodological part
will yield an estimate of the lending spread change required to maintain the level of
return on equity (ROE). The assumptions underlying the methodology allow for
changing the scenarios to utilize previous discussion and adapt the possible strategies of
compliance with capital requirements to country-specific conditions.
Methodology
The mapping methodology is adopted from a study undertaken by King (2010), which
seeks to quantify the effect of increased capital requirement on lending spreads to
achieve a given level of steady-state ROE.
42
The mapping assumes, that banks will pass on any additional costs by raising the cost of
loans to end-customers. By measuring the change in net income and shareholders‘
equity, the lending spread can be calculated, which is required to compensate for the
increase in capital requirements.
While King’s paper explicitly maps both, the requirements for capital and liquidity,
instead, this paper’s mapping will be focused on the capital requirements solely.
Undertaking an analysis of impact assessment will be made utilizing the results of EU
QIS which quantified how increased capital requirements, eligibility criteria and
deductions would affect the state of banks at the time it was undertaken.
Mapping the increased capital ratio into lending spreads
The mapping exercise begins with defining the stylized balance sheet for a
representative bank. The asset side (equation 4) consists of cash and balances with
central bank, interbank claims, trading related assets, loans, investments and other
assets.
퐴푠푠푒푡푠
= 퐶푎푠ℎ + 퐼퐵푐푙푎푖푚푠 + 푇푟푎푑퐴푠푠푒푡푠 + 퐿표푎푛푠 + 퐼푛푣푒푠푡푚푒푛푡푠
+ 푂푡ℎ푒푟퐴푠푠푒푡푠 (4)
The liabilities‘ side (equation 5) includes deposits, interbank funding, short-term
liabilities, trading liabilities, long term wholesale funding, and other liabilities (non-
interest bearing). The distinction between the short- and long-term nature of liabilities is
neccessary for computing the cost of interest bearing liabilities separately, which will be
used for more precise calculation of interest expenses.
퐿푖푎푏푖푙푖푡푖푒푠
= 퐷푒푝표푠푖푡푠 + 퐼퐵푓푢푛푑 + 푆ℎ표푟푡퐿푖푎푏푠 + 푇푟푎푑퐿푖푎푏푠 + 퐿푇푤ℎ표푙푒푠푎푙푒
+ 푂푡ℎ푒푟 (5)
43
The stylized income statement shows the composition of income and expense items
(equation 6). Regarding revenues, a distinction is made between interest income on
loans, other interest income, and non-interest income. The cost items are then
represented by interest expense and operating expenditures61. Interest expense is due on
deposits, interbank funding, short-term liabilities, trading liabilities and long-term
wholesale funding. Net income equals total revenues less total operating expenses and
income tax.
푁푒푡퐼푛푐
= (퐼푛푐퐿표푎푛푠 + 푂푡ℎ푒푟퐼푛푡퐼푛푐 − 퐼푛푡퐸푥) + 푁표푛퐼푛푡퐼푛푐 − 푂푝퐸푥) × (1
− 푡푎푥) (6)
Distinguishing between interest bearing liabilities - the different components of interest
expense - is neccessary in order to capture the decrease in interest expense which will
be realized as debt is crowded out by the increase in equity. Thus a distinction is made
on the basis of a one-year threshold for the maturity of liabilities (equation 7).
퐼푛푡퐸푥 = 푟 × 퐷푒푝표푠푖푡푠 + 푟 × (퐼퐵푓푢푛푑 + 푆ℎ표푟푡퐿푖푎푏푠 +
푇푟푎푑퐿푖푎푏푠+푟퐿푡퐷푒푏푡×퐿푇푤ℎ표푙푒푠푎푙푒
(7)
Where 푟 is the cost of deposits, 푟 is the cost of short-term liabilities
(which is payable on interbank funding, short-term liabilities and trading liabilities), and
푟 is the cost of debt with maturity of more than one year. Since this distinction is
not separately disclosed, but agregated in the interest expense item, the separate cost of
interest bearing liabilities can be calibrated based on the ratio of interest expense to
interest paying liabilities solving for the three following equations:
푟 =
푥 (8)
61 Include personnel expenses, administrative expenses, and other operating expenses
44
푟
= 푥 + 0.01 (9)
푟
= 푥 + 0.02 (10)
As pointed out in King (2010) the lower cost of deposits reflects the fact that they are
insured by government and thus least risky, and futhermore, this calibration of spreads
also reflects the upward sloping yield-curve. This specification is adopted from King
(2010) and represents long-term historical averages for the sample of his study. The cost
of each type of liabilities can be then calculated as (equation 8 is arrived at after
combining equations 8,9,10, and 11 and rearranging to solve for x):
푥
=퐼푛푡퐸푥 − 0.01 × 푆ℎ표푟푡푇푒푟푚퐷푒푏푡 − 0.02 × 퐿표푛푔푇푒푟푚퐷푒푏푡
퐷푒푝표푠푖푡푠 + 푆ℎ표푟푡푇푒푟푚퐷푒푏푡 + 퐿표푛푔푇푒푟푚퐷푒푏푡 (11)
Where ShortTermDebt consists of interbank funding, short-term liabilities and trading
liabilities.
Turning to the last source of funding, shareholders‘ equity, the estimate of expected
return on equity is obtained by averaging the ratio of net income to shareholders‘ equity
over the sample period (equation 12)62.
푟 = 푅푂퐸
=푁푒푡퐼푛푐표푚푒
퐸푞푢푖푡푦 (12)
Here, no distinction is made between the different components that constitute
shareholders‘ equity, to the extent equity-like securities63 bear different cost, this
estimate might provide an upward bias. Nevertheless, since Basel III will raise the
62 For equation 12, average data over the period 2006-2010 is taken from NBS statements 63 No specification of the components of share capital is given in the NBS statements.
45
tangible common equity element and poses a stricter definition of eligible capital, the
results should not be far from reality.
The expected return on equity will be the highest among the different sources of
funding, followed by cost of long-term, short-term, and deposit funding, respectively.
Being the most senior claim, the highest return corresponds to its highest riskiness.
Accounting and regulatory capital need to be distinguished since the latter is related to
riskiness of assets. The National Bank of Slovakia (NBS) statements, used for
calculation, do not provide the regulatory ratios, nor the amount of risk-weighted assets
(RWA). The ratio of RWA to total assets (TA) as well as total capital ratio (TCR) is,
instead obtained from OECD banking statistics64, as an average over the period 1999-
2009 (equation 13).
푇표푡푎푙 퐶푎푝푖푡푎푙 푅푎푡푖표 =
(13)
The data thus do not allow to follow King (2010) exactly, however this does not lead to
any shortcomings. The neccessary information is given in the ratio of RWA to TA as it
is needed to determine the required increase in equity to TA. If the ratio of RWA to TA
is 41,91% (as is the case in further calculations), it means, that for a 1 percentage point
(pp) increase in the TCR, the ratio of equity to TA will need to be increased by 41,91
basis points (bp) holding the size and composition of the balance sheet constant.
Equation 11 shows the increase in equity, when the TCR is increased by 1pp.
퐸 = 퐸 + ∆푇표푡푎푙 퐶푎푝푖푡푎푙 푅푎푡푖표
× 푅푊퐴 (14)
The increase in equity will be matched by an equal and offsetting decrease in liabilities.
It is assumed, that the most expensive long-term wholesale liabilities will be substituted
for in the first place (equation 12).
64 Available from: http://stats.oecd.org.www.baser.dk/BrandedView.aspx?oecd_bv_id=bank-data-en&doi=data-00270-en
46
∆퐿푇푤ℎ표푙푒푠푎푙푒
= −∆퐸푞푢푖푡푦 (15)
This change will lead to a rise in the cost of capital since debt is crowded out by the
more expensive equity, but simultaneously to a decrease in interest expense as the
amount of debt outstanding declines. Net income will increase, but since the equity now
represents a larger proportion (increasing the denominator of ROE), ROE will fall.
Finally, it is assumed that the fall in ROE is offset by raising the lending spread (α)
charged on loans. Since lending spread is not disclosed in the statements, the effect will
be modelled as an increase in the average spread charged on outstanding loans (equation
16).
퐼푛푐표푚푒퐿표푎푛푠
= 퐼푛푐표푚푒퐿표푎푛푠 + 훼
× 퐿표푎푛푠 (16)
The neccessary increase in lending spread is such, that the increase in the cost of capital
is exactly offset by an increase in net income (equation 17). Thus keeping the ROE
unchanged.
훼
=
(푅푂퐸 × 퐸 )(1 − 푡푎푥) − (푂퐼푛푡퐼푛푐 − 퐼푛푡퐸푥 + 푁표푛퐼푛푡퐼푛푐 − 푂푝퐸푥 ) − 퐼푛푐퐿
퐿표푎푛푠
(17)
With this methodology, a measure of lending spread can be obtained, that is needed to
offset the fall in ROE associated with a 1pp increase in regulatory capital ratio.
Description of data
Lending spread
47
The focus of this study is on bank lending spreads, which is the spread between a bank’s
cost of liabilities and the average rate charged on its loan portfolio.
In Repullo & Suarez (2004) the deposits are assumed to carry a risk free rate, and the
authors define lending spread as the rate charged over deposits. Similar specification
will be used for this purpose, also due to availability of data. Average lending preads,
measured as interest charged by banks on loans to prime customers less the rate paid on
demand deposits.65 Figure 2 shows the evolution of lending spreads in Slovakia over the
period from 1993 to 2007. This time series gives an average spread of 5.09%.
Figure 2
Source: www.indexmundi.com
Construction of representative statements
To construct the neccessary stylized balance sheet and income statement, data from
NBS statistics for the sector of credit institutions is used.66 The availability of yearly
data series of credit institutions‘ balance sheets and income statements is limited to the
period between years 2006 and 2010. The composition of the banking sector during
sample period ranged from 25 institutions in 2006 to 30 institutions in 2010. As
65 Source: Indexmundi, available at: http://www.indexmundi.com/facts/slovak-republic/interest-rate-spread#FR.INR.LNDP; visited on 2.8.2011 66 The statements are available from NBS website: http://www.nbs.sk/en/statistics/money-and-banking-statistics/source-statistical-data-of-monetary-financial-institutions
0123456789
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Lending spread in %
48
mentioned, the average ratios of TRC to RWA and RWA to TA are computed based on
data taken from OECD67, covering the period of 1999-2009. The stylized statements
then comprise average values of items over the sample period as percentage of assets.
67 Available from OECD Banking Statistics: http://stats.oecd.org.www.baser.dk/BrandedView.aspx?oecd_bv_id=bank-data-en&doi=data-00271-en
Table 2: Stylized balance sheet and income statement, 2006-2010
(As percentage of total assets)
BALANCE SHEET Average INCOME STATEMENT Average
Cash and balances at Central Banks 13.72% Interest income on loans 3.76%
Interbank claims 6.64% Interest income excl. loans 0.89%
Trading related assets 7.03% Interest expense 1.98%
Loans, leases, mortgages 51.31% A. Net interest income 2.67%
Investments and securities 19.08% Trading income 0.74%
Other Assets 2.22%
Non-interest income excl.
trading 1.09%
TOTAL ASSETS 100.00% B. Non-interest income 1.83%
C. Total revenues (A+B) 4.50%
D. Total operating expenses 2.50%
Deposits 32.84% E. Operating profit (C-D) 2.00%
Short-term liabilities 34.96% Income tax provision 0.44%
Interbank funding 12.15% Net income 1.56%
Trading related liabilities 3.40%
Long-term Wholesale funding 5.73%
Other Liabilities 2.54%
Total liabilities 91.62%
49
Table 2 shows the stylized balance sheet and income statement for the sector of credit
institutions. The values are shown in percentage of total assets. Importantly, loans
represent about half of the total assets, followed by investments (19.08%), cash and
central bank balances (13.72%), trading related assets (7.03%), and interbank claims
(6.64%). The most important sources of funding are deposits (32.84%), short-term
liabilities (34.96%), interbank funding (12.15%), and long-term wholesale funding
(5.73%). Risk weighted assets make up 41.91% of total assets.
Composition of the income statement shows interest income on loans as the most
significant item of income, followed by non-interest income, which is lower by about a
half. Total operating expenses are almost of the same magnitude as net interest income.
Average effective tax rate over the period stood at 22.09%, yielding a net income (or
return on assets) of 1.56% of total assets, and subsequent average ROE of 18.63%. As
can be seen, the leverage multiple over the period averaged about 12 times, alternatively
expressed as 8.38% ratio of equity to total assets.
From the data obtained after averaging the diferent components of balance sheet and
income statements for the sector, it is possible to proceed to measurement of impact of
increased capital requirements.
Estimates of higher capital requirements
Table 3 outlines the calculation of increase in lending spread, while keeping the cost of
equity and cost of debt unchanged, which will be relaxed further in the text. In the first
column, the initial values are presented. In column B, the ratio of Total Capital/RWA is
increased by 1 pp, given that the RWA remain at 41.91% of total assets, the increase in
Equity 8.38% ROE 18.63%
Total Liabilities and Shareholders'
equity 100.00% Leverage multiple 11.93
RWA/TA 41.91% Average effective tax rate 22.09%
Source: National Bank of Slovakia, OECD, Author's calculations. Totals may not add up due
to rounding.
50
regulatory capital ratio translates into a 41.9 bp increase in equity. The increase in
equity is exactly matched by the same decrease in proportion of wholesale funding,
which in turn reduces the interest expenses by 1.4 bp and subsequently pre-tax income.
While net income increases, the share of equity financingcauses the ROE to fall by 75.6
bp.
Column D shows the increase in lending spread, that is required to maintain the starting
level of ROE. To offset the effect of increased equity cushion, ore-tax income needs to
increase by additional 8.5 bp. Since loans represent 51.3% of assets, the lending spread
needs to increase by 16.7 bp.
Table 3: Calculation of increase in lending spreads for 1pp increase in capital ratio
assuming no change in ROE or cost of debt
(A)
Before
No increase in lending
spread
Increase in lending
sread
(B)
After
(C)
Change
(D)
After
(E)
Change
Total Capital / RWA 13.49% 14.49% 1.00% 1.00%
RWA/Total Assets 41.91% 41.91% 0.00% 0.00%
Equity 8.38% 8.80% 0.42% 0.42%
Wholesale funding 5.73% 5.31% -0.42% -0.42%
51
Increase in lending spreads
0.00% 0.17%
Interest income on loans 3.76% 3.76% 0.00% 3.85% 0.09%
+Interest income ex loans 0.89% 0.89% 0.00% 0.89% 0.00%
=interest income 4.65% 4.65% 0.00% 4.73% 0.09%
-interest expense 1.98% 1.96% -0.01% 1.96% -0.01%
=net interest income 2.67% 2.69% 0.01% 2.77% 0.10%
+non interest income 1.83% 1.83% 0.00% 1.83% 0.00%
=Revenue 4.50% 4.52% 0.01% 4.60% 0.10%
-Opex 2.50% 2.50% 0.00% 2.50% 0.00%
=Pre tax income 2.00% 2.02% 0.01% 2.10% 0.10%
NET INCOME 1.56% 1.57% 0.01% 1.64% 0.08%
ROE 18.63% 17.87% -0.76% 18.63% 0.00%
Source: National Bank of Slovakia, OECD, author's calculations. Totals may not add up due
to rounding
Having obtained the measure of lending spread to offset a 1pp increase in regulatory
capital ratio, the discussion will now turn to the impact of increased requirements and
strenghtened definitions of capital under Basel III regime.
Impact of Basel III on Slovak banking sector
To utilize the calculations of assumed increase in lending spread as a possible reaction
to the new capital regime, the results of EU QIS will be used to estimate a magnitude of
potential shortfall due to increased requirements, stricted elligibility criteria and wider
range of deductions. After having illustrated the simulated capital ratios, the pricing
constraints given the competitive environment and other aspects affecting the feasibility
of linearly raising the rate charged on loans will be discussed.
52
Table 4 shows the effect of new definitions of capital as well as the distances from
minimum required ratios and initial ratios.
A decrease of one third from initial capital ratios would set the Slovak banking sector
very close to the current minimum of 8%, moreover, falling short by 1.52% from the
minimum when Basel III will be fully in force. While gradual implementation will give
banks fairly enough time to adjust, since the initial ratio of more than 13% is a longer
term average, if the banks want to keep this buffer they will need to raise three times as
much capital as would be needed to comply with Basel III minimum.
Table 6:
Offsetting
measures
Increase in
lending spread
Fall in ROE and/or cost of debt of
10bp 15bp 20bp
Original level 74.94 65.03 60.08 55.12
Basel III
minimum 24.98 21.97 20.29 18.62
Table 6 shows the total rise in lending spread that would be necessary to maintain the
current ROE of 18.6%. Keeping in mind the historical 5%, these increases would
represent almost 15% increase of the average.
Table 4: Effect of Basel III on Slovak baning sector
Initial level of
TRC/RWA
Shortfall due
to new
definition of
capital
(Group 2
banks)
TRC/RWA
after EU QIS
deductions
Distance from
initial level of
TRC/RWA
Distance from
Basel III 10.5 %
minimum
requirement
effective from
2019
13.49% 33.40% 8.98% 4.50% 1.52%
53
Given that concentration ratio of the five largest banks in extending loans averaged
about 70% of the total lending, which is also similar for the share of deposit market
(73%)68, banks posses the pricing power, as documented by Ruthenberg&Landskroner
(2007).
Competitive constraints imposed by alternative sources of funding from capital markets,
are very weak in Slovakia. Of the total bond market, in year 2010, 80% is represented
by government bonds and the ratio of total capitalization of the bond market to GDP is
25%, the stock market capitalization totaled 6% of GDP.
On the other hand, the linear dependency of the rise in lending spread on increases in
capital ratios will not be realistic. Rise in lending spreads for each 1pp of capital
shortfall will most likely have to be marginally diminishing given the contraints on
charging higher rates. As pointed out by Stiglitz&Weiss (1981), higher interest charge
might lead to adversely selecting riskier borrowers, which could lead to higher loan
losses and thus lower income. The higher the capital shortfall will be, the more will the
individual bank need to search for other cources of income, such as increasing non-
interest income, lowering expenses or accepting the fall in ROE
Based on the results from discussion of bank capital structure, it would not be
unreasonable to assume the cost of equity would stay unchanged. As the studies by
Miles, Yang, and Marcceggiano (2011) and Hanson, Kashyap and Stein (2010) showed
there is at least some offsetting effect from the mechanism that increased equity cushion
decreases the volatility of equity and thus decreases the risk premium it must bear.
Therefore assuming a decrease of 10 – 15 bp in ROE for every 1pp increase in
regulatory capital ratio would seem reasonable.
Higher capital requirements, however, may lead to less desirable bank behaviour, such
as increasing the riskiness of their activities or increasing funding and currency
mismatches. Banks may also spend less time on monitoring
68 These numbers represent average values for the period between 2007 and 2010. Source: NBS (2007-2010)
54
Conclusion
This paper has sought to study the theoretical underlyings for the existence of banks in
the financial system and the associated challenges it may pose. The asymmetric
information and transaction costs rationales for existence of banks also point toward
a more understanding of the underlying principles of regulation.
Assessing, however, whether the system of capital requirements is beneficial of
detrimental seems to be an ever challenging task not only for the theoretical research,
but also for empirical investigation.
From the point of view of the social planner, one needs to weigh benefits and costs of
imposing any type of instrument, like capital regulation, that could possibly bring
frictions into how the business functions.
Another aspect is, when there are systemic threats stemming from at this stage rather
uncontrollable degree of development that leads to a network of interlocking claims,
that one can hardly understand.
The crisis experience showed, that there are externalities to operating at the very edge of
profitability and insolvency. When government and taxpayers‘ money comes into
account, then however it is not a private game anymore.
Regulation of bank capital could be called controversial in its achievements. If this is
either for the procyclical issues that it poses or for the distortive effects on the decision
making process of the agents. A backstop, however needst to exist to limiti the kinds of
irresponsible behavior that occured during the crisis.
The new Basel III framework will indeed mean a „significant“ strenghtening in the loss
absorbency of financial institutions, provided that all the risks can be captured for the
given solvency level.
The impact on banking sector of Slovakia will not seem to be large.
55
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