Unintended consequences of the market risk requirement in banking regulation (original) (raw)
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Critical Analysis of the New Basel Minimum Capital Requirements for Market Risk
In its October 2013's consultative paper for a revised market risk framework (FRTB), and subsequent versions published thereafter, the Basel Committee suggests new ways of dealing with market risk in banks' trading and banking books. The Basel Committee estimates that the new rules will result in an approximate median capital increase of 22% and a weighted average capital increase of 40% [1], compared with the current framework. Key changes can be found in the internal model approach, in the standard rules and in the scope/approval process. Among the significant changes that are being introduced by the FRTB is a stricter separation of the trading book and banking book. Regardless of whether they use standardised or internal models, banks will need to review their portfolios to determine if existing classifications of instruments and desks as trading book or banking book are still applicable or whether a revision of desk structure is needed. In this article, we analyse the theoretical foundations of the internal model approach (IMA), which are the stressed expected shortfall, liquidity adjustments, default & migration risk and non-modellable risk factors. We thoroughly investigate the criticisms for Internal Risk Model (IMA) and the introduction of a standardised floor, the sensitivity based approach (SBA) with Delta, Vega and Curvature, shock scenarios and the aggregation with asymmetric correlation and reflection of basis/default risk.
The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety
Journal of Financial Intermediation, 1996
We show that in an imperfect information environment the equity value of an impaired bank may increase or decrease when it is required to meet a capital standard. Regardless of the change in the bank's equity value, however, its stock price will fall in response to a forced recapitalization, consistent with recent empirical evidence. Simulations of our model suggest that this stock price decline is likely to be larger the smaller is the share of ownership held by the managers of the bank, also consistent with recent empirical evidence in the literature. Our model further predicts a rise in bank's non-interest expenses following a required recapitalization. Given the increase in the regulator's exposure that would accompany a reduction in the bank's market value of equity, the regulator may choose not to enforce the regulation. Hence, capital regulation may be timeinconsistent in this situation and consequently not have its intended risk-mitigating incentives.
Can Banks Circumvent Minimum Capital Requirements? The Case of Mortgage Portfolios Under Basel II
SSRN Electronic Journal, 2010
The recent mortgage crisis has resulted in several bank failures. Under the current Basel I capital framework, banks are not required to hold a sufficient amount of capital to support the risk associated with their mortgage activities. The new Basel II capital rules are intended to be more risk based and would require the right amount of capital buffer to support bank risk. However, Basel II models could become too complex and too costly to implement, often resulting in a trade-off between complexity and model accuracy. Since the Basel II rules are meant to be principal based (rather than prescriptive), banks have the flexibility to build risk models that best fit their unique structure. We find that the variation of the model, particularly how mortgage portfolios are segmented, could have a significant impact on the default and loss estimated. This paper finds that the calculated Basel II capital varies considerably across the default prediction model and segmentation schemes, thus providing banks with an incentive to choose an approach that results in the least required capital for them. We find that a more granular segmentation model produces smaller required capital, regardless of the economic environment. Our results suggest that banks may have incentives to build risk models that meet the Basel II requirement and still yield the least amount of required capital.
Can Banks Circumvent Minimum Capital Requirements? The Case of Mortgage Portfolio under Basel II
The recent mortgage crisis has resulted in several bank failures. Under the current Basel I capital framework, banks are not required to hold a sufficient amount of capital to support the risk associated with their mortgage activities. The new Basel II capital rules are intended to be more risk based and would require the right amount of capital buffer to support bank risk. However, Basel II models could become too complex and too costly to implement, often resulting in a trade-off between complexity and model accuracy. Since the Basel II rules are meant to be principal based (rather than prescriptive), banks have the flexibility to build risk models that best fit their unique structure. We find that the variation of the model, particularly how mortgage portfolios are segmented, could have a significant impact on the default and loss estimated. This paper finds that the calculated Basel II capital varies considerably across the default prediction model and segmentation schemes, thus providing banks with an incentive to choose an approach that results in the least required capital for them. We find that a more granular segmentation model produces smaller required capital, regardless of the economic environment. Our results suggest that banks may have incentives to build risk models that meet the Basel II requirement and still yield the least amount of required capital.
Journal of Banking and Finance, 1994
The "market discipline" of off-balance sheet banking activities (OBSA) has been reexamined by employing contingent claims valuation techniques to derive implied asset variances from bank equity and deposit insurance, and from risk-premia for bank subordinated debt. Specifically implied asset variances have been calculated from contingent valuation models and have been regressed over on-balance accounting risk variables and off-balance sheet activities. These implied asset variances are better than equity variance or risk-premia in proxying total risk because they consider both the non-linear nature of contingent claims model and the impact of closure rules. Empirical results document the existence of "market discipline" of some OBSA. ~rarket participants price these OBSA as risk-reducing. Therefore, regulatory additional capital requirements of such OBS may be inappropriate.
Bank Debt Regulations: Implications for Bank Capital and Bond Risk
SSRN Electronic Journal, 2013
We study how optimal bank capital and bond risk are influenced by deposit insurance, implicit guarantees, depositor preference, asset encumbrance, and bail-in resolution frameworks. We find that these features of bank financing change the optimal amount of bank capital. The net effect on bond debt risk and valuation is small, while the effects on shareholder value and public sector liability value are significant. A gap between optimal capital and required capital represents a cost to shareholders and increases the risk of regulatory arbitrage. Based on a small sample of European banks, we find support for the central model predictions.
This manuscript presents a credit-risk-based model for measuring and managing the default risk in financial institutions. The structural model determines the minimum level of equity required to yield a maximum acceptable cumulative probability of default given a bank's existing liability structure. Our model is based on a modified version of the Geske (1977) structural compound option model. The model uses market information and integrates market discipline into managing default risk and estimating bank capital requirements. The model overcomes one of the major pitfalls of current risk-based capital requirements: the lack of inclusion of the firm's liability structure. The Geske model is particularly appealing for estimating default risk in financial institutions that have complex liability structures, as it builds in de-leveraging and endogenous default, thereby yielding more accurate estimates of default probability. The manuscript examines Lehman Brothers in the midst of the 2008 Financial Crisis, to demonstrate how the model might be used by regulators as a dynamic tool to measure default risk, assess bank solvency, and, in turn, to set appropriate credit-risk-based capital requirements.
Basel II and regulatory arbitrage. Evidence from financial crises
Journal of Empirical Finance, 2016
Banks use internal models to optimize risk weights and better account for the specific risk of each asset. As the choice of risk weights affects the regulatory capital ratio, economic theory suggests that banks with a higher cost of equity should be more aggressive in reducing risk weights. We consider a large panel of international banks and find that, after controlling for a number of bank and country characteristics and contrary to what happens for a non-Basel II bank, for a Basel II bank a higher cost of equity is not associated with a higher ratio between risk-weighted assets and total assets. These results are obtained in the context of state-of-the-art endogeneity-robust econometric procedures and across several specifications. We propose an indicator of risk weights saving and assess its impact on several performance measure during the 2008-2009 and the 2010-2012 crises. We find that for European banks not located in peripheral countries, a higher degree of RWA-saving is associated with more equity raising during the European crisis, more volatility, lower distance-to-default. European banks located in peripheral countries engaged less strongly in RWA-saving than European banks located in core countries, and its impact on the various performance measures is almost non-existent, except for a decrease in the distance-todefault.
Bank failure, risk, and capital regulation
Journal of Economics and Finance, 1996
This paper examines the effect of capital regulation on bank risk. It is shown that an increase in the capital-to-asset ratio reduces the riskiness of a bank's equity capital. Nevertheless, the probability of bank failure increases. The reason for this result is that the probability of bank failure depends upon both the risk and return of the asset portfolio. An increase in the capital requirement results in an optimal portfolio with a risk-return combination that has a higher probability of bank failure.