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Can bank capital substitute for supervision and oversight?

Asli Demirgüç-Kunt's picture

Since its inception, bank capital regulation has been a topic of heated discussion and debate. At the international level, the Basel Committee on Banking Supervision (BCBS) has emerged as a global standard setter for regulation of banks. Starting with the first Basel accord in 1988, common capital targets were established to strengthen banks’ capital cushions and to ensure a level playing field at the international level.  These target capital ratios were designed to be the same across countries, without taking into consideration variations in local market conditions.

Although setting a capital standard to level the global playing field makes intuitive sense, the literature highlights significant differences across countries in terms of regulation and supervision of banks, safety net provided to the financial sector, and information availability and asymmetry in financial markets.  Do differences in bank supervision, regulation and information availability affect the relationship between capital and systemic risk in countries? Can capital substitute for weak institutional structures? What elements of the institutional environment matter most for the capital-systemic risk relationship? Can the Basel framework be tailored to local circumstances? These are some of the questions we address in a recent paper.

In our paper, we use an international sample of traded banks headquartered in 61 countries to study the relationship between systemic risk, bank capital and the local institutional environment. We compute two widely used systemic risk measures – conditional value at risk as described in Adrian and Brunnermeier (2016), and the marginal expected shortfall as described in Acharya et al. (2017) – and use three sets of institutional variables.

The first group of variables measure the strength of public and private monitoring in each country. In principle, bank capital should have a greater impact in countries where market discipline is weak and where regulators do not have the incentives or the power to take corrective actions to reduce systemic risk. The second and third sets of institutional variables capture information transparency in the banking sector and information asymmetries in the lending market. Capital provides a cushion against information shocks, thus the impact of bank capital should be less pronounced in markets with greater information availability and symmetry. Efficient private monitoring also depends on information availability and sharing, hence we would expect bank capital to have a greater impact when private monitoring is less efficient.

We find that the effect of capital on systemic risk varies significantly across countries.  In particular, the link between capital and systemic risk is weaker in countries with institutions that foster effective public and private monitoring of banks.  This finding suggests that capital can substitute for oversight in reducing systemic fragility. We also find that countries where transparency is limited and market participants face greater information asymmetry benefit more from higher bank capital.

Our findings have important policy implications. First, our results suggest that the impact of bank capital on systemic risk depends on a country’s institutional environment. This means that target capital ratios should also vary across countries according their local circumstances.  Current capital requirements that are imposed uniformly across countries based on a “one size fits all” approach may be inadequate in developing countries that lack proper institutions for effective public and private monitoring of banks.

Second, regulation and supervision of the banking sector can be prohibitively costly for smaller and less developed countries given the economies of scale in the provision of public-sector services.  Central banks for instance have taken on a more prominent role as lenders of last resort over the past few decades.  However, the ability of central banks to provide liquidity in times of distress is limited in developing countries.  Similarly, information generation and provision of ancillary financial services, such as credit ratings, tend to have high fixed costs.  These require a certain level of market development, which can be curtailed due to lack of scale and insufficient market depth.  For developing countries, our results suggest that higher capital requirements can prove to be a simpler and a cheaper way of reducing systemic risk.

Further Reading

Anginer, D., Demirgüç-Kunt, A., & Mare, D. S. (2018). Bank capital, institutional environment and systemic stability. Journal of Financial Stability, 37, 97–106.

 

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