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Bank Capital Regulations: Learning the Right Lessons from the Crisis

Asli Demirgüç-Kunt's picture

The recent financial crisis demonstrated that existing capital regulations—in design, implementation, or some combination of the two—were completely inadequate to prevent a panic in the financial sector. Needless to say, policymakers and pundits have been making widespread calls to reform bank regulation and supervision. But how best to redesign capital standards? Before joining the calls for reform, it’s important to look at how financial institutions performed through the crisis to see if we’re learning the right lessons from the crisis. Is capital regulation justified? What type of capital should banks hold to ensure that they can better withstand periods of stress? Should a simple leverage ratio be introduced to reduce regulatory arbitrage and improve transparency? These are some of the questions addressed in a recent paper I wrote with Enrica Detragiache and Ouarda Merrouche.

 

Since the first Basel capital accord in 1988, the prevailing approach to bank regulation has put capital front and center: banks that hold more capital should be better able to absorb losses with their own resources, without becoming insolvent or necessitating a bailout with public funds. In addition, by forcing bank owners to have some “skin in the game,” minimum capital requirements help counterbalance incentives for excessive risk-taking created by limited liability and amplified by deposit insurance and bailout expectations. However, many of the banks that were rescued in the latest turmoil appeared to be in compliance with minimum capital requirements shortly before and even during the crisis. In the ensuing debate over how to strengthen regulation, capital continues to play an important role. A consensus is being forged around a new set of capital standards (Basel III), with the goal of making capital requirements more stringent.  

 

In my research with Enrica and Ouarda we investigate whether banks that were better capitalized experienced a smaller decline in their stock market value during the financial crisis. Specifically, we use a panel of quarterly bank data for 12 countries over 2006-2009 to study the impact of bank capital and its various definitions and components on changes in market valuation of banks. If bank capital truly helps in curbing banks’ incentives for risk-taking and ability to absorb losses, we would expect that when a large unexpected negative shock to bank value materializes—as was the case with the financial crisis that began in August 2007—equity market participants would judge better capitalized banks to be in a superior position to withstand the shock, and the stock price of these banks would fall less than that of poorly capitalized banks.

 

We also investigate which concept of capital was more relevant to stock valuation during the crisis. Existing capital requirements are set as a proportion of risk exposure; but if the risk exposure calculation under Basel rules did not reflect actual risk, capital measures based on cruder risk-exposure proxies such as total assets might have been considered as more meaningful by equity traders. 

 

Another issue is the quality of different types of capital used for regulatory purposes. As recognized by the Basel Committee (2009), under current standards some banks were able to demonstrate strong capitalization while holding a limited amount of tangible common equity, which is the component of capital that is available to absorb losses while the bank remains a going concern. So it is important to see whether banks with higher quality capital were really viewed more positively by equity market participants.

 

What do we find? Before the crisis, differences in initial capital—whether risk-adjusted or not, however defined—did not consistently affect subsequent bank stock returns. But during the crisis period, the importance of capital for returns became evident, particularly for the largest banks in our sample. These are the banks of systemic importance, as well as those holding capital of lesser quality at the inception of the crisis. Our results also show that during the crisis the stock returns of large banks were more sensitive to the leverage ratio than the risk-adjusted capital ratio. This suggests that market participants viewed the risk-adjustment under Basel rules as more subject to manipulation or, at the very least, not reflective of true risk in the case of large banks. Finally, we also find that the positive association with subsequent stock returns is stronger for higher quality capital (Tier 1 leverage and tangible common equity).

 

Our results have potential policy implications for the current process of regulatory reform. First, we find support for the view that a stronger capital position is an important asset during a systemic crisis, suggesting that the current emphasis on strengthening capital requirements is broadly appropriate. Second, our results indicate that the introduction of a minimum leverage ratio to supplement minimum risk-adjusted capital requirements is important, as properly measuring risk exposure is very difficult, especially for large and complex financial organizations. However, this finding also questions the usefulness of emphasizing risk-weighted concepts of bank capital, and these remain at the core of Basel regulations. Finally, our study indicates that greater emphasis on “higher-quality capital” in the form of Tier 1 capital or tangible equity is justified. 

 

Further Reading

 

Demirguc-Kunt, Asli, Enrica Detragiache and Ouarda Merrouche, “Bank Capital: Lessons from the Financial Crisis,” Nov 2010.

Comments

Submitted by Riccardo de Bruyn on
Your study offers new relevant evidences on the matter and can suggest further analysis how various banks reacted to the big crisis. However, the choice to consider only listed banks impeded to evaluate how co-operative banks, existing in many parts of the world and having a high relevance both in Europe and in Japan, have managed themselves along the last years. Co-operative banks' business model makes them better able in assessing small firms capacity to borrow, and for such a reason they ration out credit far less these enterprises during negative economic phases. I have well in mind the difficulties to gather data about banks non listed but I believe that an international organisation can afford this challenge, the more if the aim of such a study should be the exploration the link between bank behaviour and SMEs financial needs. So, I hope you will continue to treat the theme and add new highlights from the suggested point of view

Submitted by Johan Hendriks on
Dear Asli, As your research shows the quality of capital is indeed important for the survival of a bank in case of a shock in the system. However what I would like to stress is the quality of the assets and the risk associated to it would get more attention. In the extreme case a bank could have a great leverage position (lots of capital) but if all their assets are valued too high there is a serious risk of insolvency. What's your view on this?

Submitted by Asli on
Dear Johan, No doubt. But the point of the paper is that assesing those risks and adjusting capital can be very difficult, particularly for large and complex financial organizations. So if risk exposure calculations under Basel rules do not reflect actual risk, cruder capital measures may be considered relatively more meaningful because they are more difficult to manipulate. Asli

Submitted by Ayobami Babalola on
As mentioned in your study, particular attention to the quality of capital components is necessary as one of the requirements for weathering financial crisis like the one witnessed in 2007-2009. Of equal importance also is the need for banks to evolve a culture of risk management and control functions that involve a continuous evaluation of their perception of the riskiness of different assets in their books. What do you think?

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