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