Small bank, big bank concept.
Countries in Europe and Central Asia (ECA) were severely affected by the Global Financial Crisis (GFC). Although there were many fault lines that triggered the GFC, inadequate capitalization of banks to cover unexpected losses resulted in greater spillovers into the real economy, which made the financial crisis much more severe. In the aftermath of the GFC, several ECA countries have introduced legislation and regulatory reforms to strengthen capital requirements. These reforms include increasing regulatory capital requirements as well as changes in what constitutes the capital instruments of the highest quality (in terms of loss absorption).
In a recent policy paper, we analyze the evolution of bank capital and capital regulations in ECA using data from the most recent Bank Regulation and Supervision Survey (BRSS) conducted by the World Bank (Anginer et al. 2019). We show three important developments over the past decade.
First, 10 years after the crisis, banks in the ECA region are better capitalized, as measured by their regulatory capital ratios, calculated as regulatory capital divided by risk-weighted assets. Figure 1 shows changes in the regulatory capital ratios for subregions in ECA. Although there is variation across countries, overall there has been an increase in regulatory capital ratios, especially for larger banks. Excluding EU countries, on average in ECA, regulatory capital increased 5 percentage points between 2007 and 2017.
FIGURE 1. Regulatory Capital over RWA
Source: Anginer, Demirgüç-Kunt, and Mare 2020.
Note: EU = Western Europe, Southern Europe, and Northern Europe; CE & BC = Central Europe & Baltic countries; WB = Western Balkans; SC = South Caucasus; CA = Central Asia; EE = Eastern Europe; ROW = rest of the world; RWA = risk-weighted assets. We report means weighted by bank size.
Second, increases in simple leverage ratios, measured as common equity divided by total assets, have been more limited. Figure 2 shows changes in the simple leverage ratios for subregions in ECA. In general, by the end of 2017, smaller banks held more capital (as a percentage of total assets) than their larger counterparts did, except in Central Europe and the Baltic countries, Turkey, and Western Balkans. In the same vein, by the end of 2017, there appears to have been on average a wide gap between the leverage ratios of small banks and large banks, especially in the Russian Federation, Eastern Europe, and South Caucasus. Overall, simple leverage ratios increased 1.3 percentage points between 2007 and 2017, excluding ECA EU countries.
FIGURE 2. Capital over Total Assets
Source: Anginer, Demirgüç-Kunt, and Mare 2020.
Note: EU = Western Europe, Southern Europe, and Northern Europe; CE & BC = Central Europe & Baltic countries; WB = Western Balkans; SC = South Caucasus; CA = Central Asia; EE = Eastern Europe. We report means weighted by bank size.
Third, the increases in regulatory capital ratios coincided with a reduction in Tier 1 stringency and reduction in risk weights. The definition of the capital elements that constitute Tier 1 capital has become less stringent in the ECA region. Similarly, the ratio of risk-weighted assets to total assets has declined. Figure 3 shows the changes in an index that captures the stringency of the Tier 1 capital definition. Overall, in most of the ECA subregions, the definition of Tier 1 capital was less stringent in 2016 than in 2010, except for the Western Balkans, South Caucasus, and Russia.
FIGURE 3. Tier 1 Stringency Index
Source: Anginer, Demirgüç-Kunt, and Mare 2020.
Note: EU = Western Europe, Southern Europe, and Northern Europe; CE & BC = Central Europe & Baltic countries; WB = Western Balkans; SC = South Caucasus; CA = Central Asia; EE = Eastern Europe; ROW = rest of the world.
Since capital acts as a buffer against unforseen losses, the quality of capital is important in determining the solvency of a bank. Lower quality capital, that is, capital instruments other than common equity, can be significantly undervalued during times of distress, reducing their effectiveness in acting as a cushion against shocks. Risk exposures are also difficult to estimate, and current regulations provide substantial discretion to banks in determining risk weights. Thus, banks can manipulate the risk weights to fulfill regulatory requirements or concoct their capital positions.
In the paper, we also show that bank risk in ECA is more sensitive to changes in simple leverage ratios than it is to regulatory capital ratios. This is because the numerator only includes equity capital and the denominator is a measure of exposure that does not rely on risk weights.
Overall, there has been progress in the region in strengthening capital regulations. Whether regulatory capital proves to be adequate in the next crisis will depend on the accuracy of the risk weights in truly capturing forward-looking risk and on the loss-absorbing capacity of the lower quality capital that is now allowed in the computation of Tier 1 regulatory capital.
Cited references
Anginer, D., Bertay, A. C., Cull, R., Demirgüç-Kunt, A., & Mare, D. S. (2019). Bank Regulation and Supervision Ten Years after the Global Financial Crisis. Policy Research Working Paper 9044, World Bank, Washington, DC.
Anginer, D., Demirgüç-Kunt, A., & Mare, D. S. (2020). Bank Capital and Risk in Europe and Central Asia Ten Years After the Crisis. Policy Research Working Paper 9138, World Bank, Washington, DC.
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