Bank capital regulation

The third chapter of the (recently launched) Global Financial Development Report 2019/2020 focuses on bank capital regulation.

Since the global financial crisis (GFC) surprised the world a decade ago, many problems with the way bank capital was regulated became evident. In a few words, banks did not have enough high-quality capital nor incentives to sufficiently curb risk-taking. Regulation was so complex that even regulators struggled enforcing it. Since then, bank capital regulation has been revamped. Basel III is the most notorious example.

In the third chapter of the report, we begin with the basics of bank capital: What are its functions? Why and how is it regulated? We then take a deep dive in the literature to review what we know about its impact on access to finance and stability, and more recently, its role in the GFC. We also examine the regulatory responses and trends in the adoption of capital regulation that followed the GFC.

The main takeaways from the chapter are:

• Higher bank capital contributes to financial stability. When banks increase capital, they have a bigger cushion to absorb losses during distress. But also, more capital implies that shareholders have more skin in the game, incentivizing banks to improve screening and monitoring, curbing risk-taking.

• The effects of bank capital on lending are mixed. Evidence suggests that increasing bank capital requirements can lead banks to cut lending in the short-run but many questions remain unanswered, such as what the long-term effects of higher requirements would be.

• The Basel accords have helped standardize capital regulation across countries by establishing required minimum capital-to-assets ratios for banks. Basel I stipulates a simple risk-weighted capital ratio, where bank assets are classified into four groups and weighted by their risk. However, its simplicity in measuring risks led to regulatory arbitrage among more complex, bigger banks.

• Basel II aims to better align risk-taking of complex banks with their required regulatory capital, by introducing more complex capital ratios. This complexity made it more challenging for supervisors and investors to monitor financial institutions properly.

• When the GFC hit, the weaknesses of Basel II became clear: banks’ assets were riskier than their risk measurement suggested and their Tier 1 capital (the highest quality capital) wasn’t enough. In response, Basel III required banks to hold higher shares of common equity and Tier 1 capital.

• Proportionality. Basel III has been widely adopted in high-income member countries of the OECD. Developing countries are taking a more cautious approach, which seems appropriate since one set of regulations may not fit all countries. Rather than adopting overly complex capital requirement approaches, regulators in developing countries should focus on simpler capital ratios and give priority to building up supervisory capacity.

• Simple is better. Banks in high-income OECD countries are now holding more regulatory capital relative to their risk-weighted assets than before the GFC (Figure 1). However, this change appears to be driven by a decrease in risk-weighted assets relative to total assets (Figure 2). It is not clear whether banks are taking fewer risks or instead are adjusting their risk models. A simple capital ratio may thus be more reliable than a risk-weighted ratio. Although a simple leverage ratio can make it possible for banks to hold overly risky assets, it also avoids manipulation of risk weights and is relatively transparent and verifiable.

• Quality matters. Data also reveal an increase in Tier 1 capital, but as regulators have relaxed the rules of what qualifies as Tier 1 capital, not all the increase may be high-quality common equity. It is thus important to carefully monitor exactly what banks are holding as part of Tier 1.

• Implementation of Basel III seems to have reduced lending, at least in the short run, in adopter countries as well as cross-border lending from high-income OECD banks in developing countries. The effects on lending may be mitigated by allowing banks to increase capital with contingent convertible bonds, but experience with these instruments remains limited. It is not clear how well they will perform in practice, and they are not an option for countries without developed capital markets.

• Greater transparency, information disclosure, and monitoring are needed to ensure that banks are not tempted to circumvent regulation. More information about the types of instruments that banks hold and how they are meeting their Tier 1 requirements would be useful.

All in all, although on the surface it looks as though banks may now be holding more equity and safer assets than before the GFC, the numbers may provide a false sense of security. The reason being that we don’t have information on the types of assets that banks have, making it difficult to know why their risk-weighted assets relative to total assets have fallen over time.