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Home > Regulation Best Practice > Capital Regulation After the Financial Crisis

Regulation Best Practice

Capital Regulation After the Financial Crisis

by Jens Hagendorff and Francesco Vallascas

This Chapter Covers

  • The scale and scope of the Basel III revisions of capital adequacy standards.

  • The benefits and costs of the higher capital requirements that will apply to banks under Basel III. We distinguish between benefits and costs realized by banks and the financial system as a whole.

  • The argument that the effect of Basel III on the costs of bank funding is likely to be less than is frequently suggested, because the reductions in bank leverage mandated under Basel III should lead to a reduction in the costs of bank equity compared with present levels.

  • How the lower bank leverage that will result from Basel III will alter the influence that shareholders and debt-holders have on risk-taking by banks. Although equity-holders under Basel III will be forced to have more “skin in the game” than previously and should be less prone to risk-taking than the shareholders of less-capitalized banks, it will be interesting to observe how the riskiness of banks changes as debt-holders, who are more risk-averse than equity-holders, play a diminished role in the capital structure of banks.

Introduction

The capital structure of banks differs in important aspects from that of nonfinancial firms. One such aspect is that bank managements need to comply with capital adequacy rules that impose minimum capital requirements. To justify regulatory interference in the capital structure of banks, financial economists point to an important moral hazard problem. The argument goes that, in the absence of regulatory capital requirements, bank shareholders will minimize capital holdings and increase risk-taking.

Such risk-taking behavior will be advantageous for bank shareholders as they seek to maximize the value of deposit insurance and other implicit or explicit government guarantees. At the heart of the problem of risk-taking by banks, therefore, lies the financial safety net (for instance, in the form of deposit insurance and “too-big-to-fail” guarantees) and the protection it affords to shareholders and other creditor groups.

Given this moral hazard problem, regulatory capital requirements are designed to force banks to maintain more capital and thus to absorb more losses linked to higher-risk portfolios (e.g. Sharpe, 1978; Furlong and Keeley, 1989; Calem and Rob, 1999). However, if capital regulation is to prevent banks from holding insufficient capital against their asset portfolios, it is essential that regulatory capital requirements are highly calibrated to the riskiness of a bank’s assets.

The financial crisis of 2007–09 has dented confidence in the effectiveness of international capital regulation. In particular, the sensitivity of capital requirements to bank risk has attracted criticism. It is now a widely accepted view that many banks entered the crisis with insufficient capital holdings, leading to widespread concerns over bank solvency and signs of panic in interbank funding markets during the crisis (Basel Committee, 2009 and 2010a; Hellwig, 2010). The widespread distress and numerous bank defaults which resulted from these solvency concerns illustrate the wholesale failure of capital regulation to ensure that capital requirements are linked to the riskiness of bank assets.

A case in point is provided by the International Monetary Fund (IMF). In a recent financial stability report, the IMF (2009) shows that banks in Europe and the United States that were in need of government assistance during the crisis were better capitalized (in terms of regulatory capital) than banks which were not in need of such help. The fact that better-capitalized banks were more (not less) likely to receive government support is hardly consistent with the view that capital regulations are “risk-based” in any meaningful way.

Doubts over the adequacy of capital regulations came after the Basel Committee on Banking Supervision (which has been charged with designing international capital rules) repeatedly revised the capital adequacy framework over the last two decades. However, despite numerous refinements and revisions of the Basel rules, the recent financial crisis has called for additional revisions to the regulatory framework. Although the latest Basel revisions, proposed by the Basel Committee at the end of 2010 and referred to as “Basel III,” maintain many of the key elements of the previous capital framework, they introduce stricter requirements that affect both the quality and quantity of bank capital.

In this chapter, we summarize the evolution of capital regulation in the banking industry before the eruption of the financial crisis of 2007–09. We then discuss the expected benefits and costs of Basel III. In our discussion we distinguish between the costs and benefits as realized by banks, the financial system, and likely changes in the ability of debt-holders and shareholders to affect bank risk-taking as a result of changes in the capital structure of banks which will result from Basel III.

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Further reading

Articles:

  • Berger, Allen N., Richard J. Herring, and Giorgia P. Szego. “The role of capital in financial institutions.” Journal of Banking and Finance 19:3–4 (June 1995): 393–430. Online at: dx.doi.org/10.1016/0378-4266(95)00002-X
  • Calem, Paul, and Rafael Rob. “The impact of capital-based regulation on bank risk-taking.” Journal of Financial Intermediation 8:4 (October 1999): 317–352. Online at: dx.doi.org/10.1006/jfin.1999.0276
  • Furlong, Frederick T., and Michael C. Keeley. “Capital regulation and bank risk-taking: A note.” Journal of Banking and Finance 13:6 (December 1989): 883–891. Online at: dx.doi.org/10.1016/0378-4266(89)90008-3
  • Hakenes, Hendrik, and Isabel Schnabel. “Bank size and risk-taking under Basel II.” Journal of Banking and Finance 35:6 (June 2011): 1436–1449. Online at: dx.doi.org/10.1016/j.jbankfin.2010.10.031
  • Jones, David. “Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues.” Journal of Banking and Finance 24:1–2 (2000): 35–58. Online at: dx.doi.org/10.1016/S0378-4266(99)00052-7.
  • Modigliani, Franco, and Merton H. Miller. “The cost of capital, corporation finance, and the theory of investment.” American Economic Review 48:3 (1958): 261–297. Online at: www.jstor.org/stable/1809766
  • Repullo, Rafael, and Javier Suarez. “Loan pricing under Basel capital requirements.” Journal of Financial Intermediation 13:4 (October 2004): 496–521. Online at: dx.doi.org/10.1016/j.jfi.2004.07.001
  • Santomero, Anthony, and Daesik Kim. “Risk in banking and capital regulation.” Journal of Finance 43:5 (1988): 1219–1233.
  • Santomero, Anthony M., and Michael Koehn. “Regulation of bank capital and portfolio risk.” Journal of Finance 35:5 (1980): 1235–1244.
  • Sharpe, William F. “Bank capital adequacy, deposit insurance and security values.” Journal of Financial and Quantitative Analysis 13:4 (November 1978): 701–718. Online at: dx.doi.org/10.2307/2330475

Reports:

  • Admati, Anat. R., Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer. “Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not expensive. “ Research paper 2065. Stanford Graduate School of Business, August 27, 2010. Updated March 23, 2011. Online at: tinyurl.com/6dcoutl [PDF].
  • Basel Committee on Banking Supervision. “International convergence of capital measurement and capital standards: A revised framework.” Bank for International Settlements, June 2006. Online at: www.bis.org/publ/bcbs128.htm
  • Basel Committee on Banking Supervision. “Strengthening the resilience of the banking sector.” Consultative document. Bank for International Settlements, December 2009. Online at: www.bis.org/publ/bcbs164.htm
  • Basel Committee on Banking Supervision. “Basel III: A global regulatory framework for more resilient banks and banking systems.” December 2010a. Online at: www.bis.org/publ/bcbs189.htm
  • Basel Committee on Banking Supervision. “Results of the comprehensive quantitative impact study.” Consultative document. Bank for International Settlements, December 2010b. Online at: www.bis.org/publ/bcbs186.htm
  • Basel Committee on Banking Supervision. “An assessment of the long-term economic impact of stronger capital and liquidity requirements.” Consultative document. Bank for International Settlements, August 2010c. Online at: www.bis.org/publ/bcbs173.htm
  • Basel Committee on Banking Supervision. “Global systemically important banks: Assessment methodology and the additional loss absorbency requirement.” Consultative document. Bank for International Settlements, July 2011. Online at: www.bis.org/publ/bcbs201.htm
  • Berrospide, J. M., and R. M. Edge. “Linkages between the financial and real sectors: Some lessons from the subprime crisis.” Working paper. Federal Reserve Board, 2008.
  • Hellwig, Martin. “Capital regulation after the crisis: Business as usual?” Working paper 2010/31. Max Planck Institute for Research on Collective Goods, 2010. Online at: www.coll.mpg.de/pdf_dat/2010_31online.pdf
  • International Monetary Fund. Global Financial Stability Report. April 2009. Online at: tinyurl.com/crs6d7 [PDF].
  • Kashyap, K., J. Stein, and S. Hanson. “An analysis of the impact of ‘substantially heightened’ capital requirements on large financial institutions.” Unpublished working paper, 2010.
  • Marcheggiano, Gilberto, David Miles, and Jing Yang. “Optimal bank capital.” Discussion paper 8333. Centre for Economic Policy Research, 2011. Online at: ssrn.com/abstract=1810296

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