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Sep 05, 2022 346 likes •516 views

Maintaining Adequate Bank Capital: An Empirical Analysis of the Supervision of European Banks Mark J. Flannery and Emanuela Giacomini Basel Standards for Adequate Capital Adequate Capital Higher portfolio risk requires more book

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SLIDE 1

Maintaining Adequate Bank Capital:

An Empirical Analysis of the Supervision

  • f European Banks

Mark J. Flannery and Emanuela Giacomini

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SLIDE 2

Basel Standards for “Adequate Capital”

Emanuela Giacomini

  • Adequate Capital
  • Higher portfolio risk requires more book-measured equity ratios
  • Bank’s capital ratio should correspond to a default probability < 0.1% for a
  • ne-year horizon
  • A large bank operating with inadequate capital is extracting value from a

conjectural government guarantee

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  • Maintaining Adequate Capital
  • Pillar 2 requires national supervisors...

“to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored” (BCBS (2006), page 212).”

  • Among the “range of actions” supervisors should consider is “requiring

banks to raise additional capital immediately” (BCBS (2006, page 212)).

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SLIDE 3

Basel Standards for “Adequate Capital”

  • Even banks with very high capital ratios encountered funding

difficulties during the financial crisis

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How could a system that defined and monitored bank capital positions so carefully, have permitted such catastrophic losses? Protection requires sufficient market-valued or economic capital

Lloyds Banking Group Royal Bank of Scotland Dexia’s UBS

Tier 1 capital ratio was 6.55% - 10%

Emanuela Giacomini 10/8/2014

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SLIDE 4

Are Basel Ratios Flawed?

  • Large banks’ survival
  • Maturity and liquidity transformation make banks “fragile”
  • Uninsured short-term liabilities are widely used among large banks
  • Short term depositors measure bank’s solvency in terms of equity market

value

  • Book values do not reliably measure ability to absorb losses
  • Substantially backward-looking
  • Distorted by managerial options (choice)
  • “capital does not appear to be a very effective regulatory weapon (Herring

(2010,p. 272))

  • Distortions are greatest when a capital ratios approach mandated minima
  • Regulators allows large banks more discretion over asset valuation as part of

regulatory forbearance of banks that are considered too big to fail (Huizinga and Laeven, 2012)

4 Emanuela Giacomini 10/8/2014

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SLIDE 5

Are Basel ratios Flawed?

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50 100 150 200 250 300 350 0,00% 1,00% 2,00% 3,00% 4,00% 5,00% 6,00% 7,00% 8,00% 9,00%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Mean BVE/TA Mean MVE/TA Mean CDS 5 Yrs

Emanuela Giacomini 10/8/2014

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SLIDE 6

Regulatory skepticism about market valuations

  • Banks’ assets are opaque, so market valuation of bank claims are
  • ften wrong, noisy and manipulated

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Even if market has it wrong, market assessments drive largest institution’s solvency because they determine rollover. Book values are also noisy and manipulated. Moreover, they are more biased as the firm’s true conditions get worse Market values are forward-looking and reflect current information about asset values

Emanuela Giacomini 10/8/2014

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SLIDE 7

Empirical Analysis

  • Sample of 25 largest European banks at each year-end, 1997-2011
  • Total of 38 institutions and 375 year-bank observations
  • Probability of default
  • Bank is insolvent if the market value of assets falls below the face value of

book liabilities

  • We infer the market value of assets and assets’ return volatility from bank

equity market value, equity return volatility and nominal liabilities (Ronn and Verma, 1986).

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Market Value of Equity Equity return volatility Market Value of Assets Assets return volatility

Emanuela Giacomini 10/8/2014

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SLIDE 8

One Year PDs Top European “Solvent” Banks, 1997-2011

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0,00% 10,00% 20,00% 30,00% 40,00% 50,00% 60,00% Median PD Mean PD Max PD

PDs have been persistently high at Europe’s largest banks (even in good times!)

Supervisory Discretion (Pillar 2) has not maintained adequate loss-absorbency

Emanuela Giacomini 10/8/2014

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SLIDE 9

Consecutive PDs >x% Top European “Solvent” Banks, 1997-2011

9 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 9 10 or more

Number of banks (out of 38)

Largest Number of CONSECUTIVE instances PD > 0.1% PD > 0.5%

Repeated Forbearance by supervisors

Emanuela Giacomini 10/8/2014

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SLIDE 10

Value of Historical Guarantees

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  • Government guarantee value as a percentage of historical equity

market value over 15 years

Emanuela Giacomini 10/8/2014

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SLIDE 11

Simulating a “Timely Recapitalization” Policy

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  • Would more aggressive supervision have made much difference?
  • Simulating a policy of “Prompt Re-Capitalization”
  • At each yearend
  • If PD > 0.1% add enough capital
  • If PD ≤ 0.1% repurchase simulated prior issues
  • Government must absorb the shortfall of asset below liabilities,

after which the bank can issue new shares to the public

Emanuela Giacomini 10/8/2014

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SLIDE 12

Timely Recap Simulated Policy

Aggressive capital measures could have mitigated the crisis, but not eliminated it

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  • Value of Conjectured Guarantees as % of MVEQ over 15 years

Mean Median Mean Median Mean Median 1997 - 2011 28.49% 1.25% 6.23% 0.01% 7.78% 0.03% 1997 - 2006 7.40% 0.31% 3.44% 0.00% 3.68% 0.01% 2007 - 2011 70.67% 25.07% 11.85% 0.27% 16.04% 0.60% Recap to PD= 0.1% Historical Capitalizations “Timely Recapitalization” Policy Recap to PD= 0.5%

Emanuela Giacomini 10/8/2014

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SLIDE 13

Recent Regulatory Innovations

  • More and better capital requirements in Basel III
  • Accounting will have to stretch more to distort enough
  • But it doesn’t address the discretion problem, instead “adequacy” depends

upon time dimension

  • Social costs? Banks’ weighted average cost of capital could rise and credit

become more expensive (perhaps curtailing real economic activity).

  • Bail-in bonds
  • conversion trigger is at the discretion of the regulator at the point of non-

viability

  • Regulatory procedures continue to rely heavily on discretion

13 Emanuela Giacomini 10/8/2014

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SLIDE 14

Final Conclusion

  • Basel capital framework based on book values and supervisory

discretion apparently failed to maintain adequate capital

  • Effective capital regulation requires at least some focus on market

equity valuations;

  • Regulatory reform continues reliance on supervisory discretion but

bank solvency should be assured by replacing discretion with “rules”

  • Supervisory forbearance can be restrained by restoring adequate

capital more quickly (maybe with continent capital)

14 Emanuela Giacomini 10/8/2014

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SLIDE 15
  • Forcing a bank to issue new shares imposes losses on identifiable

investors and managers.

  • So supervisors want to feel very confident
  • Noisy estimate of true loss absorbing capacity
  • opaque assets and asset values become even more uncertain

when markets are in disarray

  • Solvency and loss-absorption are expressed in terms of accounting

measures

  • challenging the firms’ audited financial statements

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Why hasn’t supervisory discretion worked to maintain adequate capital?

Emanuela Giacomini 10/8/2014

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SLIDE 16

16 Emanuela Giacomini 10/8/2014