Topic 9: Bank Regulation

Question 1

What are the Basel III regulations

Answer 1

CET1 ratio must be greater than 4.5% of RWAs
(common stock and retained earnings)
Tier 1 Capital = CET1 + AT1 which must be over 6% of RWAs
(AT1 includes preferred stock and CoCos)
Capital Conservation Buffer must be greater than 2.5% of RWAs
(consists of CET1 capital)
Tier 1 Capital must be greater than 3% of assets (non RWA)

Question 2

what is the rationale for capital requirements

Answer 2

moral hazard theory -> entrepreneur must hold enough equity to have incentives to work hard

Costly state verification -> equity should be large enough to render the debt info insensitive

under efficient theory of debt, sufficient equity should be issued

Question 3

how does CSV show risky asset requires more capital

Answer 3

debt on a riskier project is more info insensitive when face value is smaller, need more equity when project is riskier

Question 4

summary for rationale for capital requirements

Answer 4

short-term bank debt becomes riskless

risky short term debt hinders economic transactions (e.g. banknotes)

risky debt encourages moral hazard (risk shifting and debt overhang)

Question 5

why is public regulation often justified instead of private

Answer 5

often justified based on system wide externalities
failure by one bank = other banks become more likely to fail
liabilities to other banks not paid (counterparty risk)
fire sales - sales of assets by failed bank lowers prices - value of other banks’ assets declines
other banks perceived as weaker

failure by many banks damages payment system and flow of credit to real economy

Question 6

what are the costs of capital requirements (trade offs)

Answer 6

1. Smaller leverage - banks create less ST debt per unit of capital (costly if there is a special demand for short term bank debt e.g. bank deposits)
2. Trade-off for a bank that reduces deposits and raises capital by same amount (benefit: less likely to go bankrupt, less subject to runs) (costs: lower profits since deposits have low rates so cheaper financing than riskless rate, depositors reap some of the gains because deposits become less risky)
3. Trade off for society - Benefits: runs/bankruptcy become less likely and so do system wide externalities. Costs: fewer deposits are created

Question 7

How has bank capital changed over time

Answer 7

1840s - 55% equity to assets
declined sharply until 1940
roughly stable since then, slightly increasing
bank failures increased in 1980s

Question 8

explanations for how bank capital changed over time

Answer 8

decline of bank capital from mid 1800s to 1940 -> due to decline in perceived probability of bank runs due to clearing house lending arrangements, Fed establishment, deposit insurance establishment

increase in bank failures in 1980s -> increase in competition between banks because deposit rate caps were abolished and interstate banking was allowed. Increased competition = lower franchise value (PV of future profits) = more incentive to take risk = higher bank failures

Question 9

why were capital requirements less important in 1940-1980 and therefore less imposed

Answer 9

limited competition (due to other regulations) -> high franchise value -> weak incentive to take risk
few bank failures
limited enforcement of capital requirements until 80s

Question 10

why did cap requirements become more important since 1980s and therefore more imposed

Answer 10

increase in competition (financial liberalization) -> lower franchise value -> stronger incentives to take risk
stricter enforcement of capital requirements as a result (Basel I in 1988)

Question 11

rationale behind deposit insurance

Answer 11

avoid bank runs - runs of banks that depositors know are solvent can be avoided with lender of last insurance, yet depositors may not know whether bank is solvent so therefore deposit insurance also required for certainty for the depositors

Question 12

costs of deposit insurance

Answer 12

banks have weaker incentives to hold capital since runs become less likely

deposit insurance often framed as a trade off between moral hazard (hold less capital, take more risk) and the avoidance of runs

Question 13

why is capital requirement more important when there is deposit insurance

Answer 13

banks have weaker incentives to hold capital so therefore need regulation more

Question 14

what is the debate on size of capital requirements

Answer 14

arguments for high cap req -> holding more capital will not affect cost of capital for bank (ModMiller), make banks safer and reduce taxpayer money used to save them

arguments for low cap req -> cost of capital will increase since deposits are the cheapest financing and they will decrease, flow of credit to real economy will decrease

Question 15

differences between deposit insurance and lender of last resort

Answer 15

LLR -> central bank, lends to banks against collateral, avoids runs on banks that are known to be solvent only, does not require fiscal resources

DI -> done by a separate state agency, avoids runs on all banks, requires fiscal resources

However, losses incurred by central bank in its lender of last resort operations may require fiscal resources to recapitalize it -> threatens credibility of money and bank reserves (the main liabilities)

Question 16

why might prudential regulation lack credibility

Answer 16

if regulators lack funding then regulation lacks credibility -> regulatory forbearance (regulators may pretend that banks are well capitalized since disclosing the truth may trigger bank runs)

Question 17

example of macro prus - two options to maintain CET1 ratio and how do the two options differ

Answer 17

if 100 assets and CET1 = 5%, has 5 in capital
assume loss of 2, assets drop to 98 and capital to 3

bank has two options to meet capital requirement:
1. Raise additional capital of 2 (rights issue)
2. Sell assets so new assets are 3/5% = 60 therefore sell 38

second option can cause asset fire sale which can lower prices so other banks assets devalue so other banks may need to sell assets and so on (affects other banks)

Question 18

raise capital vs sell assets trade off

Answer 18

bank may prefer to sell assets because raising capital makes old shareholders worse off (debt overhang)

Society may prefer bank raises capital because avoids fire sales and externalities to other banks

Question 19

what are the six tools of macro prudential regulation

Answer 19

1. capital requirements are higher for larger banks and higher during booms
2. higher quality capital (common stock rather than preferred)
3. recapitalization specified in absolute terms tather than relative to assets
4. Contingent capital (CoCos)
5. Regulation of debt maturity (limit short term debt)
6. regulation of shadow banks

Question 20

Macro pru tool 1: capital requirements

Answer 20

banks do not internalize the system wide externalities that their undercap causes, so state internalizes them and imposes cap requirements

cap requirements are larger for larger banks because they generate more externalities (CET1 for large banks = extra 1-3.5%)

cap requirements should be larger during booms -> more leeway during busts as you can reduce them during recessions to avoid fire sales

Question 21

Macro pru tool 2: capital quality

Answer 21

Tier 1 capital consists of CET1 and AT1
CET1 - common stock and retained earnings
AT1 - additional securities with equity characteristics such as preferred stock

both capital types are junior to debt -> equally effective in rendering debt riskless

preferred stock makes it more difficult to issue new common equity during bad times as common stock junior to preferred, issuing new equity benefits old preferred shareholders and imposes larger losses on old common shareholders

Question 22

Macro pru tool 3: absolute vs relative capital

Answer 22

forcing banks to raise capital rather than selling assets during busts can benefit both society and the bank

society benefits - fire sales are avoided

bank benefit - asymmetric info eliminated because if they could choose between selling assets or raising capital, the market can interpret the bank’s decision to raise capital as a negative signal about the value of its assets, the problem disappears when bank if forced to raise capital

Question 23

Macro pru tool 4: contingent capital

Answer 23

instead of forcing the bank to raise capital, can hardwire that outcome into the capital structure
->bank issues debt securities that automatically convert to equity when capital falls below a pre specified threshold
-> contingent convertible debt (CoCos)

threshold can depend on market information e.g. debt yield or rating
->market info is complement to regulation
->only credible if threat of regulatory intervention is credible (intervene to make pricing of debt reflect the true risk of the debt so threshold hit if actually in trouble)

Question 24

Macro pru tool 5: regulate debt maturity

Answer 24

short term debt financing attractive for banks and for society (deposits)

yet, society may prefer banks to substitute some short-term debt for long-term debt since short term is hard to roll over during crises ->fire sales and externalities to other banks

Question 25

Macro pru tool 6: regulate shadow banks

Answer 25

shadow banks are FIGs financed by short term debt and are less regulated than banks e.g. hedge funds and investment banks

fire sales can originate from these institutions as well

arguments for regulating leverage, debt maturity etc apply as well

Question 26

Summary of topic 9

Answer 26

prudential regulation of banks - limit on banks leverage

rationale for prudential regulation - renders short term bank debt riskless

rationale for public prudential regulation - avoid system wide externalities arising from informational contagion and fire sales (banks dont internalize them, state can)

banks reluctant to limit their leverage

macro prudential regulation - New approach that accounts for system-wide
externalities more explicitly