Topic 9: Bank Regulation Flashcards
What are the Basel III regulations
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)
what is the rationale for capital requirements
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
how does CSV show risky asset requires more capital
debt on a riskier project is more info insensitive when face value is smaller, need more equity when project is riskier
summary for rationale for capital requirements
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)
why is public regulation often justified instead of private
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
what are the costs of capital requirements (trade offs)
- 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)
- 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)
- Trade off for society - Benefits: runs/bankruptcy become less likely and so do system wide externalities. Costs: fewer deposits are created
How has bank capital changed over time
1840s - 55% equity to assets
declined sharply until 1940
roughly stable since then, slightly increasing
bank failures increased in 1980s
explanations for how bank capital changed over time
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
why were capital requirements less important in 1940-1980 and therefore less imposed
limited competition (due to other regulations) -> high franchise value -> weak incentive to take risk
few bank failures
limited enforcement of capital requirements until 80s
why did cap requirements become more important since 1980s and therefore more imposed
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)
rationale behind deposit insurance
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
costs of deposit insurance
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
why is capital requirement more important when there is deposit insurance
banks have weaker incentives to hold capital so therefore need regulation more
what is the debate on size of capital requirements
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
differences between deposit insurance and lender of last resort
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)
why might prudential regulation lack credibility
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)
example of macro prus - two options to maintain CET1 ratio and how do the two options differ
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)
raise capital vs sell assets trade off
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
what are the six tools of macro prudential regulation
- capital requirements are higher for larger banks and higher during booms
- higher quality capital (common stock rather than preferred)
- recapitalization specified in absolute terms tather than relative to assets
- Contingent capital (CoCos)
- Regulation of debt maturity (limit short term debt)
- regulation of shadow banks
Macro pru tool 1: capital requirements
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
Macro pru tool 2: capital quality
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
Macro pru tool 3: absolute vs relative capital
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
Macro pru tool 4: contingent capital
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)
Macro pru tool 5: regulate debt maturity
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
