Maintaining Adequate Bank Capital: An Empirical Analysis of the - PowerPoint PPT Presentation

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 -measured equity ratios  Bank’s capital ratio should correspond to a default probability < 0.1% for a one-year horizon  A large bank operating with inadequate capital is extracting value from a conjectural government guarantee  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)). 10/8/2014 Emanuela Giacomini 2

Basel Standards for “Adequate Capital”  Even banks with very high capital ratios encountered funding difficulties during the financial crisis Lloyds Banking Group Tier 1 capital ratio Royal Bank of Scotland was 6.55% - 10% Dexia’s UBS 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 10/8/2014 Emanuela Giacomini 3

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) 10/8/2014 Emanuela Giacomini 4

Are Basel ratios Flawed? 9,00% 350 8,00% 300 7,00% 250 6,00% 200 5,00% 4,00% 150 3,00% 100 2,00% 50 1,00% 0,00% 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Mean BVE/TA Mean MVE/TA Mean CDS 5 Yrs 10/8/2014 Emanuela Giacomini 5

Regulatory skepticism about market valuations  Banks’ assets are opaque, so market valuation of bank claims are often wrong, noisy and manipulated 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 Even if market has it wrong, market assessments drive largest institution’s solvency because they determine rollover. 10/8/2014 Emanuela Giacomini 6

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). Market Value of Assets Market Value of Equity Equity return volatility Assets return volatility 10/8/2014 Emanuela Giacomini 7

One Year PDs Top European “Solvent” Banks, 1997 -2011 PDs have been persistently high 60,00% at Europe’s largest banks (even in good times!) 50,00% 40,00% 30,00% 20,00% 10,00% 0,00% Median PD Mean PD Max PD Supervisory Discretion (Pillar 2) has not maintained adequate loss-absorbency 10/8/2014 Emanuela Giacomini 8

Consecutive PDs >x% Top European “Solvent” Banks, 1997 -2011 Repeated Forbearance by supervisors 8 PD > 0.1% 7 PD > 0.5% Number of banks (out of 38) 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 or more Largest Number of CONSECUTIVE instances 10/8/2014 Emanuela Giacomini 9

Value of Historical Guarantees  Government guarantee value as a percentage of historical equity market value over 15 years 10/8/2014 Emanuela Giacomini 10

Simulating a “Timely Recapitalization” Policy  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 10/8/2014 Emanuela Giacomini 11

Timely Recap Simulated Policy  Value of Conjectured Guarantees as % of MVEQ over 15 years “Timely Recapitalization” Policy Historical Capitalizations Recap to PD= 0.1% Recap to PD= 0.5% 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% 70.67% 25.07% 11.85% 0.27% 16.04% 0.60% 2007 - 2011 Aggressive capital measures could have mitigated the crisis, but not eliminated it 10/8/2014 Emanuela Giacomini 12

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 10/8/2014 Emanuela Giacomini 13

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) 10/8/2014 Emanuela Giacomini 14

Why hasn’t supervisory discretion worked to maintain adequate capital?  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 10/8/2014 Emanuela Giacomini 15

10/8/2014 Emanuela Giacomini 16