Tuesday, November 13

How much capital should a bank keep?

I have been thinking about corporate performance, capital and corporate governance for some time now. These three are very tightly linked together. In almost every case of a bank getting into difficulties, it was because the firm had bad capital controls and bad capital management. And thus it leads to bad performance and the balance sheet looks like Swiss cheese.

More importantly, if you control the amount of capital you can have very tightly based upon the risk factor, then counter-intuitively, in times of market turmoil, you make the problem worse. For example, say based upon their internal risk measures, you have determined that the capital I need to keep aside is 10 quid. So far so good. But say the markets have dived like a dingo down its hole. Now the risk measures would be saying that I have to either get rid of positions or I have to increase my capital. In the case of the former, I will be exacerbating the market problem by increasing the selling pressure. In case of the latter, you will end up with no take-up of your capital increase (either by a rights issue or bond issue or what have you) (who wants to purchase in a selling market?).

Furthermore, as we have seen in the case of the Northern Rock (btw, did you know that we have spent more on this stupid incompetent fiasco of Northern Rock than the entire military budget of this year? our squaddies are dying because they do not have equipment and our taxpounds are going to save the collective patooties of the government, FSA and the central bank - makes me furious, I tell you!), corporate governance problems kicks in, who wants to purchase it? Hedge Funds? Private Equity? Other banks? What? So what do you do?

Well, here’s one answer: In other words, it is not sufficient to just meet Basel II requirements, but also to go ahead and have a buffer over and above it! But more importantly, certain economies which have a preponderance of bank lending compared to market lending (such as Germany or countries with less developed capital markets such as China and India) will be hit harder despite having buffer capital!. I quote the full conclusion as it is worthwhile reading it.

The problem of cyclicality of the Basel II minimum capital requirements is currently the subject of an intense discussion in the financial and supervisory community. This paper provides two important contributions to the debate. First, whereas previous research has largely focused on fluctuations in capital charges only, it finds that the behavior of capital buffers is crucial to assess the impact of capital requirements on bank lending. Second, it provides an analysis of macroeconomic consequences emphasizing the conceptual difference between the cyclicality of regulatory capital ratios and lending and their pro-cyclical effect on the real economy.

With regard to the cyclicality of lending I find that the capital buffers are likely to mitigate the impact of changes in capital charges. I find that by ignoring this effect one might substantially overestimate any potential lending volatility. At the same time, the capital buffer will only partially absorb the fluctuations in minimum capital (roughly by 50%). It is worth noting that the cyclical effects of regulatory capital on lending are not unique to Basel II, but that they are also present in the old framework with time invariant risk weights.

While pro-cyclical effects occur or are to be expected under the old and the new framework, the capital buffer is found to differ completely. Under the old framework this paper predicts an increase in the capital buffer during an economic downturn due to a reduction in lending (which is in line with previous empirical research). Under Basel II, however, the capital buffer will actually decrease, because the rise in the average risk weights will usually overcompensate the reduction in lending. I think that this finding has important implications for further empirical research on Basel II. In my view, it would be wrong to look at the movements of capital buffers under the old framework and assume a similar pattern under Basel II, as some previous papers seem to suggest.

As to macroeconomic fluctuations, the impact of Basel II on aggregate demand can be significant – even if banks hold significant capital buffers – in particular for economies where bank lending plays an important role in the firms’ investment decisions. However, the pro-cyclical effects on macroeconomic fluctuations will vary among countries. In general, bank-based economies will most probably experience the biggest effects, while the effects in financial markets-based economies will be smaller. The magnitude of any such pro-cyclical effect will depend on various factors, which are not specifically modelled in this paper, such as the firms’ access to outside capital for instance. Among other things, the average size of firms, the sectoral specialization of a particular economy, its accounting framework and the competitive condition in the banking industry play an important role in this regard.16

Finally, I need to mention some other qualifications of the model presented above. First, it assumes that the riskless interest rate remains constant over the business cycle. This assumption was made to separate the pro-cyclical effects of Basel from any potential counter-cyclical measures of the central bank. In the present context this means that the central bank needs to accommodate any income-induced changes in money demand in order to keep the interest rate fixed, and this has an additional effect on real demand. Further research is necessary to assess the interdependence of the prudential regulation of banks and monetary policy. Secondly, the model is not explicitly dynamic but makes interpretations that are dynamic in nature. However, augmenting the model with a dynamic specification is unlikely to change the basic results in principle unless one assumes very high portfolio adjustment costs on behalf of the bank.17 Deviating from the assumption of full flexibility in the portfolio adjustment – for example if assets are illiquid – it suffices to assume that a sufficiently large fraction of loans expires every year.

Frank Heid, The cyclical effects of the Basel II capital requirements, Journal of Banking & Finance, Volume 31, Issue 12, , December 2007, Pages 3885-3900.
Capital requirements play a key role in the supervision and regulation of banks. The Basel Committee on Banking Supervision is in the process of changing the current framework by introducing risk sensitive capital charges. Some fear that this will unduly increase the volatility of regulatory capital. Furthermore, by limiting the banks' ability to lend, capital requirements may exacerbate an economic downturn. The paper examines the problem of capital-induced lending cycles and their pro-cyclical effect on the macroeconomy in greater detail. It finds that the capital buffer that banks hold on top of the required minimum capital plays a crucial role in mitigating the impact of the volatility of capital requirements.

All this to be taken with a grain of piquant salt!!!

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