https://www.bis.org/bcbs/events/wkshop0303/p10nierbaum.pdf

Market discipline, disclosure and moral hazard in banking

Market discipline for financial institutions can be imposed not only from the liability side, as has often been stressed in the literature on the use of subordinated debt, but also from the asset side. This will be particularly true if good lending opportunities are in short supply, so that banks have to compete for projects. In such a setting, borrowers may demand that banks commit to monitoring by requiring that they use some of their own capital in lending, thus creating an asset market-based incentive for banks to hold capital. Borrowers can also provide banks with incentives to monitor by allowing them to reap some of the benefits from the loans, which accrue only if the loans are in fact paid off. Since borrowers do not fully internalize the cost of raising capital to the banks, the level of capital demanded by market participants may be above the one chosen by a regulator, even when capital is a relatively costly source of funds. This implies that capital requirements may not be binding, as recent evidence seems to indicate.

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Credit Market Competition and Capital Regulation

This study investigates the pricing behaviour of firms in the euro area on the basis of surveys conducted by nine Eurosystem national central banks, covering more than 11,000 firms. The results, robust across countries, show that firms operate in monopolistically competitive markets, where prices are mostly set following markup rules and where price discrimination is common. Around one-third of firms follow mainly time-dependent pricing rules while two-thirds allow for elements of state-dependence. The majority of firms take into account past and expected economic developments in their pricing decisions. Price stickiness is mainly driven by customer relationships - explicit and implicit contracts - and coordination failure. Firms adjust prices asymmetrically in response to shocks: while cost shocks have a greater impact when prices have to be raised than when they have to be reduced, reductions in demand are more likely to induce a price change than increases in demand.

/pdf/the-pricing-behaviour-of-firms-in-the-euro-area-new-survey-2m9vea5u4p.pdf

The Pricing Behaviour of Firms in the Euro Area: New Survey Evidence

The regulation of bank capital as a means of smoothing the credit cycle is a central element of forthcoming macro-prudential regimes internationally. For such regulation to be effective in controlling the aggregate supply of credit it must be the case that: (i) changes in capital requirements affect loan supply by regulated banks, and (ii) unregulated substitute sources of credit are unable to offset changes in credit supply by affected banks. This paper examines micro evidence—lacking to date—on both questions, using a unique data set. In the UK, regulators have imposed time-varying, bank-specific minimum capital requirements since Basel I. It is found that regulated banks (UK-owned banks and resident foreign subsidiaries) reduce lending in response to tighter capital requirements. But unregulated banks (resident foreign branches) increase lending in response to tighter capital requirements on a relevant reference group of regulated banks. This “leakage” is substantial, amounting to about one-third of the initial impulse from the regulatory change.

Does Macro-Prudential Regulation Leak? Evidence from a UK Policy Experiment

This paper documents patterns of price setting at the retail level in the euro area, summarized in six stylized facts. First, the average euro area monthly frequency of price adjustment is 15 p.c., compared to about 25 p.c. in the US. Second, the frequency of price changes is characterized by substantial cross product heterogeneity - prices of oil and unprocessed food products change very often, while price adjustments are less frequent for processed food, non energy industrial goods and services. Third, cross country heterogeneity exists but is less pronounced. Fourth, price decreases are not uncommon. Fifth, price increases and decreases are sizeable compared to aggregate and sectoral inflation rates. Sixth, price changes are not highly synchronized across retailers. Moreover, the frequency of price changes in the euro area is related to several factors, such as seasonality, outlet type, indirect taxation, pricing practices as well as aggregate or product specific inflation.

Price setting in the euro area: Some stylized facts from Individual Consumer Price Data. NBB Working Paper Nr.74, September 2005

In this paper we review hypotheses about how decisions on capital are taken and how they affect the ‘buffer’ between actual capital and the regulatory requirement. The hypotheses come from the literature and from discussion with policy makers, supervisors and practitioners. We argue that the amount of capital held by banks and building societies depends on risk management, market discipline and regulatory environment. Using both quantitative and qualitative approaches, we provide evidence on which hypotheses hold in the UK. We find that regulatory requirements affect the amount of capital held by banks and by building societies.

What determines how much capital is held by UK banks and building societies

The UK?s Financial Services Authority sets individual capital requirements that reflect its assessment of risks and that are greater than the 8% minimum required by Basel. This approach is similar to the supervisory review in Pillar II proposed in the new Basel Accord. Using regulatory returns for UK banks and building societies, we empirically assess how changing a firm?s individual capital requirement affects its capital ratio. We find that banks faced with an increase in capital requirements transfer nearly 50% of the increase into changes in their capital holdings, but only 20% if they face a reduction. The results are different for building societies, where about 20% of either an increase or a decrease in capital requirements is transferred into capital ratios.

/pdf/how-individual-capital-requirements-affect-capital-ratios-in-31a4xywc02.pdf

How individual capital requirements affect capital ratios in UK banks and building societies

The proposed contents of the planned Financial Services and Markets Act have been revealed in the draft bill (FSMB) that was introduced into Parliament on 17 June, 1999 and in various announcements by the government. On that basis, the Act is expected to require the Financial Services Authority (FSA) to have regard, in discharging its functions, to the economic impacts of the provisions it makes and to publish a cost‐benefit analysis (CBA) of proposed rules and general guidance with respect to the operation of rules. This paper describes the technical and organisational measures that the FSA is taking in order to fulfil the FSMB's requirements for CBA and considers the rationale for those requirements. The paper suggests that the case for undertaking cost‐benefit analysis rests on the dangers of interfering in markets without analysing the likely consequences in a rigorous and theoretically sound manner. The paper also reviews the (so far limited) experience of applying cost‐benefit analysis to financial regulation in the UK and suggests how difficulties in the assessment of the costs and benefits can be addressed, with a consequent increase in the value of financial regulation.

Cost‐benefit analysis in financial regulation: How to do it and how it adds value

The UK's Financial Services Authority sets individual capital requirements that reflect its assessment of risks and that are greater than the 8% minimum required by Basel. This approach is similar to the supervisory review in Pillar II proposed in the new Basel Accord. Using regulatory returns for UK banks and building societies, we empirically assess how changing a firm's individual capital requirement affects its capital ratio. We find that banks faced with an increase in capital requirements transfer nearly 50% of the increase into changes in their capital holdings, but only 20% if they face a reduction. The results are different for building societies, where about 20% of either an increase or a decrease in capital requirements is transferred into capital ratios.

The increasing use of cost‐benefit analysis (CBA) in financial regulation is bringing a sharper focus on the benefits conferred by regulation. This paper addresses the impact of that sharper focus on the compliance culture of regulated firms. Why focus on the benefits of regulation? What does CBA have to offer to the compliance culture of authorised firms? How does the introduction of CBA fit in with other developments in the regulatory arena? This paper offers some tentative answers to these questions.

Isaac Alfon

Papers

What determines how much capital is held by UK banks and building societies

How individual capital requirements affect capital ratios in UK banks and building societies

Cost‐benefit analysis in financial regulation: How to do it and how it adds value

How individual capital requirements affect capital ratios in UK banks and building societies

Cost‐benefit analysis and compliance culture