Risk in Banking and Capital Regulation
TL;DR: In this paper, the role of bank capital regulation in risk control is investigated using the mean-variance model, and it is shown that the use of simple capital ratios in regulation is an ineffective means to bound the insolvency risk of banks.
Abstract: This paper investigates the role of bank capital regulation in risk control. It is known that banks choose portfolios of higher risk because of inefficiently priced deposit insurance. Bank capital regulation is a way to redress this bias toward risk. Utilizing the mean-variance model, the following results are shown: (a) the use of simple capital ratios in regulation is an ineffective means to bound the insolvency risk of banks; (b) as a solution to problems of the capital ratio regulation, the "theoretically correct" risk weights under the risk-based capital plan are explicitly derived; and (c) the "theoretically correct" risk weights are restrictions on asset composition, which alters the optimal portfolio choice of banking firms. THE RECENT INCREASE in bank failures, especially after the 1980 and 1982 Deregulatory Acts, has again ignited a controversy over the risk portfolio of the banking industry. Given the importance of this sector, there has been increased scrutiny of the industry's motives for risk taking and possible regulatory changes to improve its stability. These investigations have centered around two rather complementary areas. The first of these is the role of deposit insurance and how its current pricing procedure encourages risk taking and justifies current bank regulations. The works of Buser, Chen, and Kane [4], Kane [9], and Benston et al. [2] have made substantive contributions. The authors demonstrates the way in which our current fixed-rate insurance system rewards risk taking by the firm and insulates it through deposit insurance from the market discipline that needs to exist to ensure proper risk evaluation. This realization has led these authors to propose a series of regulatory changes to encourage proper portfolio choice within the industry. These include a shift to, market value accounting, risk-based deposit insurance premiums, and additional capital regulation. The last of these serves as a method of coinsurance whereby higher capital levels require the bank to absorb greater losses in the event of failure and encourage additional prudence in management. In essense it is one method of risk reduction that may offset the risk preference imposed on the industry due to the inappropriate insurance pricing. Because the amount of capital influences the probability of bank insolvency and thus the soundness of the entire banking system, the regulators, ceteris paribus, prefer more capital to
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TL;DR: In this paper, the authors conduct an empirical assessment of theories concerning risk taking by banks, their ownership structures, and national bank regulations, and show that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank.
1,965Â citations
TL;DR: In this paper, the authors assess two broad and competing theories of government regulation: the helping hand approach, according to which governments regulate to correct market failures, and the grabbing-hand approach according to where government regulates to support political constituency.
1,665Â citations
Book•
01 Jan 2005TL;DR: In this article, the authors present a review of bank regulation and its effect on bank performance and its role in the development of banks around the world, focusing on two approaches to bank regulation: public interest approach and private interest approach.
Abstract: 1. Introduction: 1.A Motivation 1.B Objectives and contributions 1.C Key findings: a brief synopsis 1.D Guide to the book 2. Contrasting approaches to bank regulation: 2.A Two approaches to bank regulation: 2.A.1 Public interest approach 2.A.2 Private interest view of regulation 2.B Bank regulation: how 2.C The Basel Committee and regulatory convergence 2.D Conclusion 3. How are banks regulated and supervised around the world?: 3.A Overview 3.B Structure, scope and independence of regulation and supervision 3.C What is a 'bank'? 3.D Entry into banking, capital requirements and supervisory powers 3.E Explicit deposit insurance schemes 3.F Private monitoring and external governance 3.G Does bank ownership type affect the choice of regulations and supervisory practices? 3.H Forces for greater harmonization of regulation and supervision among countries 4. What works best: 4.A Goals and boundaries 4.B Bank regulation and supervision and bank development 4.C Bank supervision, regulation, and stability 4.D Bank supervision, regulation, and bank efficiency 4.E Bank supervision, regulation, and bank lending 4.F Supervision, regulation, and bank governance 4.G Summary of results 5. Choosing bank regulations 5.A Recap and motivation 5.B Motivating example: Mexico and the United States 5.C Conceptual framework 5.D Empirical framework and data 5.E Summary remarks 6. Rethinking bank regulation: 6.A Approach and context 6.B Lessons and implications.
1,082Â citations
Posted Content•
TL;DR: In this paper, the authors assess two broad and competing theories of government regulation: the helping hand approach, according to which governments regulate to correct market failures, and the grabbing-hand approach according to where government regulates to support political constituency.
Abstract: The authors draw on their new database on bank regulation and supervision in 107 countries to assess different governmental approaches to bank regulation and supervision and evaluate the efficacy of different regulatory and supervisory policies. First, the authors assess two broad and competing theories of government regulation: the helping-hand approach, according to which governments regulate to correct market failures, and the grabbing-hand approach, according to which governments regulate to support political constituencies. Second, they assess the effect of an extensive array of regulatory and supervisory policies on the development and fragility of the banking sector. These policies include the following: Regulations on bank activities and the mixing of banking and commerce. Regulations on entry by domestic and foreign banks. Regulations on capital adequacy. Design features of deposit insurance systems. Supervisory power, independence, and resources; stringency of loan classification; provisioning standards; diversification guidelines; and powers to take prompt corrective action. Regulations governing information disclosure and fostering private sector monitoring of banks. Government ownership of banks. The results raise a cautionary flag with regard to reform strategies that place excessive reliance on a country's adherence to an extensive checklist of regulatory and supervisory practices that involve direct government oversight of and restrictions on banks. The findings, which are much more consistent with the grabbing-hand view of regulation than with the helping-hand view, suggest that the regulatory and supervisory practices most effective in promoting good performance and stability in the banking sector are those that force accurate information disclosure, empower private sector monitoring of banks, and foster incentives for private agents to exert corporate control.
853Â citations
Cites background from "Risk in Banking and Capital Regulat..."
...For instance, Kahane (1977), Koehn and Santomero (1980), Lam and Chen (1985), Kim and Santomero (1988), Flannery (1989), Genotte and Pyle (1991), Rochet (1992), Besanko and Katanas (1996), Blum (1999), Alexander and Baptista (2001) note that actual capital requirements may increase risk-taking…...
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...7 For bank development, we update Levine et al. (2000). The net interest margin and overhead cost v are from Beck et al....
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Posted Content•
TL;DR: In this paper, the role of capital in financial institutions is discussed and some possible unintended consequences of capital requirements are examined. But the authors focus on the problem of measuring the Modigliani-Miller (MM) risk exposure, which is difficult to measure and its measured value may be subject to manipulation by gains trading.
Abstract: This paper examines the role of capital in financial institutions. As the introductory article to a conference on the role of capital management in banking and insurance, it describes the authors' views of why capital is important, how market-generated capital requirements' differ from regulatory requirements and the form that regulatory requirements should take. It also examines the historical trends in bank capital, problems in measuring capital and some possible unintended consequences of capital requirements. According to the authors, the point of departure for all modern research on capital structure is the Modigliani-Miller (MM it is difficult to measure, and its measured value may be subject to manipulation by gains trading . The risk exposure in the denominator is also difficult to measure, corresponds only weakly to actual risk and may be subject to significant manipulation. These imprecisions worsen the social tradeoff between the externalities from bank failures and the quantity of bank intermediation. To keep bank risk to a tolerable level, capital standards must be higher on average than they otherwise would be if the capital ratios could be set more precisely, raising bank costs and reducing the amount of intermediation in the economy in the long run. Since actual capital standards are, at best, an approximation to the ideal, the authors argue that it should not be surprising that they may have had some unintended effects. They examine two unintended effects on bank portfolio risk or credit allocative inefficiencies. These two are the explosive growth of securitization and the so-called credit crunch by U.S. banks in the early 1990s. The authors show that capital requirements may give incentives for some banks to increase their risks of failure. Inaccuracies in setting capital requirements distort relative prices and may create allocative inefficiencies that divert financial resources from their most productive uses. During the 1980s, capital requirements may have created artificial incentives for banks to take off-balance sheet risk, and changes in capital requirements in the 1990s may have contributed to a credit crunch.
824Â citations
References
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TL;DR: In this article, a measure of risk aversion in the small, the risk premium or insurance premium for an arbitrary risk, and a natural concept of decreasing risk aversion are discussed and related to one another.
Abstract: This paper concerns utility functions for money. A measure of risk aversion in the small, the risk premium or insurance premium for an arbitrary risk, and a natural concept of decreasing risk aversion are discussed and related to one another. Risks are also considered as a proportion of total assets.
5,207Â citations
"Risk in Banking and Capital Regulat..." refers methods in this paper
...3 The risk preference is measured by the Pratt [15] relative risk aversion parameter F....
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2,107Â citations
TL;DR: In this article, the authors examine the effect of portfolio reaction to capital requirements by investigating the impact of capital ratio regulation on the portfolio behavior of commercial banks and conclude that the results of a higher required capital-asset ratio in terms of the average probability of failure are ambiguous, while the intra-industry dispersion of the probability for failure unambiguously increases.
Abstract: regulating bank capital, however, is a detailed consideration of the impact of such regulation on individual bank behavior and whether the regulation actually achieves its desired result.' Typically regulation is assumed to function in an essentially ceteris paribus environment, whereby the mere addition of capital to the bank's balance sheet reduces risk. The purpose of this paper is to examine explicitly the issue of portfolio reaction to capital requirements by investigating the effect of capital ratio regulation on the portfolio behavior of commercial banks.2 Implicit in the analysis is the view that bank regulators presently do not constrain portfolio risk so as to prevent such asset reshuffling. Given the lack of objective standards or guidelines on asset portfolio risk, this approach seems more appropriate than to assume no asset portfolio response. This paper examines the portfolio allocation that flows from the portfolio decision of the firm. Next it examines the effects on bank portfolio risk of a regulatory increase in the minimum capital asset ratio that is acceptable to the supervisory agency. For the system as a whole, the results of a higher required capital-asset ratio in terms of the average probability of failure are ambiguous,3 while the intra-industry dispersion of the probability of failure unambiguously increases. This result leads us to question the viability of regulating commercial banks in terms of a capital requirement. Thus, serious consideration should be given to the discontinuance of regulation of bank capital via ratio constraints. Alternatively, regulation should be imposed on both asset composition and capital in a way that has heretofore not been considered.
1,027Â citations
"Risk in Banking and Capital Regulat..." refers background or methods in this paper
..., Mingo and Wolkowitz [13], Kahane [8], and Koehn and Santomero [10]) has addressed only the problems of, without suggesting any solution to, the capital ratio regulation, one more specific goal of this paper is to derive the "theoretically correct" risk weights as a solution to those cited problems....
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...The model builds upon the portfolio approach utilized by Koehn and Santomero [10]....
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...9See Kahane [8] and Koehn and Santomero [10]....
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...As Koehn and Santomero [10] pointed out, it appears possible that regulatory efforts to control risk taking through capital ratio regulation may actually increase the probability of failure for some institutions....
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Book•
16 Aug 2011
TL;DR: It is shown that under certain conditions, the classic graphical technique for deriving the efficient portfolio frontier is incorrect and the most important implication derived from these characteristics, the separation theorem, is stated and proved in the context of a mutual fund theorem.
Abstract: The characteristics of the mean-variance, efficient portfolio frontier have been discussed at length in the literature. However, for more than three assets, the general approach has been to display qualitative results in terms of graphs. In this paper, the efficient portfolio frontiers are derived explicitly, and the characteristics claimed for these frontiers are verified. The most important implication derived from these characteristics, the separation theorem, is stated and proved in the context of a mutual fund theorem. It is shown that under certain conditions, the classic graphical technique for deriving the efficient portfolio frontier is incorrect.
904Â citations
Posted Content•
556Â citations
"Risk in Banking and Capital Regulat..." refers background in this paper
...Their general effect will be the shrinkage of the bank opportunity set (Levy [11], Blair and Heggestad [3])....
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