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1 Master’s Thesis Author: Michal Zajicek Academic Supervisor: Anders Grosen MSc Finance & International Business Department of Business Studies Assessment of Basel III capital requirements and their impact on financial sector in Slovakia Aarhus School of Business, Aarhus University 2011

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Master’s Thesis Author: Michal Zajicek

Academic Supervisor: Anders Grosen

MSc Finance & International Business

Department of Business Studies

Assessment of Basel III capital requirements and their impact on

financial sector in Slovakia

Aarhus School of Business, Aarhus University

2011

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Acknowledgements

To Anders Grosen

And to Jana Taskova

Michal Zajicek

August, 2011

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ABSTRACT

The purpose of this paper is to investigate the potential impact of increased capital requirements

on lending spreads charged by banks in the Slovak financial sector. The results yield a 17bp

increase in lending spread for a 1 pp increase in capital ratio. Given the characteristics of the

Slovak financial environment, it has capacity to absorb this increase given the transition period

is long enough.

KEYWORDS: BASEL II, BASEL III, Capital requirements, lending, bank, information

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Introduction

The aim of this paper is to illustrate the need for regulation in the financial industry,

show the significance of the new Basel III capital requirements in terms of increased

quality and quantity of regulatory capital and to illustrate the impact of Basel III capital

requirements on the banks in Slovakia.

Relevance of the subject area

The importance of banks in economy and in financial system is demonstrated by how

savings of the surplus units are channeled into productive activities of the deficit units.

This shows a clear effect on the economic activity and growth.1 In the theory of the

transmission channels of monetary policy, bank lending channel shows how the role of

bank credit can augment monetary policy actions, depending on the relative importance

of credit supplied by banks to economy. Part of the bank lending channel is related to

banks‘ capital positions and their influence on availability of credit. The banks’capital

positions are then subject to minimum regulatory requirements and credit-ratings based

target ratios.2 This provides a link how capital requirements can influence the amount of

credit in the economy and subsequently the growth of GDP.The central role of banks in

economy was also nicely demonstrated by the recent financial and economic crisis,

where interlinkages among banks themselves and between banks and financial markets

became very clear.3

1 Allen, Franklin & Carletti, Elena. (2010). Chapter 2: The roles of banks in financial systems. In: Berger, Allen N.; Molyneux, Philip; & Wilson, John O. S.: The Oxford Handbook of Banking, pp. 37-57. Oxford: Oxford University Press

2 European Central Bank (2008b), "The role of banks in the monetary policytransmission mechanism", Monthly Bulletin, August

3 Shyamala Gopinath: Centrality of banks in the financial system

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The dynamics of the recent crisis highlighted the areas of financial system that need to

be revised and require an improvement in their design.4 The centrality of banks in the

recent financial and economic crisis demonstrated the need for more efficient regulation

of banking industry. Based on the continuing work in the field of financial system

regulation and as a response to the crisis, Basel Committee on Banking Supervision

(BCBS) issued a number of documents proposing the establishment of a new regulatory

capital and liquidity regime. The Committee’s package of reforms was fully endorsed

by the Group of Governors and Heads of Supervision, the oversight body of BCBS, at

its September 2010 meeting. As noted by top representatives from the supervisory

environment, the package of reforms will mean a fundamental strenghtening of global

capital standards.5

A wide range of criticism of the currently-in-effect regulatory framework of Basel II

standards has arrised to argue about its weaknesses and their potential causal and

augmenting effect during the years of recent crisis. Basel III regulatory initiative is

a further attempt to narrow the gap that provides room for banks’missbehavior and

makes the financial system fragile. Basel III is aiming to eliminate the opportunities for

missbehavior that occured during the crisis.

Purpose of the project

While the rationale for regulating the banking industry has quite solid theoretical logic,

there are many studies that provide evidence of empirical inconsistencies on the

efficiency of bank regulation as well as works that propose alternative design of

Inaugural address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India, at the 12th Fixed Income Money Market and Derivatives Association-Primary Dealers Association of India (FIMMDA-PDAI) Annual Conference, Udaipur, 8 January 2011.

4 BCBS (October 2010); The Basel Committee’s response to the financial crisis: report to the G20

5 The Basel Committee on Banking Supervision is a committee of banking supervisory authorities which was established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. It usually meets at the Bank for International Settlements (BIS) in Basel, Switzerland, where its permanent Secretariat is located.

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regulation or its complete elimination.6 It is not the aim of this paper to assess the idea

of regulation from fundamental point of view, nor to criticise or propose alternative

design of regulation. Rather this paper aims at assessing the proposed Basel III

measures from the grounds of widely accepted regulatory logic currently in practice.

The aim is to show how Basel III capital requirements fit in the current regulatory

framework and how these measures will strenghten the current regime of regulation.

The banking industry, regulatory environment, and consultancy firms, among others,

have so far produced a number of studies for assessing the potential impact of the new

Basel III increased requirements. 7 These impact studies provide an overview of the

potential benefits and costs of Basel III as well as estimates of their quantification. The

benefits are stemming mainly from reduction in the costs associated with banking

crises. Another source of benefit of increased resilience of banks is its potential to

decrease the volatility of output. On the other hand, the source of costs is represented

by increased price of financial intermediation in the form of higher lending spreads

banks will require to maintain their profitability. Assuming that the costs associated

with being required to hold higher portions of equity capital will be passed through by

banks directly on their customers (borrowers). This would then potentially lead to

a decrease in availability of credit and would eventually translate into slower output

growth.

This is the widely accepted point of view for assessing the benefits and costs of

introducing increased capital requirements. While it is expected, that the reactions of

banks to recover the increased cost of funding outlined in the papers assessing the

impact are likely to occur, there might be a misconception about the grounds this kind

6 See for example: Levine, Ross; (2005); Bank Regulation and Supervision; in NBER Reporter: Research Summary Fall 2005; available at: http://www.nber.org/reporter/fall05/levine.html#N_*_; and Dowd, Kevin; (1996): The Case for Financial Laissez-Faire; The Economic Journal Vol. 106, No. 436, pp. 679-687 7 For example: BCBS (2010) “An assessment of the long-term economic impact of stronger capital and liquidity requirements.” (August). Macroeconomic Assessment Group (2010) “Interim Report – Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements.” (August). Institute of International Finance (2010): Interim Report on the Cumulative Impact of Proposed Changes in the Banking Regulatory Framework. Härle, Heuser, Pfetsch, Poppensieker (2010): Basel III-What the draft proposals might mean for European banking; in: Banking & Securities; McKinsey & Company; available at: http://ec.europa.eu/internal_market/bank/docs/gebi/mckinsey_en.pdf

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of understanding is based on, as suggested by Admati, et al. (2010)8. This paper will

provide theoretical arguments for this possible missconception.

In this paper, the arguments for how costly the Basel III implementation may be, will be

assessed from a theoretical ground, focusing especially on the costliness of bank capital.

Also I will make an attempt to demonstrate the soundess of the increased quality and

quantity of capital to provide an argument for the benefits of Basel III requirements.

Since the Basel III framework will be also implemented into legislature in Slovakia, to

conclude the whole assessment, I will illustrate the position, or readiness of banks

operating in Slovakia facing the implementation of Basel III. The assessment part will

serve two purposes – to illustrate the distance between current and proposed levels of

capital of banks in Slovakia and to discuss the methodology used to quantify the impact

of incresed capital requirements in light of the theoretical foundation provided in

preceding parts of the paper.

Problem formulation and methodology

This paper aims at assessing the following questions:

1. Is the argument that equity is costly relevant?

2. Is the claim that Basel III means a significant improvement in strenghtening the

resilience of banks justified?

3. What is the nature of results the methodology used for mapping increased

capital requirements into lending spreads will yield?

4. What is the potential impact of Basel III on the banks in Slovakia?

Arguments for answering the above outlined questions will be provided in this paper

structured as follows.

Part 1 - International Financial Regulation

8 Admati, Anat R., DeMarzo, Peter M., Hellwig, Martin F. and Pfleiderer, Paul C., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive (October 29, 2010). Rock Center for Corporate Governance at Stanford University Working Paper No. 86 ; MPI Collective Goods Preprint, No. 2010/42. Available at SSRN: http://ssrn.com/abstract=1669704

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In this part, the need for regulation in the financial industry will be discussed. I will

provide a picture about how the core characteristics of bank’s function as a financial

itermediary gives rise to behavior that needs to be regulated.

To argue for the neccessity of regulation in the banking industry I will first position the

arguments for regulation arising from market imperfections. These imperfections of

financial markets give rise to intermediation where one type of a financial intermediary

is a bank. Further, the functions and characteristics of banking business will be outlined

and the subsequent problems arising from these characteristics will be discussed. The

literature used for this topic will include, but will not be limited to: Merton, Bodie

(2000); Allen, Carletti (2010); Heffernan (2005); Brunnemeier, Goodhart et. al (2009);

Freixas, Santomero (2003).

Further on, the global regulatory measures introduced by the Bank for International

Settlements and its Basel Committee for Banking Supervision, commonly known as

Basel II9 will be introduced, with a focus on credit risk and its measurement for

regulatory purposes. The need for revision of Basel II due to its adverse impact on

banks during crisis will be discussed and subsequently I will provide an explanation on

how the new Basel III addresses these shortcomings.1011To conclude the regulatory

framework part I will outline the increased regulatory requirements pronounced in the

Basel III document „A global regulatory framework for more resilient banks and

banking systems“.

Part 2 – Benefits and costs of Basel III

This part of thesis will focus on the benefits and costs of increased capital requirements.

From the widely assumed arguments that banks will be forced to pass the costs

associated with the required increased in the level of the most expensive source of

funding – common equity- the idea of the cost of equity will be discussed. According to 9 BCBS( June 2006): International Convergence of Capital Measurement and Capital Standards A Revised Framework, Comprehensive Version 10 BCBS (October 2010); The Basel Committee’s response to the financial crisis: report to the G20 11 BCBS (December 2010): Basel III: A global regulatory framework for more resilient banks and banking systems

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Modigliani and Miller12, in a an ideal world, wihere no tax deductibility of debt exists

and all information is instatntly available to everybody, the value of a firm is

independent of its capital structure. However in real world, an optimal capital structure

can be achieved to maximize the value of a firm, this is due to the deviations from the

ideal world. The environment banks operate in gives rise to some additional features of

behavior that need to be taken into account such as the effect of deposit insurance.13

Which slightly alters the application of Modigliani and Miller’s theory on the capital

structure of banks, nevertheless, I will explain how the ratio of equity to assets affects

the relative riskiness of bank’s sources of funding. The arguments used here will follow

the statements presented in Admati, et al. (2010).

Turning to the side of benefits, I will explain why the common equity element of

regulatory requirements is the soundest part that can ensure that banks are able to better

withstand potential adverse events. To show the soundness of the Basel III capital

requirements, I will discuss the types and roles of different components of regulatory

bank capital. The quality of common equity will be discussed in the light of bank capital

management and risk management practices. For arguments in in this part of the paper,

I will use, among others, the following literature: Mishkin (1992), Hull (2007), Mejstrik

et al. (2009).

Part 3 - The potential impact of Basel III capital requirements on banks in

Slovakia and its quantification

The impact assessment on the banks in Slovakia will be undertaken based on the model

used in King (2010)14. The model uses actual balance sheet data of banks to calibrate

the impact of increased capital requirements. Based on modified Modigliani-Miller

analysis, where the weighted average cost of capital does not change for different

12 Modigliani, Franco and Merton H. Miller, (1958), “The Cost of Capital, Corporation Finance, and the Theory of Investment” American Economic Review, 48, 261-297.

13 Santos, João A. C., Bank Capital Regulation in Contemporary Banking Theory: A Review of the Literature (April 2000). BIS Working Paper No. 90. Available at SSRN: http://ssrn.com/abstract=248314 14 King, Michael R., Mapping Capital and Liquidity Requirements to Bank Lending Spreads (November 1, 2010). BIS Working Paper No. 324. Available at SSRN: http://ssrn.com/abstract=1716884

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capital structure choices, the model assumes, that banks respond to the fall in return on

equity (ROE) by raising the lending spread charged on loans. The model therefore

quantifies the increase in lending spread required to maintain the level of ROE and also

assumes that the cost of liabilities remains unchanged (King 2010).

These assumptions will be discussed from the theoretical basis outlined by preceding

parts of this paper focused on the cost of equity. Further discussion of the nature of the

results that this model yields will be based on the constraints imposed on bank loan

pricing decisions.

Balance sheet data of banks operating on the Slovak market will be used to determine

the distance between their current levels of capital and the required increased levels of

capital imposed by the Basel III framework. The rest of the discussion will be related to

the options that banks have to bring their capital ratios to required levels, taking into

account the nature of slovak economic, financial, and banking environment as well as

the discussion of the model used to quantify the increase in lending spread.

International Regulatory Framework

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The process of chanelling funds from deficit units to surplus units in the financial

system can materialize in two ways, the first is through financial markets (directly) and

the second is through banks and other financial intermediaries (indirectly).15 Thus, in

many aspects,the availability of these two types of fund channeling puts the financial

markets and financial intermediaries in position of competing against each other in the

course of funds allocation.

Across countries, there are differences in the design of financial system which lead to

a question, whether these can be linked to efficiency. Levine (1997) argues with

evidence that more developed financial system is not just a result of economic growth,

but that it can be a good predictor and facilitator of it. Differences in legal and political

traditions as well as natural resource endowments may all influence the structure and

development of financial environment. It is however hard to reconcile the question

whether either institutional structure – bank based or market based - dominates in

facilitating economic growth. It then follows that the preferential choice of funding

channel made by deficit units may be motivated by their own characteristics, position

and intentions, therefore suggesting that each of the two types of funding channels have

their pros and cons, or in other words „intermediated financial contract markets emerge

in conjunction with a direct financial contract market, rather than in place of it,“

(Seward 1990, p. 371).

Merton explains financial markets and institutions in a dynamic perspective as

complementaries, reinforcing each other on the road to efficiency. Markets are a more

efficient alternative when the products have standardized terms, can serve a large

number of customers and the assessment of their price is well understood.

Intermediaries, on the other hand, are better capable of handling products which are

highly customized and/or contain fundamental information asymmetries (Merton 1995,

p. 26).

Existence and roles of intermediaries in the financial system

15 Allen & Carletti (2010), p. 37

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As noted by Freixas & Santomero (2003), the first logical step before any discussion

about banks and banking regulation takes place is to explore the reasons for the mere

existence of these institutions.

Literature, so far, has provided many explanations for the existence of financial

intermediation from the perspective of overcoming market frictions. Researchers look at

this problem from many different positions, taking into account bank’s functions. The

different perspectives of approaching to this question causes, that the ideas given as to

justify the existence of banks can be aligned under two logical bases.

Santos (2001) in his review of banking literature states that in a world with complete

and frictionless markets, there would be no need for financial intermediaries, because

investors and borrowers would be able to achieve efficient risk allocation on their own.

Earlier theories of financial intermediation emphasize the role of banks overcoming

frictions that result from transaction cost, whereas contemporary theories state that these

frictions arise instead from asymmetric information (Santos 2001, p. 3).

Akerlof (1970) in his famous „lemons“ problem showed how quality and uncertainty

can be detrimental to the exchange between transacting parties. Increase in price will

result in lower overall quality, buyers will anticipate this and as a consequence, no

market will exist at all. Akerlof then concludes that in reality, many institutions arise to

counteract these effects of quality uncertainty.

To provide a rationale for intermediation, Ramakrishnan & Thakor (1984) and Leland

& Pyle (1977) show, how adverse selection problem can be efficiently overcome by

production of information by intermediaries. When production of information is costly,

however, two problems arise. The first one is due to appropriability of returns from the

production of information given its nature of a „public good“. The second being

associated with reliability of the information16.

Leland & Pyle (1972) explain how a bank has the necessary characteristics to represent

a type of intermediary who can efficiently produce information. Production of

16 Ramakrishnan & Thakor focus on the explanation of existence of rating agencies as „diversified information brokers“. Firms that exceed the cross sectional average value will have an incentive to purchase certification of their value from the information producer. By this, the problem of information as a „public good“ is avoided. The reliability is achieved through diversification, since incentives to produce unreliable information diminish as the number of information producers grows with size of the coalition.

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information about individuals is beneficial to the bank if it achieves economies of scale

in doing so. The problem of appropriability of returns is eliminated by the bank if it

buys and holds the assets about on which it has produced the information – this is now

captured as a private good in the returns on the bank’s portfolio. The organizers‘

willingness to invest (investing their own wealth in assets about which it has special

knowledge) in their firm’s equity then signals the quality/reliability of information – by

putting their own capital at risk they signal a commitment to monitor the returns17.

The second aspect of asymmetric information is that of incentive problems caused by

separation of ownership and control after a transaction is made. In case of a debt

contract18, the borrower has incentives to substitute assets or a project for more risky

ones than those, which were underlying the loan approval (Myers 1977). Additionally,

the lender might be unable to observe the true return realized by the borrower. In both

cases, the lenders need to monitor the borrowers. Some of the adverse incentives can be

mitigated by imposing restrictive covenants into the loan contract, but these are costly

to enforce (Smith & Warner 1979).

In his well cited model, Diamond (1984) assumes the existence of information

technology allowing costly monitoring of the realization of borrower’s output.

Delegating this monitoring activity to a single entity eliminates the duplication of

monitoring costs and the free-rider problem present among individual lenders observing

each others‘ actions. He further stresses the role of diversification in the context of

avoiding the problem of needing to „monitor the monitor“. As the size of intermediary

(and its diversification) increases, it can achieve the market return on its loans with

certainty. If the investors (depositors) do not receive this return, they know that

monitoring was not undertaken properly and will impose non-pecuniary penalties19

upon the intermediary.

17 Banks are however not able to eliminate the problems of adverse selection and moral hazard completely. The screening mechanisms – such as the interest rate a bank charges on its loans can affect the average risk profile of the borrowers as a result of residual imperfect information after the evaluation of loan applications. This can give rise to „credit rationing“ according to Stiglitz & Weiss (1981). 18 In the strand of literature on contracting under „costly state verification“ the standard debt contract is derived as the optimal incentive contract under certain conditions of costly monitoring. Lacker (1991) shows that contingent payment schedule coupled with collateral mitigate the incentives problem when lender is uncertain about borrower’s future resources. 19 e.g. in forms of bankruptcy costs or loss of reputation.

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Benston & Smith (1976) represent an earlier view on the existence of intermediaries.

The bank’s specialization gives it a comparative cost advantage in acquiring

information about borrowers‘ ability to repay debts, in monitoring costly covenants and

in processing documents. By specializing in these activities, banks can develop

standardized forms and procedures, which bring scale efficiencies. Information received

about a consumer also has a potential to be reused in scope – for example in processing

other consumers in the same industry. The authors further argue, that important, detailed

information about borrowers‘ financial condition can be obtained at much lower cost.

This fact is also recognized by Fama (1985), who states that since borrowers usually

maintain deposits at the same bank which they obtain credit from, the bank is allowed to

assess the risks of loans and monitor them at lower cost than other lenders20.

Diamond & Dybvig (1983) contain one aspect of liquidity provision. They show that

when bank depositors have unobservable, random consumption needs, banks issuing

demand deposits can provide superior risk sharing among them. As they further note:

„banks are able to transform illiquid assets by offering liabilities that have a smoother

pattern of returns over time, than the illiquid assets offer“.

Another aspect of liquidity is shown by Lacker & Wineberg (2003), who stress the

uniqueness of banks in issuance of payment instrument liabilities. This rationale for

banks can be related all the way to the reason why money was created as a means of

exchange and payment. Gorton & Winton (2002) present an overview of this aspect of

bank function. Banks act as a central clearing location, which facilitates trade between

agents located in different places. Thus eliminating the costs of barter trade and

providing liquidity by offsetting requested payments. Another important property of

banks arises due to their diversified portfolio - banks are suited for providing riskless

debt securities (deposits) which can act as a medium of exchange. In yet another way,

banks can provide a line of credit to a firm that can be drawn to the extent, the firm

experiences an unexpected liquidity need, and thus allows the firm to transfer value

across time.

Campbell & Kracaw (1980) argue that neither of the explanations – asymmetric

information, and transaction costs stand alone as satisfactory in motivating the existence

20 This implies there may also be benefits for both parties from this „relationship lending“ as discussed in Berger & Udell (1995).

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of intermediaries, but are rather complementary. Emergence of intermediaries is

profitable, when they can jointly produce information and also offer other - liquidity,

transaction, and insurance services. Campbell & Kracaw thus link the synergies of

banks producing information and their role in provision of liquidity and facilitation of

payments and transactions.

Intermediaries are efficient in mitigating ex-ante and ex-post information asymmetries.

The nature of bank liabilities has value since they act as a medium of exchange and

payment. Banks create liquidity and provide monitoring services thanks to

diversification. Information production makes funds available to flow to borrowers who

would be unable to directly access the market either due to lack of their own funds21 or

insufficient reputation22. The bank obtains proprietary information about the borrower,

which it can reuse in a way beneficial for both parties23.

The dynamic perspective also explains that relative importance of banks‘ roles and

functions changes over time. Allen & Santomero (1996) account for the complexity of

large financial institutions which engage in a range of interest and non-interest bearing

activities24. New products brought by securitization, derivative instruments, and shift

from holding to originating-and-distributing of loans stress the role of intermediaries in

risk management services and reduction of participation costs to uninformed investors.

Services provided by banks and risks involved

Bhattacharya & Thakor (1992) provide an overview of services offered by financial

intermediaries. Nondepository intermediaries often specialize in certain services, but

banks have traditionally provided virtually all of these services. In the brokerage line,

these include: transaction services, financial advice, screening and certification,

origination, issuance. Whereas qualitative transformation services include: maturity

transformation, asset divisibility, liquidity transformation and credit risk.

21 Repullo & Suarez 1998 22 Diamond 1991 23 Boot (2000) p. 10 24 Besides traditional deposit taking and provision of credit, to financial innovation and engineering, advisory services, and proprietary trading, i.e. trading on their own account as opposed to being their customers‘ broker.

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Along the classes of risks that all, i.e. non financial and financial companies are

subjected to, like legal, business and market risk, the services of asset transformation

mean a particular set of risks is accentuated for banks.

Liquidity transformation - While other sectors of economy are also exposed to liquidity

risk - the ability to fund increases in assets and meet obligations as they come due25 and

is crucial for the bank to remain viable due to the nature of their assets and liabilities. To

be able to extend loans, which are usually individual arrangements containing publicly

unobservable borrower-specific information, banks issue deposits which are payable on

demand. Thus if a bank experiences large unexpected cash withdrawals, it can end up

being forced to insolvency. In case of the banking industry, liquidity risk can lead to

a major systemic problem.

The reason why banks can offer liquidity transformation service is that they are able to

diversify a large portion of risk of their portfolio, however not all of it26. Liquidity is

defined as the ability to fund increases in assets and meet obligations as they come due

and is crucial for the bank to remain viable27. As will be further discussed, due to

imperfect information about the quality of banks‘ assets (loans) giving rise to asset

liquidity risk, depositors may take actions that force banks to early liquidation of assets,

accentuating the funding liquidity risk, which can eventually force the bank into

distress.

Maturity transformation - Another mismatch between bank’s assets and liabilities lies in

the term until maturity. Long term loans financed by short term deposits expose a bank

to interest rate risk.

Risk transformation (credit risk) - The core business of banks is to make loans to

customers. Service of lending means banks hold assets that are subject to credit risk.

Credit risk is the risk of losses owing to the fact, that counterparties may be unwilling or

unable to fulfill their contractual obligations (Jorion 2007, p. 24). Credit risks are

traditionally managed by ensuring that the portfolio is well diversified, which reduces

nonsystematic risk, but does not eliminate systematic risk (Hull 2007, p. 19).

25 Sound Practices for Managing Liquidity in Banking Organisations, BCBS, February 2000. http://www.bis.org/publ/bcbs69.htm 26 Saunders & Cornett (2006), Chapter 1, p. 7 27 Sound Practices for Managing Liquidity in Banking Organisations, BCBS, February 2000. http://www.bis.org/publ/bcbs69.htm

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Regulation of banking

It is difficult to draw a clear cut picture of where one type of regulatory instrument starts

to be justified and where its application ends. It is also the case, that it may be beneficial

for mitigating one issue while giving a rise to another one. Rationale for regulation of

banking industry lies first in the issues that are specific to the banking environment; and

second due to general market imperfections.

Llewellyn (1999) states, there are three objectives (goals) of regulation in the financial

industry:

- To sustain systemic stability.

- To maintain safety and soundness of financial institutions.

- To protect the consumer.

Freixas and Rochet28 in their microeconomic analysis of banking discuss the safety and

soundness regulation of banks. In general, public regulation is justified by market

failures that come from market power, externalities, or asymmetric information between

buyers and sellers. Banks arise to overcome problems of asymmetric information,

however it is not ensured that they can completely solve this problem, and may even

lead to new market failures. The two main market failures in the banking industry are: i)

the fact that depositors are generally not in the position to monitor the bank’s

management – they need a representative; and ii) the fragility of banks because of their

illiquid assets and liquid liabilities – systemic risk.

Depositors‘ representative

The concern that depositors are not armed to monitor the management of their banks is

approached by Dewatripont and Tirole (1993) who build on the corporate governance

problem created by the separation of ownership and management.

28 Freixas and Rochet (1997)

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Given the payoff structure of debt and equity securities29, the managers should be

rewarded by low interference by outsiders when performing well and conversely, should

be punished by substantial outside involvement when the performance is poor. Their

model assumes some verifiable bank performance measures that determine the threshold

when the control is taken away from equity owners and shifted to debt-holders.

Moreover, by keeping assets and liabilities unchanged, the mere new information about

existing loans gives the equity holders an incentive to gamble for resurrection –

managers and shareholders of decapitalized banks benefit from undertaking high-risk,

high-yield negative NPV investments at the expense of creditors – if successful, this

may keep them in business and capture rents, while on the downside, their loss is

limited.

The above mentioned thus demonstrates the limitations of a free banking sector because

equity holders are biased in favor of managers and can be only relied upon in good

times. When bank performs badly, to set the threshold, monitor and intervene, a public

agency (such as FDIC in US) should act on behalf of the small depositors, who have

neither the incentive, nor the information or competence to do so30.

Systemic risk and cost of bank failure

Diamond & Dybvig with their explanation for existence of banks stemming from

provision of liquidity risk insurance at the same time recognize that this function makes

banks instable. The authors state that „uninsured demand deposit contracts are able to

provide liquidity but leave banks vulnerable to runs“ (Diamond & Dybvig 1983, p.402).

Thus the liquidity insurance that banks provide makes these institutions fragile. Along

with pure panic runs, where withdrawals are random events based on depositors‘

consumption preferences, Jacklin and Bhattacharya model the existence of information-

based runs31. Interim information might be observed about bad performance of bank’s

assets, which will lead depositors to withdraw their money. While a bank run in both

29 Because of limited liability, the payoff function of the holders of equity is convex, which brings tendency to favor risky decisions. On the other hand, the payoff function to debt holders is concave indicating more risk aversion. 30 Dewatripont, M., and J. Tirole. 1993. Efficient governance structure: Implications for banking regulation. In Capital markets and financial intermediation, ed. C. Mayer and X. Vives. Cambridge: Cambridge University Press. 31 Jacklin, C. and S. Bhattacharya (1988): “Distinguishing Panics and Information–Based Bank Runs: Welfare and Policy Implications,” Journal of Political Economy 96, 568–592.

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above mentioned settings could be a beneficial source of discipline on banks, the

reasons why bank failure is seen to be undesirable is due to much larger costs it can

impose on the financial system, which can also spread into the real sector (Jacklin &

Bhattacharya 1988).

The U.S. experience of bank failures during the 1930’s lead to a decision that

widespread loss of confidence in banks needs to be prevented. Following the years of

Great Depression, retail depositors‘ confidence in the stability of the banking system,

and that they receive their money has been guaranteed by a state deposit insurance

scheme. Since then, many advanced countries adopted similar explicit guarantee

schemes following their own experience of banking crises (Demirgüç-Kunt & Kane

2002)32.

In principle, if depositors redeposit their money from a suspected bank to another one,

interbank market could well satisfy the shortage of liquidity in the troubled institution33.

In case, depositors redeem their holdings for cash, liquidity needs to come from an

outside source – central bank. The ideas that a central bank act as a source of last resort

lending to troubled banks dates to early nineteenth century. The central bank is thought

to be a useful correction of some of the frictions in interbank market, because the ability

of interbank lending to remedy liquidity problems severely depends on the

completeness of information banks have about each other. Interbank market may

become more cautious during a crisis because participating institutions may not have

the capacity or willingness to lend to each other. Possible reasons are the inability to

distinguish between an illiquid and an insolvent institution or when banks are not

certain about their own funding needs for the immediate future (Freixas et al. 1999).

As the experience showed, runs by depositors are not the only source of bank’s balance

sheet fragility. The failure of Continental Illinois bank began when its short-term

wholesale funding 34. A recent example of a „modern bank run“ is the dry-up of

interbank and money market funding that lead the U.K savings and mortgage bank

32 Some of the alternative proposals to ensure the stability of banking system include - narrow banking; all-equity funded banks; suspension of convertibility. 33 Provided the interbank market is functioning well. 34 Chapter 4 - Continental Illinois National Bank and Trust Company. Available at: http://www.fdic.gov/bank/historical/managing/history2-04.pdf

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Northern Rock to dependent on the assistance of central bank and subsequently

nationalized (Shin 2008). For the U.S., Bear Sterns experienced a run, when its short-

term funds provided by hedge funds was not rolled over in March 2008 (Brunnermeier

2009).

Contagion is a major concern for regulation since the primary objective is to preserve

the whole system’s stability and confidence. The high degree of interconnectedness

among the financial institutions and consequences for the whole system are also taken

as a distinguishing nature that makes a failure of one bank causing high cost to society

in contrast to a failure of a non-financial firm (Crockett 1996).

Crockett identifies three channels of contagion through which a failure of one large or

a number of small banks can spread: interbank market; over-the-counter derivatives

transactions; and the payments and settlements system. Within this network, banks hold

interlocking claims, where a failure of a counterparty to fulfill its obligations can have

direct knock-on (or domino) effects on other banks. Stability of payments and

settlement systems and smooth functioning of interbank market is thus vulnerable.

The threat of instability in case of a large bank’s failure was a rationale for the „Too-

Big-To-Fail“ doctrine35 where a government bailout of the troubled bank seeks to avoid

the high systemic cost of failure.

Leverage and cost to society

Banks have systematically the highest leverage of firms in any industry36. Since this is

so, even a small decrease in asset value can lead to distress and potential insolvency,

and can lead to severe consequences, particularly when the financial system is deeply

interconnected37. This is one of the facts that bring higher concern about a failure of

a bank as opposed to a non-financial company.

When a bank experiences liquidity problems it can best rely on meeting the shortage by

selling its liquid assets, which are easily marketable and without depressing the price.

On the contrary, when forced to sell its loans to borrowers, much of their value may be

35 Goodhart & Huang 1999; alternatively: Too-Interconnected-To-Fail 36 Berger et al. (1995), p. 394 37 Admati, et al. (2010), p. 1

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lost for the lemons premium that may be requested by buyers, because of the specific

information those loans contain. Moreover the projects financed by bank loans are most

valuable while being going-concern because they require specific human capital to

create value38. Forced liquidation of long term loans to borrowers can thus rapidly bite

off the capital base of a bank.

As discussed above, diversified financial institutions remain vulnerable to systematic

shock. Given the high leverage and wide maturity mismatch between assets and

liabilities, the financial industry can quickly get into trouble when a general adverse

shock affects the assets. Deleveraging, higher margin requirements and forced asset

sales can put a strong pressure on the asset markets causing drop in market liquidity39

and depressing the price of assets, so srinking the balance sheet becomes very costly.

The combination of market liquidity and funding liquidity deterioration can quickly tilt

highly leveraged institutions toward the brink of insolvency (Brunnermeier 2009).

Besides the fragility of leverage, there are costs to society from liquidating loans to

borrowers. As discussed previously, the monitoring effort and costs that banks incur in

course of lending create relationships with borrowers. If their credit is cut-off, the bank-

dependent borrowers will incur cost of finding a new lender and re-establishing

a relationship, for the lender will need to replicate the screening and monitoring costs

(Bernanke & Gertler 1995). Thus when a bank fails, customers are facing the very

imperfections the bank was supposed to solve.

SAFETY NET AND MORAL HAZARD

The notion of inherent subsidizing of risk taking behavior by charging a flat deposit

insurance premium was modeled by Merton (1977). In his paper, he uses the formula

for option pricing developed by Black & Scholes to derive the actuarially fair risk

premium of deposit insurance40. In this setting, the flat premium paid to the insurer

38 James 1991 reports substantial loss in value of gone-concern bank 39 Market liquidity is low, when it is difficult to raise money by selling the asset. (Brunnermeier 2009, p. 92) 40 The price of deposit insurance can be thought of as an option premium paid for a put option on the value of bank’s assets, where the strike price is equal to the promised value of deposits at maturity. By construction of the Black-Scholes pricing formula, the value of the premium then increases both with deposits-to-assets ratio (leverage) and the volatility of the banks assets (the measure of risk) when holding time to maturity fixed.

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becomes more valuable, the more risky the bank’s assets are and the higher leverage it

takes, which gives rise to moral hazard41.

By making the deposits informationally insensitive, the depositors will have no need to

monitor the banks’ performance. Based on this fact, the bank managers are given

incentives to take excessive risks.

The original proposal, that emergency lending be done at a penalty rate to prevent banks

for seeking this support, is questioned on the grounds that it may aggravate the situation

of the already fragile bank (Crockett 1996, Freixas et al. 1999). Higher rate paid for

emergency support may induce the managers of troubled institution to pursue more

risky strategy – gamble for resurrection. Moreover the announcement of last resort

support could be associated with a negative stigma and market’s reaction of further

withdrawals of funds.

These undesired consequences however give rise to moral hazard stemming from

expectation of cheap support. In case of an emergency injection of risk capital, the

incentives are even more distorted since risk-taking institution might be deemed as

insured against all types of risk (not only the liquidity risk). Firstly it gives the managers

and shareholders incentives to maximize the implicit subsidy, and secondly, it reduces

the incentives for uninsured creditors to monitor the institution (Freixas et al. 1999).

From Basel II to Basel III

The first attempt to set risk-based internationally harmonized capital standards was the

1988 Basel Accord. The motives behind its introduction were to boost the low capital

ratios of internationally active banks and to reduce competitive inequalities42. The

requirement defined a minimum capital ratio for credit risk-weighted assets, where the

41 Merton (1977) 42 Jackson, et al. 1999

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risk weights were based on four institutional categories ranging from 0% for claims

deemed the safest to 100% for risky ones43.

Total regulatory capitalRisk Weighted Assets ≥ 8% (1)

As the progress in financial industry continued, banks were increasingly relying on off-

balance sheet activities, while also being more engaged in trading. The first Accord was

therefore criticized for being too crude and failing to incorporate other risks that banks

face, as well as for the fact that banks already found ways for regulatory capital

arbitrage44. The original Accord was amended in June 1996 to include a capital charge

for market risk and in June 1999, a first consultative proposal was published for a major

revision of the 1988 Accord. The agreed text of „Basel II“ framework was published in

June 2004, with implementation beginning from 2007 and reaching its full in year 2009.

The structure of Basel II consists of three mutually reinforcing pillars. Pillar 1 - sets the

regulatory capital minima for three types of risk – credit, market, and operational. The

pillar 2 – supervisory review process serves to ensure that banks develop sound risk

management practices. The 3rd pillar – market discipline, recognizes that increased

transparency will lead to better understanding by market participants whether banks‘

capital position is adequate to its risk profile.

Basel II credit risk

Basel II provides an option to choose between two approaches to determine capital for

credit risk i) standardized and ii) internal ratings based. Using the standardized

approach, banks rely on credit ratings of external agencies to determine risk weights for

different classes of their claims, similar to the first Accord, except the focus is on risk

profile within each of the classes45. In addition, the Framework also allows for a limited

degree of national discretion in the way in which each of these options may be applied,

to adapt the standards to different conditions of national markets46.

43 For example: 0% - cash, OECD governments, Central banks;20% - multilateral development banks, banks in OECD countries; 50% - secured residential mortgage loans; 100% - claims on private sector and non OECD countries 44 Extensive use of securitisation 45 Sovereigns, public sector entities, banks, corporates, securities firms, etc. 46 This is also subject to criticism especially regarding definitions of capital, since deviations on national level undermine the idea of level-playing-field and give scope to regulatory arbitrage.

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Internal ratings based approach

The IRB approach, which is subject to an explicit approval of the bank’s supervisor,

would allow banks to use their internal rating systems for credit risk. Under the IRB

approach, two alternatives are possible: the foundation and advanced. Under the

foundation approach, banks only use their models to estimate the probability of default

(PD), whereas under the advanced approach, bank can rely on its own estimates for all

parameters.

Foundation and advanced approaches

Basel II Credit risk

Corporate,

Sovereign,

Banks, Eligible

purchased

corporate

receivables

Retail and

Eligible

purchased

retail

receivables47

Equity

Advanced

IRB

Bank's

internal

estimates

PD, LGD,

EAD, M

PD, LGD,

EAD, M

PD/LGD

approach

Market

based

approach Foundational

IRB

Bank's

internal

estimates

PD

Supervisory

estimates LGD, EAD, M

The model underlying this approach is the one-factor Gaussian copula model of time to

default. Equation 2 presents the calculation of capital requirement for corporate,

sovereign and bank exposure.

퐾 = 퐿퐺퐷 × 푁 ×퐺(푃퐷) + √푅 퐺(0,999)

√1 − 푅− (푃퐷 × 퐿퐺퐷)

×(1 + (푀 − 2,5)푏)

(1 − 1,5푏) (2)

47 Once the bank meets the criteria for using the IRB approach, there is no distinction for calculating exposures for the retail class, the bank uses its own estimates for all risk components.

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Where K denotes the capital requirement for defaulted exposure, that is equal to the

greater of zero and the difference between its LGD and estimate of expected loss. R

denotes the correlation parameter, N (x) is the cumulative distribution function and and

G(z) is its inverse. The expected loss is subtracted from the worst case loss, since it

should be covered by the loan’s price and corresponding provisions. The capital then

covers the unexpected portion of loss. The last term represents adjustment for maturity.

R, the parameter for correlation can take maximum of 24% and is decreasing in the size

of borrower’s turnover and probability of default, reaching a minimum of 12%. The

idea here is that the borrowers‘ with high probability of default will be less susceptible

to common risk factor. Similarly, the small borrowers‘ default probabilities will exhibit

higher vulnerability to market conditions. Risk weighted assets are then arrived at by

multiplying the unexpected loss by EAD and a factor of 12.5 to arrive at an 8% capital

ratio.

The events that precipitated in the recent crisis were accompanied by excessive funding

maturity mismatch. High amounts of leverage and on and off balance sheet risk taking.

As a response to these events, in December 2009, the Basel Committee on Banking

Supervision (BCBS) published two consultative documents that propose increasing the

quantity while improving the quality regulatory capital and reducing funding and

maturity mismatches between bank assets and bank liabilities (BCBS, 2009a,b).

Financial institutions, while showing sufficient capitalization, did not have sufficient

amount of loss absorbing capital. The new proposal increases quality and quantity of the

capital base. It further enhances risk coverage for trading book and securitization

exposures, and resecuritizations in both the banking and trading book. Increasing capital

requirements for counterparty credit exposures arising from derivative, repo and

securities financing to reduce interconnectedness by favoring central counterparties.

A simple leverage ratio of 3% Tier 1 capital to total assets will be introduced48. To

contain excessive buildup of on- and off- balance sheet leverage to mitigate the

deleveraging feedback loop. Included will be a 100% credit conversion factor for

recognizing off-balance sheet sources of leverage49.

48 Also after all deductions. 49 Such as commitments (including liquidity facilities), direct credit substitutes, acceptances, letters of credit, etc.

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To mitigate procyclicality, Basel III introduces less procyclical forward looking

provisioning, capital conservation buffer and countercyclical capital buffer.

Capital conservation buffer is one of the elements introduced to mitigate adverse effects

of deleveraging, it will consist of 2.5% Common Equity Tier 1 (CET 1) above the

regulatory requirement when fully phased-in. Banks will be required to hold buffers

above the regulatory minimum during good times, so they can draw the buffers down to

support their operations through period of stress. When the value of conservation buffer

falls within the range of 0-2.5%, constraints on distributions50 will be imposed. The

percentage of earnings required to be conserved will grow as the buffer approaches the

minimum.

The countercyclical buffer will be imposed by national authorities, when they judge that

excess credit growth is associated with a buildup of system-wide risk, and will be

released, when the situation dissipates or materializes. Its maximum amount will be

2.5% of RWA, will consist of CET1 and will be in excess of capital conservation

buffer.

Basel III will introduce two liquidity measures. The liquidity coverage ratio -LCR- high

quality liquid assets that can be converted to cash to be able to meet liquidity needs over

a 30-day stress horizon. Stock of these assets must be equal to or exceed net cash

outflows under such stress-scenario. And the net stable funding ratio -NSFR- for

medium and long term funding, a minimum amount of available stable funding that can

consist of capital, preferred stock and liabilities with a maturity of at least 1 year . The

required amount will be set based on the characteristics of liquidity risk profiles of

institutions assets, off-balance sheet exposures and selected activities.

The implementation of Basel III will begin in 01/2013 and the requirements are to be

phased-in gradually, with full requirements being in force in January 2019. The gradual

portions of Common Equity Tier 1, Additional Tier 1, Tier 2, and Capital conservation

buffer will mandatory at the beginning of each year, as shown in Figure 1 below. The

Countercyclical capital buffer

50 Such as dividends and share buybacks, payments on Tier 1 instruments, and bonus payments to staff.

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Figure 1:

Basel III requirements - Amount, definition and loss absorbency of capital

The new Basel requirements will represent a significant change in regulatory regime.

The impact studies undertaken bu BIS and CEBS demonstrate that at the end of year

2009 the largest banks would be lacking about 40% of the capital under new

requirements. This is a significant distance, representing about

Common equity Tier 1

Common equity Tier 1 (CET 1) can comprise of common equity, retained earnings and

disclosed reserves. Equity represents unlimited residual claim on assets, while

distributions can only be paid to equity holders after all obligations and payments to

more senior creditors are satisfied. Common equity is therefore the highest quality

component with and highest loss absorbency. It is perpetual and never repaid outside

liquidation (aside from stock repurchases), and has the attribute of „patient money“

3,5% 4% 4,5% 5,125% 5,75% 6,375% 7%1%

1,5%1,5%

1,5%1,5%

1,5%1,5%

3,5%2,5% 2%

2%2%

2%2%

0,0%1,0%2,0%3,0%4,0%5,0%6,0%7,0%8,0%9,0%

10,0%11,0%

2013 2014 2015 2016 2017 2018 2019

Basel III Phasing in period 2013-2019common equity Tier 1 (incl conservation buffer Aditional Tier 1 Tier 2

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(Berger, Herring, Szego, 1995) In contrast to Additional Tier 1 (AT 1) instruments, on

the balance sheet, it must be classified as equity, not as a liability.

Unlike Basel II, which allowed the regulatory adjustments to be deducted from the

entire Tier 1 layer, under the new regime, the vast majority of deductions will be made

from CET 1. The results of Comprehensive Quantitative Impact Study undertaken by

CEBS51 at the end of 2009, showed that the major portions of deductions under Basel

III would come from goodwill, deferred tax assets, holdings of other financial

institutions, and other intangibles.52 Main features of the regulatory Tiers under Basel

III are summarized in Table 2:

Table 2 -

Characteristics of

regulatory

capital

instruments

Common equity

Tier 1 Additional Tier 1 Tier 2

Subordination most subordinated subordinated to Tier

2

subordinated to

depositors and

general creditors

Loss absorbency going concern

going concern,

specified trigger

point

gone concern,

repayment before

CET 1 and AT 1

Maturity perpetual perpetual, callable

after a minimum of minimum 5 years

51 Committe of European Banking Supervisors, now European Banking Authority, is the EU wide supervisory authority responsible for coordination of financial supervision and develops technical standards for implementing Capital Requirements Directives 52 CEBS (2010)

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5 years

Distributions no obligation to

distribute

cancellable - not

triggering default

non-payment

constitutes default

Additional Tier 1

The instruments qualifying for inclusion into Additional Tier 1 (AT 1) must satisfy loss

absorbency on a going-concern basis. This layer can however be formed by hybrid

securities, those having equity and debt-like characteristics. If recognized as a liability,

the instruments must have a specified trigger point to ensure loss absorbency by either

being converted to common shares, or having a write-down mechanism of loss

allocation. This feature is meant to ensure that the instruments take losses before

a public sector capital injection is made.

Requirement of being perpetual remains, however, the instruments can include an

option to be called. The call can be exercised only after a minimum of five years,

subject to meeting the minimum requirements, this specification is also shared with Tier

2 instruments.

Tier 2

Insturments representing the Tier 2 portion can consist of debt that is subordinated to

depositors and general creditors, and the objective is to provide loss absorbency on

a gone-concern basis. Failure to make payment constitutes default and in the even of

bankruptcy, claims of Tier 2 holders are satisfied before those of CET 1 and AT 1.

Inclusion of this Tier 2 is advocated on the premises that spreads on uninsured debt

have the potential to be an indicator of bank’s risk taking and thus a source of market

discipline. Similarly as the conversion feature in AT1, Tier 2 subordinated debt is useful

to protect governments from losses in the event of liquidation (Carey, 2002).

To achieve the goals of public policy, instruments, that qualify for inclusion in

regulatory capital should satisfy three main characteristics (Berger, Herring & Segö,

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1995, p. 408). First, the claims should be junior to those of deposit insurer and absorb

losses before insurance fund. Second, as stated above, it should provide a stable source

of funding during a possible panic run by other creditors. Lastly, the instrument should

reduce the bank’s moral hazard incentives to undertake excessive portfolio or leverage

risk. Common equity satisfies the first two objectives, but only partly the third one. The

leverage risk is reduced as higher amount of equity is required, theoretical results on

whether it reduces portfolio risk are divergent. These will be discussed later in this

section.

Empirical evidence from the recent financial crisis sheds light on the quality of „tiers“.

Demirguc-Kunt et al. (2010) study the relationship between different capitalization

measures and stock price returns for a sample of 381 banks over the period before and

during the recent crisis. Until Q2 2007, which is the time of the crisis dummy, the

coefficient for capital is small and marginally significant, while during the crisis period

spanning between Q3 2007 and Q1 2009, their results show the strongest positive

relationship for common equity, Tier1, and tangible common equity. Their results are

most pronounced for a subsample of large banks53 and for ratios to total assets as

opposed to RWA.54

The above study provides clear cut evidence for what investors in the market deem as

highest quality. The issues with tangibility were earlier most pronounced for Japanese

banks, which became heavily reliant on deffered tax assets55 in 1998. Skinner (2005)

ascribes the decision for including these assets into capital to regulatory fobearance56 of

government authorities to prevent the weakest banks from failing subsequent to the

burst of stock market and real estate bubble in 1990.

Subsequently to the new proposal, two impact studies were undertaken by BIS and

CEBS at the end of 2009 to measure the difference between banks‘ actual capital ratios

53 Total assets more than $ 50 billion 54 The authors assign this effect to a possibility that large banks have more opportunities to engage in regulatory arbitrage, that blurred the information content of RWA. 55 Deferred tax assets (DTAs) represent operating loss, tax credit or other carry forwards. These items require significant portion of subjective judgement made by managers. Moreover, DTAs are only economically meaningfull if a firm remains going concern, in case of bankruptcy, they are lost. (Skinner, Miller 1998) 56 Regulatory forbearance is reluctancy to wind up a bank in

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and the Basel III proposals. The impact studies are focused on Group 1 banks (Tier 1

capital in excess of EUR 3 bil.) and Group 2 banks (all other banks). The shortfall of

common equity Tier1 resulting from new proposed increases, definitions, and

deductions was roughly 50% for Group 1 banks and 30% for Group 2 banks and was

mainly due to deductions. Tier 1 ratios showed a shortfall of about 30% for the group of

large banks and was mainly attributable to eligibility of instruments.

Market discipline

Regarding the effectiveness of market discipline, the usual argument goes, that

explicitly as well as implicitly insured depositors do not have incentives to monitor and

thus the institutions will not be disciplined for the risks it takes. Flannery (1998)

reviews the empirical evidence on monitoring of US banking firms. They conclude, that

bank share prices react promptly to new information, and bank liability holders behave

rationally. Large certificates of deposits reflect bank risks even in the presence of

government guarantees. This is contrary to the experience from recent crisis, where the

case of Lehman bankruptcy is put forward as the ultimate evidence of investors being

complacent or uninformed about the true risks. However, as stated in Levy-Yeyati et al.

(2007) while bank fundamentals may be useful indicators of bank health during calm

times, they tend to fail in capturing macroeconomic risk in a run-up to a crisis and may

be slow in responding, once the risks materialize.

Economic capital

Economic capital (or risk capital) is defined as the amount of capital a bank needs to

absorb losses over a certain time horizon with a certain confidence interval – a VaR

concept (Hull, 2007, p. 366). As Basel II IRB approach uses this concept in order to

„allign“ regulatory capital with the economic one, the amount of economic capital is

defined as difference between the actual worst case losses and expected losses.

Figure 1 shows, that economic capital will include risk that is specific to the bank and is

not covered by regulatory capital. To arrive at an institution-wide risk capital,

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unexpected losses for non-business risk and business risk are aggregated. The time

horizon is usually set to one year, which corresponds to notion that bank is able to

recapitalize within this time period. The confidence level is subject to each bank’s

objective. As noted by Hull, a common objective for banks is to obtain a desired credit

rating.

Figure 1:

Source: Hull (2007)

Distinction between regulatory and economic capital and associated issues

The two concepts reflect the needs of different primary stakeholders. For economic

capital, the primary stakeholders are the bank’s shareholders whose objective is to

maximize their wealth. Whereas for regulatory capital, the primary stakeholders are the

bank’s depositors and their objective is to minimize the possibility of loss (Allen 2006,

p. 45).

Elizalde & Repullo (2006) analyze the differences between the two concepts of capital

in the context of the single risk factor IRB model of Basel II, where the level of capital

is chosen by shareholders in order to maximize their wealth. In this context, they show,

that economic and regulatory capital do not depend on the same variables. The former

depends on the cost of capital and on intermediation margin. They show, that economic

capital is higher that regulatory capital only when cost of capital is low. Intermediation

margin substitutes for capital in incompetitive loan market and thus drives economic

Total risk

Non-business risk (regulatory capital)

*Credit risk

*Market risk

*Operational risk

Business risk (no regulatory capital)

*Risk from strategic decisions

*Reputation risk

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capital low. They advocate regulations of prompt corrective action type, which mandate

progressive penalties as capital ratios deteriorate.

Carey 2002 argues, that allowing subordinated debt to be included in the amount of

capital required to achieve desired degree of solvency may render the amount of capital

insufficient to satisfy the social planner’s goal.

A critical point is made by Kupiec (2004). Using Merton’s option pricing framework

and assuming wealth maximizing shareholders, the author shows, that IRB capital

requirements do not eliminate incentives created by mispriced safety net. The interest

rate subsidy that is captured by the IRB models differs among investments with

different risk profiles making it possible for the bank to meet the regulatory solvency

rate with less capital than would otherwise be adequate for an uninsured institution. The

assets for which the subsidy is most pronounced have low volatility and high risk

premium.

Bank capital, risk taking and unintended consequences

The large theoretical literature predicting behavior of banks under capital restrictions

yields divergent conclusions. VanHoose (2007) surveys the field of theoretical

predictions. The different approaches study: i) capital constrained portfolio selection; ii)

incentives to take risk; iii) capital and demandable debt as mitigation of moral hazard;

iv) influence of capital regulation on bank lending and monitoring choices; v) capital

regulation and adverse selection of borrowers, extended for heterogenous banks.

VanHoose makes following conclusions:

- Immediate effects of capital constraining standards are reduction in lending and

increased market loan rates

- Longer term effect of capital regulation leads to increase in capital ratios, with

an ambiguous effect on amount of lending

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Capital regulation can thus protec depositors and depsit insurers from losses in the event

of bank failures. The divergence of literature is rooted in the marginal choice of the

bank in question. Capital cushion may cease to achieve its objective if banks choose to

take higer risks or reduce screening and monitoring. An agreement rests in tying the

capital requirement to asset risk, but not in how many banks will become less risky.

Capital regulation might need to be complemented with other policy instruments, such

as supervision or market discipline.

Jackson et al. (1999) undertake a survey of empirical studies on the performance of

capital requirements. They make several observations. Capital ratios seem to induce

banks to hold higher capital levels. Banks adjust their balance sheets depending on the

stage of the business cycle and banks‘ capitalization. In times, when it is costly to raise

equity, banks change the composition or level of lending. For the question, whether

higher requirements lead to higher risk taking, they conclude, that no reliable evidence

can be forwarded. Finally, they find there was significant securitisation-related capital

arbitrage in Canada, Europe and Japan.

Capital Structure and Cost of Equity

In this section, the cost of equity in relation to capital structure will be discussed. The

classical finance theory of irrelevance of capital structure on firm value and investment

choices presented by Modigliani and Miller is hardly applicable to banks when one

takes a look at the theoretical underpinnings of the mere existence of banks. There are

also features, that may make banks „special“ such as the presence of government

guarantees and the regulatory constraints applied to their capital structure. This would

all suggest, there is no merit in studying banks‘ capital structures because, they are just

unique in every aspect. Below, the standard theories of deviations from the perfect

worls are presented and applied on the banking firms, it turns out, that there might be

much more similarities between banks and non financial firms, as well as a fact that

banks might be subject to the same mechanics. From this analysis, the costliness of

equity will be discussed to prepare for an analysis for the methodological part of this

paper.

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While existence of banks lacks any justification in a world without frictions, several

authors posit that Modigliani & Miller needs to be the starting point for analysis of bank

capital structure choices.

In formulating their famous propositions, Modgliani and Miller (1958), henceforth M-

M, showed that in a world without frictions, where all investors have full access to

information and price risk rationally, the way how a firm is financed does not create

value. Their Proposition I states that: „the average cost of capital to any firm is

independent of its capital structure and is equal to the capitalization rate of a pure equity

stream of its class.“ (M-M, 1958, p. 268). Proposition II: „the expected yield of a share

of stock is equal to the appropriate capitalization rate (Re) for pure equity stream in the

class, plus a premium related to financial risk equal to the debt-to-equity ratio times the

spread between (Re) and (Interest rate charged on debt) (M-M, 1958, p. 271).

The frictions of the real world then allow for the value of the firm to be determined by

its capital structure choices – an optimal amount of leverage. There may be costs to

holding too much as well as too little equity. Moreover, there may be costs associated

with raising, rather than holding equity. There are also factors that are specific for banks

that need to be taken into account when analyzing their capital structure choices. The

sources of these costs are discussed below.

General theories of capital structure choice

The tradeoff theory states that there are offsetting effects from leverage (see e.g.

Bradley 1984). The existence of corporate tax rate makes leverage favorable because

the interest payments on debt are tax deductible, so maximizing leverage adds to the

value of the firm. The other side of the coin is that raising leverage increases the

probability of bankruptcy. Thus firms will optimize the amount of leverage up to

a point, where the marginal benefit of tax shield equals the marginal cost of rising

probability of bankruptcy.

Separation of ownership and control and asymmetric information give rise to agency

costs, where conflicts of interest arise between contracting parties – the conflict between

principal and agent. According to Jensen&Meckling (1976), if the owner-managers

have only a small stake in the firm, they migh be pursuing their own interests (for

example by perquisites consumption and empire building) instead of maximizing

shareholder value. Jensen & Meckling additionally show, how a conflict of interest

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exists between shareholders and creditors, stemming from the variable and fixed payoff

to shareholders and debt-holders, respectively. Shareholders benefit from investing in

riskier projects, gaining if the gamble succeeds, but this is detrimental to the debt-

holders, who bear the cost of increased probability of bankruptcy, in turn the

debtholders will demand a premium for this possibility and the ultimate cost is born by

the shareholders. Similar insights to the shareholder-creditor conflict are presented in

Myers (1977), the author adds the possibility of underinvestment. When the firm is near

bankruptcy, shareholders lack incentives to contribute new equity, thus giving up value-

increasing investments in anticipation that the benefits would accrue to creditors.

The above theories are concerned with the reason, why holding equity might be costly.

The insight into why raising equity might turn out to be costly and make firms seek

other sources of funding to undertake investments is given by Myers (1984) and

Myers&Majluf (1984). The authors suggest, that since managers hold inside

information about the firm’s state and prospects, the investors will regard the equity

issuance to be made exactly when the shares are overvalued. Investors will thus demand

a „lemon“ premium and will be only willing to purchase the issue for a discounted

price. This theory suggests, that firms will first choose to fund projects with funds that

are least informationally costly, yielding a „pecking-order“ theory, where the firm first

uses internally generated funds, then issues debt, and chooses to issue equity only when

previous sources cannot be used anymore.

Bank-specific features

Merton Miller, in his response to the question, whether the M-M theorem applies to

banks, stated: „The government payment guarantees for bank demand deposits, found

on no other corporate securities, will surely affect the cost of capital from this source.“

(Miller, 1995, p. 485).

Thus the presence of (underpriced) government safety net poses an addition to the

above outlined theories that might determine an optimal capital ratio. The market capital

„requirements“ as Berger (1995) calls them, will take account of these guarantees,

demanding a lower risk premium on their securities and leaving the bank to attain

a higher than normal leverage. Banks can be insulated from potential market discipline.

Apart from insured creditors, also those that are not explicitly insured may perceive

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themselves to have a de-facto guarantee. This would allow banks to increase their

leverage without suffering by having to pay higher interest rate on its liabilities.

Empirical evidence on capital structure theories for non-financial firms is vast and

evolving, producing a long list of factors that could be meaningful in determining

a pattern of firms‘ capital structure choices. Frank & Goyal (2007) make an attempt to

test overarchingly the performance of six „core“ factors out of 19, that are most

frequently associated with choices of leverage. The core factors include i) industry

median leverage; ii) market-to-book assets ratio; iii) proportion of tangible assets; iv)

profitability; v) firm size; and vi) expected inflation. Their conclusion goes, that

although these factors are significant on a standalone basis, when interpreted jointly,

they posit weaknesses in following the theoretical link between one another.

A recent study by Gropp and Heider (2010) seeks to apply the standard factors on

banks. The authors study a sample of 100 large publicly traded banks and bank holding

companies in the US and Europe over the period between 1991 and 2004. Their findings

indicate, that neither deposit insurance, nor capital requirements can explain the capital

structure of banks. Gropp & Heider conclude, that banks in their sample seem to

optimize their capital structure much like non-financial firms.

A rather alternative approach to test, whether bank capital matters was undertaken by

Mehran & Thakor (2009) they develop a model that predicts bank capital to be

positively correlated in the cross section, and test it using mergers and acquisitions data.

They find, that target bank’s equity has a significant positive relationship to the amount

of its capital. Thus concluding that higher levels of capital are cross-sectionally

correlated with higher bank values.

As a response to the argument of costliness of equity, there are two studies that examine

to what extent does the M-M principle of conservation of risk hold for banks.

Specifically, the theory would suggest, that if the bank’s ratio of equity to assets is

doubled, and if underlying riskiness of the assets does not change, its beta coefficient

should fall by one half.

Miles, Yang and Marcheggiano (2011) approach this question by examining six large

publicly traded banks in UK over the period between 1992-2010 using CAPM to

decompose asset betas into equity betas and assuming the debt is riskless. They regress

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half-yearly betas to get an estimate of how leverage ratio impacts the correlation

between market returns and bank equity returns. Results yield higly significant positive

relationship between leverage and equity betas. The authors then use the inputs to

compute weighted average cost of capital (WACC) assuming risk-free rate and risk

premium to be equal to 5%. The resulting WACC shows that a 45% M-M offsetting

effect is present.57 The authors then also estimate the regression in log specification, and

for the third case, without assuming that CAPM holds, they regress earnings-to-price

ratio (as a proxy for required returns on equity) on leverage. The two subsequent

estimates yield a WACC with 75% and 100% M-M offsetting effect, respectively.

A study by Kashyap, Stein and Hanson (2010) undertakes a similar investigation of

large US publicly traded banking firms with assets exceeding $10billon. They estimate

market betas and return volatilities using monthly regressions. Both of the regressions

yield statistically significant results satisfying the prediction that betas and volatilities

decrease as the ratio of equity to assets increases. The M-M principle of conservation of

risk is present to about two thirds.58

The results are clearly divergent. It can be the case, that capital is costly for banks to

hold, conversely it can increase the value. The third possibility is that the frictions,

while no reason to claim that they are not present in the real world, do allow the

classical theories to hold to a limited extent. It could then well be the case, that raising

equity is much more costly than just holding it, and holding lowest possible portions of

equity increases the returns, but at the expense of increased risk.

Loan Pricing

To evaluate the model that will be used for quantifying the impact of Basel III in the

following section of this paper, since it has implications for an increase in loan prices,

this sections will look at what factors come in the decision process when evaluating the

rate to be chaged on aloan. There are also aspects of the environment that determine the

feasibility of loan pricing choices.

57 Meaning that the WACC rose only 55% of the magnitude if there was no M-M offset. 58 Using the estimated coefficients, when doubling the equity-to-assets ratio, beta falls by 0.32 as opposed to a fall of 0.5 if the M-M held exactly.

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Decision to extend a loan involves taking various factors into account. In Saunders &

Cornett (2006, p. 297) a traditional return on assets approach is presented to arrive at a

contractually promissed return on a loan. The return will be affected by cost of funding

the loan, any fees related to the loan (e.g. for administrative expenses), borrower’s

credit risk premium, collateral backing the loan, and other non price items.

Although the parameters are all important, the component measuring risk is of particular

significance for bank’s decision process.

Hasan & Zazzara (2006) divide the risk-adjusted pricing into ‘technical‘ and

‘commercial‘ portions. Their focus is on technical pricing – to reflect the riskiness of

the loan, cost of expected and unexpected losses needs to be covered. The authors

employ a risk-neutral approach59 to express spread charged for the expected loss and

utilize the Basel II IRB formula for spread to cover unexpected loss. Where the risk-

adjusted spread is equal to (equation 3)60:

푆푝푟푒푎푑 = ×( ) − 1 − 푟 + 퐵2 × 푅푂퐸 (X)

The first term represents spread for expected loss and the second term is the IRB capital

requirement (B2) multiplied by the return on equity. The authors highlight the need to

properly account for regulatory capital constituting a risk-sensitive component of cost.

This is also the approach promoted by regulators, since it seeks to properly price the

total risk that a loan bring to its holder.

As pointed out by Stiglitz & Weiss (1981), however, under assymmetric information,

the interest charge reflecting risk might itself determine the average quality of

borrowers. Increased interest rate might lead to adverse selection of borrowers, because

those willing to borrow at high rates perceive their probability of repayingthe loan to be

low. Similarly, the borrowers might undertake projects with same expected returns but

much higher variance as a response to change in rates. The authors thus explain, why

banks ration credit among identical applicants. It is sometimes optimal for a bank to

extend only a limited amount of loans even if it has a capacity for more.

59 Under risk-neutrality, investors are indifferent between a risk-free investment and a risky investment with the same expected value. 60 For simplicity, only one period is assumed here

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Thus, the interest rate might not deliver the desired expected return to a bank. When

setting the loan terms, a common remedy is to limit the loan-to-value ratio or require

collateral to secure the repayment.

The price of a loan must also take into account the industry environment. Ruthenberg &

Landskroner (2007) present a loan pricing model taking into account banking industry,

that is characterized by imperfect competition. They examine the loan pricing

implications of the two approaches under Basel II- the standardized and IRB. The banks

are assumed to be risk neutral and maximize their expected profits with respect to their

decision variables – amount of loans extended and deposits. In their setting, the interest

rate on loans is determined by five parameters. The first one represents risk premium

expressed as a yield differential that takes into account borrowers‘ probability of

defaulting. Second term represents market structure, taking into account the Herfindahl-

Hirschman index of concentration in the loan market (bank’s market power) and the

elasticity of deman for loans. Next two terms are the risk-free rate and cost of rising

debt in the secondary market. The last component is given by the sensitivity of required

capital to changes in loans extended (or marginal capital requirement) multiplied by the

cost of equity capital. The authors test their model in context of Israeli loan market and

show that low risk customers will get a more favorable loan terms when choosing to

borrow from an IRB using bank. Higher risk customers, on the other hand will be better

of, when applying for a loan from bank that uses standardized approach to credit risk.

Taken from the other side, the larger, more sophisticated banks, that use IRB approach,

will experience an inflow of low risk borrowers, whereas the less advance banks, using

standardized approach, will end up holding a riskier portfolio.

Repullo & Suarez 2004 examine Basel II loan pricing in context of perfectly

competitive market for business loans. They assume risk neutral bank shareholders. The

competitive equilibrium interest rate is such, that makes each loan’s contribution to the

expected discounted value of shareholders’ final payoff equal to the initial equity

contribution that is required for the loan. The equity contribution is determined by IRB

capital requirement. Similarly to Ruthenberg & Landskroner, they come to a conclusion

that banks adopting the IRB approach will specialize in making loans to less risky

borrowers.

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For analyzing the potential reactions of banks to increased capital requirements, thus

several factors will need to be taken into account. The market environment, which will

determine the capacity tocharge higher rates and not loosing business to the

competition. The constraint given by deterring the low risk borrowers from applying,

when the interest rate is high enough so that mostly opportunistic projects will seek

financing. And lastly the amount of equity that will need to back the loan.

The next section turns to the impact assessment and will try to discuss these factors in

the analysis.

Impact Assessment of the Basel III Proposal

In this section, the accounting identities and neccessary equations will be presented and

discussed. Following through data description, I will explain, how the stylized balance

sheet and income statement were constructed. The final step of the methodological part

will yield an estimate of the lending spread change required to maintain the level of

return on equity (ROE). The assumptions underlying the methodology allow for

changing the scenarios to utilize previous discussion and adapt the possible strategies of

compliance with capital requirements to country-specific conditions.

Methodology

The mapping methodology is adopted from a study undertaken by King (2010), which

seeks to quantify the effect of increased capital requirement on lending spreads to

achieve a given level of steady-state ROE.

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The mapping assumes, that banks will pass on any additional costs by raising the cost of

loans to end-customers. By measuring the change in net income and shareholders‘

equity, the lending spread can be calculated, which is required to compensate for the

increase in capital requirements.

While King’s paper explicitly maps both, the requirements for capital and liquidity,

instead, this paper’s mapping will be focused on the capital requirements solely.

Undertaking an analysis of impact assessment will be made utilizing the results of EU

QIS which quantified how increased capital requirements, eligibility criteria and

deductions would affect the state of banks at the time it was undertaken.

Mapping the increased capital ratio into lending spreads

The mapping exercise begins with defining the stylized balance sheet for a

representative bank. The asset side (equation 4) consists of cash and balances with

central bank, interbank claims, trading related assets, loans, investments and other

assets.

퐴푠푠푒푡푠

= 퐶푎푠ℎ + 퐼퐵푐푙푎푖푚푠 + 푇푟푎푑퐴푠푠푒푡푠 + 퐿표푎푛푠 + 퐼푛푣푒푠푡푚푒푛푡푠

+ 푂푡ℎ푒푟퐴푠푠푒푡푠 (4)

The liabilities‘ side (equation 5) includes deposits, interbank funding, short-term

liabilities, trading liabilities, long term wholesale funding, and other liabilities (non-

interest bearing). The distinction between the short- and long-term nature of liabilities is

neccessary for computing the cost of interest bearing liabilities separately, which will be

used for more precise calculation of interest expenses.

퐿푖푎푏푖푙푖푡푖푒푠

= 퐷푒푝표푠푖푡푠 + 퐼퐵푓푢푛푑 + 푆ℎ표푟푡퐿푖푎푏푠 + 푇푟푎푑퐿푖푎푏푠 + 퐿푇푤ℎ표푙푒푠푎푙푒

+ 푂푡ℎ푒푟 (5)

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The stylized income statement shows the composition of income and expense items

(equation 6). Regarding revenues, a distinction is made between interest income on

loans, other interest income, and non-interest income. The cost items are then

represented by interest expense and operating expenditures61. Interest expense is due on

deposits, interbank funding, short-term liabilities, trading liabilities and long-term

wholesale funding. Net income equals total revenues less total operating expenses and

income tax.

푁푒푡퐼푛푐

= (퐼푛푐퐿표푎푛푠 + 푂푡ℎ푒푟퐼푛푡퐼푛푐 − 퐼푛푡퐸푥) + 푁표푛퐼푛푡퐼푛푐 − 푂푝퐸푥) × (1

− 푡푎푥) (6)

Distinguishing between interest bearing liabilities - the different components of interest

expense - is neccessary in order to capture the decrease in interest expense which will

be realized as debt is crowded out by the increase in equity. Thus a distinction is made

on the basis of a one-year threshold for the maturity of liabilities (equation 7).

퐼푛푡퐸푥 = 푟 × 퐷푒푝표푠푖푡푠 + 푟 × (퐼퐵푓푢푛푑 + 푆ℎ표푟푡퐿푖푎푏푠 +

푇푟푎푑퐿푖푎푏푠+푟퐿푡퐷푒푏푡×퐿푇푤ℎ표푙푒푠푎푙푒

(7)

Where 푟 is the cost of deposits, 푟 is the cost of short-term liabilities

(which is payable on interbank funding, short-term liabilities and trading liabilities), and

푟 is the cost of debt with maturity of more than one year. Since this distinction is

not separately disclosed, but agregated in the interest expense item, the separate cost of

interest bearing liabilities can be calibrated based on the ratio of interest expense to

interest paying liabilities solving for the three following equations:

푟 =

푥 (8)

61 Include personnel expenses, administrative expenses, and other operating expenses

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= 푥 + 0.01 (9)

= 푥 + 0.02 (10)

As pointed out in King (2010) the lower cost of deposits reflects the fact that they are

insured by government and thus least risky, and futhermore, this calibration of spreads

also reflects the upward sloping yield-curve. This specification is adopted from King

(2010) and represents long-term historical averages for the sample of his study. The cost

of each type of liabilities can be then calculated as (equation 8 is arrived at after

combining equations 8,9,10, and 11 and rearranging to solve for x):

=퐼푛푡퐸푥 − 0.01 × 푆ℎ표푟푡푇푒푟푚퐷푒푏푡 − 0.02 × 퐿표푛푔푇푒푟푚퐷푒푏푡

퐷푒푝표푠푖푡푠 + 푆ℎ표푟푡푇푒푟푚퐷푒푏푡 + 퐿표푛푔푇푒푟푚퐷푒푏푡 (11)

Where ShortTermDebt consists of interbank funding, short-term liabilities and trading

liabilities.

Turning to the last source of funding, shareholders‘ equity, the estimate of expected

return on equity is obtained by averaging the ratio of net income to shareholders‘ equity

over the sample period (equation 12)62.

푟 = 푅푂퐸

=푁푒푡퐼푛푐표푚푒

퐸푞푢푖푡푦 (12)

Here, no distinction is made between the different components that constitute

shareholders‘ equity, to the extent equity-like securities63 bear different cost, this

estimate might provide an upward bias. Nevertheless, since Basel III will raise the

62 For equation 12, average data over the period 2006-2010 is taken from NBS statements 63 No specification of the components of share capital is given in the NBS statements.

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tangible common equity element and poses a stricter definition of eligible capital, the

results should not be far from reality.

The expected return on equity will be the highest among the different sources of

funding, followed by cost of long-term, short-term, and deposit funding, respectively.

Being the most senior claim, the highest return corresponds to its highest riskiness.

Accounting and regulatory capital need to be distinguished since the latter is related to

riskiness of assets. The National Bank of Slovakia (NBS) statements, used for

calculation, do not provide the regulatory ratios, nor the amount of risk-weighted assets

(RWA). The ratio of RWA to total assets (TA) as well as total capital ratio (TCR) is,

instead obtained from OECD banking statistics64, as an average over the period 1999-

2009 (equation 13).

푇표푡푎푙 퐶푎푝푖푡푎푙 푅푎푡푖표 =

(13)

The data thus do not allow to follow King (2010) exactly, however this does not lead to

any shortcomings. The neccessary information is given in the ratio of RWA to TA as it

is needed to determine the required increase in equity to TA. If the ratio of RWA to TA

is 41,91% (as is the case in further calculations), it means, that for a 1 percentage point

(pp) increase in the TCR, the ratio of equity to TA will need to be increased by 41,91

basis points (bp) holding the size and composition of the balance sheet constant.

Equation 11 shows the increase in equity, when the TCR is increased by 1pp.

퐸 = 퐸 + ∆푇표푡푎푙 퐶푎푝푖푡푎푙 푅푎푡푖표

× 푅푊퐴 (14)

The increase in equity will be matched by an equal and offsetting decrease in liabilities.

It is assumed, that the most expensive long-term wholesale liabilities will be substituted

for in the first place (equation 12).

64 Available from: http://stats.oecd.org.www.baser.dk/BrandedView.aspx?oecd_bv_id=bank-data-en&doi=data-00270-en

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∆퐿푇푤ℎ표푙푒푠푎푙푒

= −∆퐸푞푢푖푡푦 (15)

This change will lead to a rise in the cost of capital since debt is crowded out by the

more expensive equity, but simultaneously to a decrease in interest expense as the

amount of debt outstanding declines. Net income will increase, but since the equity now

represents a larger proportion (increasing the denominator of ROE), ROE will fall.

Finally, it is assumed that the fall in ROE is offset by raising the lending spread (α)

charged on loans. Since lending spread is not disclosed in the statements, the effect will

be modelled as an increase in the average spread charged on outstanding loans (equation

16).

퐼푛푐표푚푒퐿표푎푛푠

= 퐼푛푐표푚푒퐿표푎푛푠 + 훼

× 퐿표푎푛푠 (16)

The neccessary increase in lending spread is such, that the increase in the cost of capital

is exactly offset by an increase in net income (equation 17). Thus keeping the ROE

unchanged.

=

(푅푂퐸 × 퐸 )(1 − 푡푎푥) − (푂퐼푛푡퐼푛푐 − 퐼푛푡퐸푥 + 푁표푛퐼푛푡퐼푛푐 − 푂푝퐸푥 ) − 퐼푛푐퐿

퐿표푎푛푠

(17)

With this methodology, a measure of lending spread can be obtained, that is needed to

offset the fall in ROE associated with a 1pp increase in regulatory capital ratio.

Description of data

Lending spread

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The focus of this study is on bank lending spreads, which is the spread between a bank’s

cost of liabilities and the average rate charged on its loan portfolio.

In Repullo & Suarez (2004) the deposits are assumed to carry a risk free rate, and the

authors define lending spread as the rate charged over deposits. Similar specification

will be used for this purpose, also due to availability of data. Average lending preads,

measured as interest charged by banks on loans to prime customers less the rate paid on

demand deposits.65 Figure 2 shows the evolution of lending spreads in Slovakia over the

period from 1993 to 2007. This time series gives an average spread of 5.09%.

Figure 2

Source: www.indexmundi.com

Construction of representative statements

To construct the neccessary stylized balance sheet and income statement, data from

NBS statistics for the sector of credit institutions is used.66 The availability of yearly

data series of credit institutions‘ balance sheets and income statements is limited to the

period between years 2006 and 2010. The composition of the banking sector during

sample period ranged from 25 institutions in 2006 to 30 institutions in 2010. As

65 Source: Indexmundi, available at: http://www.indexmundi.com/facts/slovak-republic/interest-rate-spread#FR.INR.LNDP; visited on 2.8.2011 66 The statements are available from NBS website: http://www.nbs.sk/en/statistics/money-and-banking-statistics/source-statistical-data-of-monetary-financial-institutions

0123456789

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Lending spread in %

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mentioned, the average ratios of TRC to RWA and RWA to TA are computed based on

data taken from OECD67, covering the period of 1999-2009. The stylized statements

then comprise average values of items over the sample period as percentage of assets.

67 Available from OECD Banking Statistics: http://stats.oecd.org.www.baser.dk/BrandedView.aspx?oecd_bv_id=bank-data-en&doi=data-00271-en

Table 2: Stylized balance sheet and income statement, 2006-2010

(As percentage of total assets)

BALANCE SHEET Average INCOME STATEMENT Average

Cash and balances at Central Banks 13.72% Interest income on loans 3.76%

Interbank claims 6.64% Interest income excl. loans 0.89%

Trading related assets 7.03% Interest expense 1.98%

Loans, leases, mortgages 51.31% A. Net interest income 2.67%

Investments and securities 19.08% Trading income 0.74%

Other Assets 2.22%

Non-interest income excl.

trading 1.09%

TOTAL ASSETS 100.00% B. Non-interest income 1.83%

C. Total revenues (A+B) 4.50%

D. Total operating expenses 2.50%

Deposits 32.84% E. Operating profit (C-D) 2.00%

Short-term liabilities 34.96% Income tax provision 0.44%

Interbank funding 12.15% Net income 1.56%

Trading related liabilities 3.40%

Long-term Wholesale funding 5.73%

Other Liabilities 2.54%

Total liabilities 91.62%

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Table 2 shows the stylized balance sheet and income statement for the sector of credit

institutions. The values are shown in percentage of total assets. Importantly, loans

represent about half of the total assets, followed by investments (19.08%), cash and

central bank balances (13.72%), trading related assets (7.03%), and interbank claims

(6.64%). The most important sources of funding are deposits (32.84%), short-term

liabilities (34.96%), interbank funding (12.15%), and long-term wholesale funding

(5.73%). Risk weighted assets make up 41.91% of total assets.

Composition of the income statement shows interest income on loans as the most

significant item of income, followed by non-interest income, which is lower by about a

half. Total operating expenses are almost of the same magnitude as net interest income.

Average effective tax rate over the period stood at 22.09%, yielding a net income (or

return on assets) of 1.56% of total assets, and subsequent average ROE of 18.63%. As

can be seen, the leverage multiple over the period averaged about 12 times, alternatively

expressed as 8.38% ratio of equity to total assets.

From the data obtained after averaging the diferent components of balance sheet and

income statements for the sector, it is possible to proceed to measurement of impact of

increased capital requirements.

Estimates of higher capital requirements

Table 3 outlines the calculation of increase in lending spread, while keeping the cost of

equity and cost of debt unchanged, which will be relaxed further in the text. In the first

column, the initial values are presented. In column B, the ratio of Total Capital/RWA is

increased by 1 pp, given that the RWA remain at 41.91% of total assets, the increase in

Equity 8.38% ROE 18.63%

Total Liabilities and Shareholders'

equity 100.00% Leverage multiple 11.93

RWA/TA 41.91% Average effective tax rate 22.09%

Source: National Bank of Slovakia, OECD, Author's calculations. Totals may not add up due

to rounding.

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regulatory capital ratio translates into a 41.9 bp increase in equity. The increase in

equity is exactly matched by the same decrease in proportion of wholesale funding,

which in turn reduces the interest expenses by 1.4 bp and subsequently pre-tax income.

While net income increases, the share of equity financingcauses the ROE to fall by 75.6

bp.

Column D shows the increase in lending spread, that is required to maintain the starting

level of ROE. To offset the effect of increased equity cushion, ore-tax income needs to

increase by additional 8.5 bp. Since loans represent 51.3% of assets, the lending spread

needs to increase by 16.7 bp.

Table 3: Calculation of increase in lending spreads for 1pp increase in capital ratio

assuming no change in ROE or cost of debt

(A)

Before

No increase in lending

spread

Increase in lending

sread

(B)

After

(C)

Change

(D)

After

(E)

Change

Total Capital / RWA 13.49% 14.49% 1.00% 1.00%

RWA/Total Assets 41.91% 41.91% 0.00% 0.00%

Equity 8.38% 8.80% 0.42% 0.42%

Wholesale funding 5.73% 5.31% -0.42% -0.42%

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Increase in lending spreads

0.00% 0.17%

Interest income on loans 3.76% 3.76% 0.00% 3.85% 0.09%

+Interest income ex loans 0.89% 0.89% 0.00% 0.89% 0.00%

=interest income 4.65% 4.65% 0.00% 4.73% 0.09%

-interest expense 1.98% 1.96% -0.01% 1.96% -0.01%

=net interest income 2.67% 2.69% 0.01% 2.77% 0.10%

+non interest income 1.83% 1.83% 0.00% 1.83% 0.00%

=Revenue 4.50% 4.52% 0.01% 4.60% 0.10%

-Opex 2.50% 2.50% 0.00% 2.50% 0.00%

=Pre tax income 2.00% 2.02% 0.01% 2.10% 0.10%

NET INCOME 1.56% 1.57% 0.01% 1.64% 0.08%

ROE 18.63% 17.87% -0.76% 18.63% 0.00%

Source: National Bank of Slovakia, OECD, author's calculations. Totals may not add up due

to rounding

Having obtained the measure of lending spread to offset a 1pp increase in regulatory

capital ratio, the discussion will now turn to the impact of increased requirements and

strenghtened definitions of capital under Basel III regime.

Impact of Basel III on Slovak banking sector

To utilize the calculations of assumed increase in lending spread as a possible reaction

to the new capital regime, the results of EU QIS will be used to estimate a magnitude of

potential shortfall due to increased requirements, stricted elligibility criteria and wider

range of deductions. After having illustrated the simulated capital ratios, the pricing

constraints given the competitive environment and other aspects affecting the feasibility

of linearly raising the rate charged on loans will be discussed.

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Table 4 shows the effect of new definitions of capital as well as the distances from

minimum required ratios and initial ratios.

A decrease of one third from initial capital ratios would set the Slovak banking sector

very close to the current minimum of 8%, moreover, falling short by 1.52% from the

minimum when Basel III will be fully in force. While gradual implementation will give

banks fairly enough time to adjust, since the initial ratio of more than 13% is a longer

term average, if the banks want to keep this buffer they will need to raise three times as

much capital as would be needed to comply with Basel III minimum.

Table 6:

Offsetting

measures

Increase in

lending spread

Fall in ROE and/or cost of debt of

10bp 15bp 20bp

Original level 74.94 65.03 60.08 55.12

Basel III

minimum 24.98 21.97 20.29 18.62

Table 6 shows the total rise in lending spread that would be necessary to maintain the

current ROE of 18.6%. Keeping in mind the historical 5%, these increases would

represent almost 15% increase of the average.

Table 4: Effect of Basel III on Slovak baning sector

Initial level of

TRC/RWA

Shortfall due

to new

definition of

capital

(Group 2

banks)

TRC/RWA

after EU QIS

deductions

Distance from

initial level of

TRC/RWA

Distance from

Basel III 10.5 %

minimum

requirement

effective from

2019

13.49% 33.40% 8.98% 4.50% 1.52%

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Given that concentration ratio of the five largest banks in extending loans averaged

about 70% of the total lending, which is also similar for the share of deposit market

(73%)68, banks posses the pricing power, as documented by Ruthenberg&Landskroner

(2007).

Competitive constraints imposed by alternative sources of funding from capital markets,

are very weak in Slovakia. Of the total bond market, in year 2010, 80% is represented

by government bonds and the ratio of total capitalization of the bond market to GDP is

25%, the stock market capitalization totaled 6% of GDP.

On the other hand, the linear dependency of the rise in lending spread on increases in

capital ratios will not be realistic. Rise in lending spreads for each 1pp of capital

shortfall will most likely have to be marginally diminishing given the contraints on

charging higher rates. As pointed out by Stiglitz&Weiss (1981), higher interest charge

might lead to adversely selecting riskier borrowers, which could lead to higher loan

losses and thus lower income. The higher the capital shortfall will be, the more will the

individual bank need to search for other cources of income, such as increasing non-

interest income, lowering expenses or accepting the fall in ROE

Based on the results from discussion of bank capital structure, it would not be

unreasonable to assume the cost of equity would stay unchanged. As the studies by

Miles, Yang, and Marcceggiano (2011) and Hanson, Kashyap and Stein (2010) showed

there is at least some offsetting effect from the mechanism that increased equity cushion

decreases the volatility of equity and thus decreases the risk premium it must bear.

Therefore assuming a decrease of 10 – 15 bp in ROE for every 1pp increase in

regulatory capital ratio would seem reasonable.

Higher capital requirements, however, may lead to less desirable bank behaviour, such

as increasing the riskiness of their activities or increasing funding and currency

mismatches. Banks may also spend less time on monitoring

68 These numbers represent average values for the period between 2007 and 2010. Source: NBS (2007-2010)

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Conclusion

This paper has sought to study the theoretical underlyings for the existence of banks in

the financial system and the associated challenges it may pose. The asymmetric

information and transaction costs rationales for existence of banks also point toward

a more understanding of the underlying principles of regulation.

Assessing, however, whether the system of capital requirements is beneficial of

detrimental seems to be an ever challenging task not only for the theoretical research,

but also for empirical investigation.

From the point of view of the social planner, one needs to weigh benefits and costs of

imposing any type of instrument, like capital regulation, that could possibly bring

frictions into how the business functions.

Another aspect is, when there are systemic threats stemming from at this stage rather

uncontrollable degree of development that leads to a network of interlocking claims,

that one can hardly understand.

The crisis experience showed, that there are externalities to operating at the very edge of

profitability and insolvency. When government and taxpayers‘ money comes into

account, then however it is not a private game anymore.

Regulation of bank capital could be called controversial in its achievements. If this is

either for the procyclical issues that it poses or for the distortive effects on the decision

making process of the agents. A backstop, however needst to exist to limiti the kinds of

irresponsible behavior that occured during the crisis.

The new Basel III framework will indeed mean a „significant“ strenghtening in the loss

absorbency of financial institutions, provided that all the risks can be captured for the

given solvency level.

The impact on banking sector of Slovakia will not seem to be large.

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