OPTIMAL REGULATION OF BANK CAPITAL AND LIQUIDITY

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OPTIMAL REGULATION OF BANK CAPITAL AND LIQUIDITY
Course on Financial Instability at the Estonian
Central Bank, 9-11 December 2009 Lecture 8

• E Philip DavisNIESR and Brunel UniversityWest
  Londone_philip_davis_at_msn.comwww.ephilipdavis.com
  groups.yahoo.com/group/financial_stability

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Abstract

• Raising capital adequacy standards and
  introducing binding liquidity requirements can
  have beneficial effects if they reduce the
  probability of a costly financial crisis, but may
  also reduce GDP by raising borrowing costs for
  households and companies.
• We estimate both benefits and costs of raising
  capital and liquidity, with the benefits being in
  terms of reduction in the probability of banking
  crises, while the costs are defined in terms of
  the economic impact of higher spreads for bank
  customers.
• Result shows a positive net benefit from
  substantial regulatory tightening, depending on
  underlying assumptions.

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Structure

• Introduction
• Literature survey
• Could we predict the crisis?
• Impact of the crisis
• Modelling the banking sector
• Costs and benefits of tighter regulation
• Conclusion

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1 Introduction

• NIESR research for FSA - background is recent
  crisis and discussion of regulatory changes at
  global level authors Ray Barrell, E Philip
  Davis, Tatiana Fic, Dawn Holland, Simon Kirby and
  Iana Liadze
• Review literature on bank behaviour relative to
  regulation of capital and liquidity
• Then assess whether a link of capital and
  liquidity to crisis probabilities can be traced
• Consider long run cost of crises (scarring)
• Model behaviour of banks, impact on economy
• Consider over what range there are positive net
  benefits to regulatory tightening

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2 Literature survey

• Much theoretical work abstracts from regulation
• Most relevant is on bank capital buffers
• and UK empirical work showing regulation
  (trigger ratios) is main determinant of capital
  held and also impacts loan supply
• Overall procyclicality of capital and balance
  sheet, and impact of introduction of Basel in
  early 1990s (credit crunch)
• Cross country work showing impact of
  capitalisation on margins
• Controversy regarding relevance of MM
• Developing literature on crisis probabilities

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UK bank capital adequacy
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3 Predicting crises

• Most work on predicting crises, such as Demirguc
  Kunt and Detragiache (1998) uses logit and
  estimates across global sample of crises (mainly
  in emerging market economies)
• Typically crises found to be correlated with
  macroeconomic, banking sector and institutional
  indicators
• Low GDP growth, high interest rates, high
  inflation, fiscal deficits.
• Ratio of broad money to Foreign Exchange
  reserves, credit to the private sector/GDP ratio,
  lagged credit growth
• Low GDP per capita and deposit insurance.

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Could they predict the crisis?

• Traditional crisis prediction models did not pick
  up the risks that were developing (Davis and
  Karim 2008)
• The build up of debt was worrying
• The house price bubble was a concern
• The regulatory architecture was flawed
• The dangers of securitisation were not seen
• None of these were under the control of the
  monetary authorities
• A crisis means credit rationing
• (Barrell et al 2006 Journal of Financial
  Stability)

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Explaining Crises
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Comments on results

• We use unadjusted capital adequacy due to data
  limitations over 1980-2006 sample
• Changes in capital alone twice as effective as
  liquidity according to estimate
• Results show substantial reduction in crisis
  probabilities from regulatory tightening in
  Europe using OECD logit
• Weaker effect in US, which we consider relates to
  omission of off balance sheet activity work
  under way to rectify this

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4 Impact of the crisis

• Seek to assess effect of current crisis on UK
  economy, as a benchmark for benefits of
  regulation
• Key background is approach of Hoggarth and
  Sapporta (2001) who saw costs of crisis as
  integral of output lost below previous trend
• Highlight that initial recession is only part of
  costs given the possible long run effect on
  capital stock (scarring)

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Assessing long run costs of crises
Output depends on the supply side as described
by the production function
The equilibrium capital output ratio depends on
the user cost of capital
The user cost is driven by weighted average cost
of capital, linked in turn to risk free long real
rates (lrr) and by the borrowing margin charged
by banks (corpw) or the bond market (iprem) to
reflect costs and risks
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Risk premia on corporate borrowing rose in 2007-9
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Trend UK output and the scar

• Trend output has stepped down
• Risk premia rose in two stages before and after
  Lehmans this reduced trend 3-4
• Banking sector gains were illusary (1-2)
• In-migration will fall reducing trend by ¾
• There is only a 1 in 20 chance output will be at
  July 2008 projections in 2018

Output projections and scarring from the Crisis
July 2008 forecast
95, 90 and 80 confidence bounds around April
forecast
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5 Modelling the banking sector

• Shown that regulation has benefits in reducing
  incidence and costs of crises
• May also have a negative impact on output in both
  the short and the long run by increasing
  borrowing costs and raising user cost of capital
  (an effective tax on banks has real effect, e.g.
  widens spreads)
• So model effects of regulation on output by
  constructing banking sector model and embedding
  in NiGEM
• Use the risk weighted capital adequacy, but
  correlation of 0.92 to unweighted

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NiGEM model

• NiGEM covers the OECD economies
• Supply and demand spelled out
• Trade and capital account linkages
• Stock flow consistent
• Long run properties as a DSGE model
• Financial and exchange markets forward looking,
  as is the wage bargain
• Capital stock depends on user cost and on
  expected output 4 years ahead
• Increasing spread between borrowing and lending
  rates for individuals changes their incomes, and
  decision making on the timing of consumption,
  with possibility of inducing sharp short term
  reductions (no long run effect).
• Changing spread between borrowing and lending
  rates for firms may change user cost of capital
  and hence equilibrium level of output and capital
  in the economy in a sustained manner (short and
  long run effects).

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UK banking sector model

• Banking activity modelled as a set of supply (or
  price) and demand curves.
• Demand depends on levels of income or activity,
  and on relative prices, whilst supply, or price,
  depends upon the costs of providing assets and on
  the risks associated with those assets.
• Banking sector has four assets
• secured loans to individuals for mortgages,
  (morth) with a borrowing cost (rmorth),
• unsecured loans to individuals for consumer
  credit (cc) with a higher borrowing cost or rate
  of return (ccrate),
• loans to corporates (corpl) with a rate or return
  or cost of borrowing (lrrcorpw) where lrr is the
  risk free long rate and corpw is the mark up
  applied by banks
• liquid assets (lar).
• The categories subsume, along with deposits and
  risk weighted capital adequacy itself (levrr),
  all on-balance sheet activity within the UK.

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Key equations

• Corporate spread related to capital adequacy and
  inverse of headroom to trigger ratio
• Household spread related to capital adequacy

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Model details

• Each spread feeds into borrowing cost and then
  credit volume, with appropriate signs
• No direct role for liquidity (effect is
  calibrated based on estimated results for US)
• One to one relation of bank spread to bond spread
  (arbitrage)
• Adjustment equations for balance sheet and capital

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Tighter regulation and margins
Note changes to target capital only
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Tighter regulation and output
Note equal changes to target and actual capital
in this and following
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(6) Costs and benefits of tighter regulation

• Compare the gains from tighter regulation to the
  costs of regulation
• Gains are the change in the probability of a
  crisis times lost output in this crisis
• Costs are regulatory impacts
• Look at steady state impacts in 2018

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Borrowing costs
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Long run - regulation on output
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Cost benefit analysis - combined
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7 Conclusions

• Lax regulation raises the risk of a crisis
• Raising capital adequacy standards and
  introducing binding liquidity requirements
  beneficial if they reduce probability of costly
  financial crisis
• Also costs - any effective banking regulation
  works as a tax on bank activity. Hence
  regulations may reduce output through impacts on
  borrowing costs for households and companies

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• Find short run impact on consumption and short
  and long run impact on investment
• Estimates of impacts on costs are upper bound as
  structure of portfolios and of relative prices
  may change if regulations significantly tighten
• When capital adequacy standards tightened by 1
  pcp, banks contract balance sheets by 1.2 per
  cent and reduce riskiness of portfolio, with
  their risk weighted assets falling by 1.6 per
  cent - results contrary to the Modigliani Miller
  theorem of irrelevance of the debt equity choice

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• Caution needed with rapid regulatory tightening
  owing to immediate impact on margins
• Positive net benefit from regulatory tightening,
  with a 2 to 6 percentage point increase in
  capital and liquidity ratios increasing welfare,
  depending upon assumptions
• Separate tightening of capital or liquidity
  ratios offers benefit up to 10 percentage points

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References

• Barrell R, Davis E P, Fic T, Holland D, Kirby S,
  Liadze I (2009), "Optimal regulation of bank
  capital and liquidity how to calibrate new
  international standards, FSA Occasional Paper No
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