Capital regulation and rising risk of banking industry: a financial accounting perspective.

Author:Bhattacharya, Hrishikes
Position::Abstract
 
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INTRODUCTION

Banking is the most regulated among all industrial sectors of the economy. Thirty years ago Buser, Chen and Kane (1981) remarked that, "a bank has traditionally been conceived as more than just another business firm; it operates under unusual regulatory restrictions.....". Since then the regulatory environment surrounding banks has not changed much. When financial market was deregulated in the early 1980s banks were reregulated by more stringent capital regulation which restricted their asset generation capacity. Banking is now the only industry that is subjected to international capital regulation supervised through Basle Capital Accords.

Banks may be special institutions but they are primarily business organizations whose ultimate aim is to generate enough profit to satisfy a market determined ROE. Capital structure (mix of equity and debt) of any business is an endogenous variable geared towards generating a required level of sales (which is also an endogenous variable) with a certain return from which to earn the required profit to satisfy the required ROE. For banks, sales are analogous to generating banking assets; everything else is same. Regulatory intervention seeking to alter the capital structure of banks, transforms the character of some of the endogenous variables (like leverage, assets-capacity etc.) to exogenous variables. As capital regulation is administered through capital-assets ratio, a rise in the ratio lowers down the sales (banking assets) generation capacity of banks. A transition from a low capital regime (pre-regulation) to high capital regime (post- regulation) 'reduces the banks' future ability to pledge which can lead to a bank run because maturing deposits may exceed what the bank can pledge' (Diamond and Rajan, 2000). With fewer assets available banks may be forced to cross boundaries and reach for high-return-high- risk assets which has the potential of endangering the system as a whole.

In particular, the paper seeks to establish the following:

  1. Bank capital regulation has reduced the rate of growth of assets of US banks substantially over the pre-regulation period. The reduced level of assets has motivated the banks to make investments in assets with higher rate of return in order to earn enough to satisfy required return on equity (ROE).

  2. As higher rate of return on assets is associated with higher risk, capital regulation has ultimately resulted in increasing level of asset losses, thereby increasing the risk of the banking industry.

    Unlike Saunders (2000) and Flannery and Rangan (2004) who prefer market value accounting, we have followed book value accounting as in Kopecky and VanHoose (2006). This approach appears to be more appropriate while presenting a critique of bank capital regulation which itself is based on book-value accounting. Moreover, closure decisions of bank regulators are also based on book value accounting. Definitions of variables are given in the Appendix.

    The study is based on the data of US insured banks for the period, 1950-2004 as available from Historical Statistics on Banking published by Federal Deposit Insurance Corporation (http://www2.fdic.gov/hsob/hsobrpt.asp, accessed on June 26, 2011).

    Prior to 1980 bank supervisors in the US did not impose specific numerical capital adequacy standards. Instead, the supervisors applied informal and subjective measures tailored to the circumstances of individual institutions. Since 1980, bank supervisors had placed much more emphasis on precisely defined numerical minimum capital standards. This was later firmed up with the passage of Institutional Lending and Supervision Act of 1983, which adopted a leverage ratio of primary capital (consisted mainly of Equity and Loan Loss Reserves), to average total assets (Besanko and Kanatas, 1996; Federal Deposit Insurance Corporation (FDIC), 2003). The first Basle capital accord, which was introduced in 1988, expanded the idea and brought in international convergence of capital standards. The data-period for the study is, therefore, divided in two parts: (1) Pre-regulation period (1950-1979) and (2) Post-regulation period (1980- 2004).

    The study is diagnostic in nature. Statistical models presented in the text are based on ordinary least square linear regression. In a time series model presence of serial correlation, though does not cause bias in the estimate of the regression coefficients, may result in underestimation of standard errors (and overestimation of 't' values), which may question the validity of the model. We have, therefore, tested autoregressive models as prescribed in the Ochrane-Orcutt estimation procedure wherever serial correlation is found to be present at [alpha]=0.01. It has been observed that though the 't' values of regression equations have fallen as expected, they mostly remain significant (or otherwise) as in OLS estimations presented in the text.

    We have not also detrended the data in the text, as our purpose is to capture the trends. However, in order to bring out the correct trends it may be necessary to eliminate any obscuring cyclical or random (irregular) fluctuations. Following Demirguc-Kunt and Detragiache (2005) we have excluded unusual years from our data set, wherever found appropriate, to partially minimize the impact. Additionally, we have run regressions on three-year moving average data of the variables. Findings are similar to those in the text.

    General assumptions

  3. Cash flows from securitized assets are continuously invested in either balance sheet assets or other securitized assets. Income (loss) derived from such transactions is ultimately reflected in the return on (balance sheet) assets.

    Risk is defined as the probability of loss of assets. As losses are materialization of risks, rise in assets loss is considered as an indicator of rising risk of the banking industry.

  4. While calculating capital ratios subordinated debt is excluded; only Tier I capital (equity) is considered. This is in line with major studies cited above. For the period 1980-04 average subordinated debt is found to be only 11.5 percent of total 'regulatory capital' of US banks.

    RELATED LITERATURE

    There are arguments for and against capital regulation, which are summarized below. Some of the papers referred here have featured in both sets of arguments. This is either due to their being review articles or the author(s) is (are) referring an argument which may not be the main theme of the paper. Our intention is to divide the arguments between two groups, not the authors.

    Arguments for Capital Regulation

  5. Banks are more risky than any other business firm; capital reduces banks risk-taking ability, provides risk-mitigating incentive for bank managers (Ross, 1977, Harris and Raviv, 1990, Cebenoyan and Strahan, 2004).

  6. Banks are vulnerable to runs due to provision of liquidity services; the depositors suffer from an asymmetry of information about bank's assets which may cause runs; an all deposit structure could lead to runs when real assets value falls; bank's capital, therefore, provides a kind of cushion against losses for depositors (Diamond and Dybvig, 1983, Jacklin and Bhattacharya, 1988, Bhattacharya and Thakor, 1993, Kashyap, Rajan and Stein, 2002, Morrison and White, 2005).

  7. Increase in leverage increases the cost of financial distress; cost of financial distress rises with the decline of capital ratio (Cooke, 1990, Berger, Herring and Szego, 1995).

  8. Banks are prone to take extra-ordinary risks; high risk-taking has almost become part of banking culture--a protective equity cushion should vary directly with a bank's risk exposure (Kerkhof and Melenberg, 2004; Lindquist, 2004,. Kopecky and VanHoose, 2006, Rajan, 2005, Kashyap, Rajan and Stein, 2002).

  9. Capital regulation is necessary for long-term solvency and public credibility--capital acts as a buffer against insolvency; maintenance of a sufficient capital cushion can solve the financial fragility problem and prevent liquidity crisis from occurring. (Dowd, 2000, Kashyap, Rajan and Stein, 2002, Barrios and Blanco, 2003).

  10. In the absence of sufficient equity 'at stake' banks may make investment decisions which could be sub-optimal for the society, though optimal for the shareholders; banks are motivated to reduce assets risk on the face of higher capital requirement; it induces the banks to choose safer assets, thereby mitigating 'moral hazard' problem that depositors face. (Furlong and Keeley, 1989, 1990, Cooper and Ross, 2002).

  11. Capital regulation has the desirable effect of discouraging unsound and undesirable institutions from setting up operations (Morrison and White, 2005).

  12. Increasing the capital standards results in a contract adjustment that mitigates between the higher cost of required capital and the cost of probable bankruptcy, which lowers the risk of insolvency (Santos, 1999).

  13. When monitoring costs are above a critical level, regulators are able to increase efficiency by imposing higher capital adequacy requirement (Morrison and White, 2005).

  14. In a real world, only a small fraction of the banking system is typically constrained by capital requirements (VanHoose, 2007).

  15. Capital regulation is necessary but, in a dynamic environment, it is not sufficient to protect banks from high risk-taking; it should be combined with deposit-rate controls (Hellman, Murdock and Stiglitz, 2000).

    Arguments against Capital Regulation

  16. Higher capital ratio does not always predict a lower probability of bank failure--the relationship between the capital ratio and bank safety is often weak (Thomson, 1991).

  17. Capital regulation decreases loan supply, dampens entrepreneurial activity, reduces the size of banking industry and quantity of intermediation; it may also exacerbate the business cycle and even accentuate systemic risk (Santomero and Watson, 1977, Crocket, 2000, Acharya, 2001, Kopecky and VanHoose, 2004, Estrella, 2004).

  18. If it is too costly for a bank to raise equity to meet higher capital standards tomorrow, an alternative is...

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