The Optimal Level of Capitalization
The impact of Basel II on Bank Capitalization
The global financial crisis has highlighted the importance of prudential regulation of banks for ensuring stability of the global financial system. Yet, there is no consensus on the best way for regulating banks among both academic researchers and practitioners. This is especially true for setting the minimum level of regulatory capital. On the one hand, higher capitalization implies lower probability of failure. On the other hand, holding more capital restricts banks from earning higher profits, so they prefer holding less capital than is desirable from the regulators' perspective. Therefore, regulators impose capital restrictions on banks in order to prevent possible bank runs and large fiscal costs associated with the bailout of insolvent banks. Nowadays, Basel II is the most recent set of rules intended to achieve an optimal level of capitalization subject to the constraints imposed both by banks and regulators.
The theoretical literature on optimal regulatory capital restrictions in banking mainly analyses risk-weighted capitalization, where the required minimum capital held by banks increases with the riskiness of bank assets. However, the main practical issue with the risk-weighted bank capitalization is the assessment of risks, which is not straightforward. The most recent literature analyzes advantages and disadvantages of Basel II, which differs from the previous regulation by delegating the assessment of risks to banks themselves (internal rating based approach - IRB) on a voluntary basis. On the one hand, banks have better understanding of their risks than regulators and are expected to hold sufficiently high level of non-weighted capitalization (capital to assets ratio). Consequently, regulators don't need to spend money to design complicated models for assessing risks of banks. On the other hand, banks have incentive to artificially reduce the level of their asset risk in order to hold lower capital. Hence, the non-weighted capitalization of banks might decline under the new regulation. Which of these two effects dominates is not clear theoretically and remains an empirical issue to be tested on the data. Do banks that volunteer to use the IRB approach maintain lower capital holdings? As it will become apparent from this literature review, there is no study addressing this question empirically, partially because data on banks reporting capitalization using the IRB approach has become available only from 2008, when Basel II was enacted. Hence, the aim of the proposed research is to fill this gap in the literature and to provide an empirical assessment of the impact of Basel II on bank capitalization. If the hypothesis that banks reporting their capital using the IRB approach hold lower capital holdings is confirmed, then results of this study would call for reassessment of Basel II and introduction of non-weighted bank capitalization ratio to complement the current risk-weighted ratio, as suggested in.#p#分页标题#e#
A seminal study that started the discussion on optimal capital structure was written by Modigliani & Miller (1958). The key result derived in this study is that if markets are perfect and there is no information asymmetry, then the capital structure of firms (i.e., proportion of total assets financed by capital and debt) does not affect their value given in the frictionless environment with complete markets and full information. However, the practical value of this result is limited because of non-realistic initial assumptions. In particular, taxes, transaction costs, imperfection of product markets and asymmetric information are examples of the deviations potentially distorting the results provided by Modigliani & Miller (1958). Also, as pointed out by Bischel & Blum (2005), there are externalities from bank failures, such as the costs of financial distress, since third parties (consumers and firms holding deposits in banks) can be affected if a bank fails. In addition, bank deposits are usually insured by deposit insurance schemes, so banks are aware that they would be bailed out in case of insolvency and thus may hold less capital than is socially optimal. Hence, unlike firms, banks are subject to minimum capitalization requirement as a safeguard against failure.
The first study discussing the issue of minimum capitalization requirement is Merton (1977). This paper uses arbitrage pricing method to analyze the impact of deposit insurance on banks' risk-taking activity. He considers deposit insurance as a put option on the value of the bank assets, where the striking price effectively is the value of the debt promised by the bank, when the asset becomes mature. Therefore, when this insurance premium is not risk-sensitive, the bank is likely to increase the value of the put-option by increasing the risk of its assets and consequently decreasing its capitalization ratio. Moreover, increased competition in banking sector may additionally catalyze the risky behavior of the bank, thus increasing the likelihood of the possible failure in future. As a solution, Merton (1977) proposes to introduce risk-adjusted deposit insurance. However, the arbitrage pricing method provides fairly priced deposit insurance only when, among the other things, the markets are complete and there is no information asymmetry between the depositor and the bank, consequently making the role of the deposit unnecessary because there is no risk of bank panics.
The existence of fairly priced deposit insurance under the assumption of asymmetric information is discussed in (Chan, Greenbaum & Thakor, 1992). They consider a framework consisting of two types of banks, separated by their attitude towards risk. The insurance here is essentially a menu of contracts demanding from the bank to keep some capitalization ratio according to the insurance premium for each deposit held by the bank. The main conclusion of the article is that in this framework there cannot be any incentive-compatible scheme providing fairly priced deposit insurance. In particular, risky banks will always choose the menu of contracts chosen by low-risk banks, thus preventing of the fairly priced deposit insurance being implemented.#p#分页标题#e#
(Freixas & Rochet, 1995) is another study analyzing fairly priced deposit insurance in a framework, where the value of the bank is determined by deposits managed. Less efficient banks here do not mimic the more efficient ones because of the subsidy received from them. The authors find that although the fairly priced deposit insurance exists in this framework, it is not socially desirable, since the banks here do not have any incentive to act efficiently.
The main shortcoming of Merton (1977), Chan, Greenbaum & Thakor (1992) and Freixas & Rochet (1995), however, is that all of them develop their framework in the world of complete markets, so the role of deposit insurance here is unclear. As opposed to them, Rochet (1992) discusses the problem of risky behavior of banks in the case of incomplete markets. In this framework the bank is modeled as a portfolio of securities, so it can trade its stock for any given price, regardless of its investment policy if it is fully liable. However, in the case of limited liability the bank shows more risk-loving behavior with decrease in the level of capitalization. Rochet (1992) claims that only risk weighted capitalization restrictions cannot prevent bank from risky behavior and it is necessary to supplement it with a minimum capital level. Nevertheless, because of no asymmetry of information between the supervisors and the banks in this framework the article cannot fully explain the processes taking place in banking sector.
(Blum, 2008) is the first study which develops a theoretical model predicting that banks may have an incentive to underreport their risks under both assumptions of information asymmetry and incomplete markets. This model also considers two types of banks, risky banks and low-risk banks, which are not observable by supervisors before the uncertainty about the banks' behavior is resolved. Both types of banks are aware of their risk type. The analysis provided by Blum (2008) reveals that risky banks artificially reduce the level of their risky assets in order to hold less capital and earn higher profits. For this reason, he suggests to supplement the existing risk-weighted capital ratio requirement with additional non-weighted capital ratio requirement. Nevertheless, imposing additional non-weighted capital ratio requirement forces safe banks to keep some amount of their capital without necessity, thus making them suffer because of existence of risky banks. This information rent paid by the low-risk banks eventually leads the environment to the second-best outcome.
In accordance with some theoretical studies discussed above, Basel I and Basel II advocate that bank capitalization should be set against risk-weighted assets. The justification behind this proposition is that if non-weighted capitalization is set, then banks would have incentive to put all their funds into risky assets yielding higher returns. Therefore, risk-weighted capitalization penalizes banks for investing into risky assets by requiring larger capital holdings. However, the practical issue arising here is how to measure the risk of bank assets. Basel I approach suggests uniform risk weights for all banks. Basel II, in turn, suggests that banks know their risks better and should have an option to report their risk using the IRB approach. Apparently, among the literature studying banking regulation, represents the framework which is the closest by its characteristics to the one provided by Basel II. The outcome of the model provided by Blum (2008) already suggests that IRB approach potentially may be a source of significant decrease in the level of the bank capitalization, thus increasing the likelihood of bank's failure. It remains only to test this hypothesis empirically in order to find out whether Basel II is subject to the further improvement or not.#p#分页标题#e#
To conclude, the problem of prudent banking regulation is widely discussed topic in corporate finance. As it was mentioned above, Basel II Accord is the most recent set of rules intended to lead the banks to the optimal level of capitalization. In particular, Blum (2008) models Basel II in a theoretical framework and concludes that Basel II in its recent level of development cannot serve as a safeguard against bank insolvency if it is not complemented by leverage-ratio restriction. Nevertheless, there cannot be achieved any breakthrough in understanding whether Basel II leads banks into the optimal level of capitalization unless the theoretical model analyzing this issue doesn't find any support on real data. Therefore, the empirical question whether Basel II decreases the level of bank capitalization remains opened and yet unexplored. The main motivation of the proposed research is to provide an empirical analysis of this question. The significance of this research can scarcely be underestimated since the results of the analysis provided there will enlighten whether the most recent set of rules for banking regulation is subject to the further improvement or it is the best we can have in banking industry.
Basel committee on banking supervision (1988). International Convergence of Capital Measurement and Capital Standards: Consultative Document. Bank for International Settlements.
Basel committee on banking supervision (1999). Capital requirements and bank behavior: The impact of the Basel Accord. Working Paper No.1. Bank for International Settlements.
Bichsel, R., & Blum, J. (2005). Capital regulation of banks: Where do we stand and where are we going? SNB Quarterly Bulletin, 4/2005, 42-51.
Blum, J. (2008). Why 'Basel II' may need a leverage ratio restriction. Journal of Banking & Finance, 32 (2008), 1699-1707.
Chan, Y. S., Greenbaum, S. I., & Thakor, A. V. (1992). Is fairly priced deposit insurance possible? Journal of Finance, 47, 227-245
Freixas, X., & Rochet, J.C. (1995). Fair pricing of deposit insurance. Is it possible? Yes. Is it desirable? No. Mimeo, Universitat Pompeu Fabra, Barcelona
Merton, R. C. (1977). An analytic derivation of the cost of deposit insurance and loan guarantees. Journal of Banking and Finance, 1, 512-520
Modigliani, F., & Miller, M. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297.
Rochet, J.C. (1992). Capital requirements and the behavior of commercial banks. European Economic Review, 36, 1137-1178
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