Capital regulation Flashcards
What is the difference between the economic vs the regulatory vew of capital ?
Economically = difference between mkt value of total assets and debt
Regulatory perspective:
• Takes an accounting view of many assets
• Excludes certain assets
• Adds certain debt instruments to definition of capital
What are the two main types of capital requirements?
- Leverage ratio restrictions
* Risk-weighted capital requirements
What are the advantages and drawbacks of leverage ratio restrictions?
Advantage:
• Straightforward to compute, interpret and compare
Drawbacks
• Treats all banks equally
• Incentive for banks to engage regulatory arbitrage
What are the drawbacks and advantages of risk-weighted requirements?
Advantage
• Banks need to hold more capital for riskier assets = less regulatory arbitrage
Drawbacks
• More complex than leverage ratio requirements
• If weights not reflect correctly true risks within or across asset classes = still regulatory arbitrage
• Main problem: how to define correctly weights ?
What are the improvements in Basel III ?
- Higher quantity and quality of regulatory capital requirements
- Improved risk weights
- Leverage ratio restriction, including some off-BS positions, in addition to the risk-weighted requirements
What is the basic intuition of risk weights and leverage ratio as complements?
Leverage ratio helps to offset banks’ potential capital savings of understating risks by:
• Reducing banks’ option value of limited liability ex-ante
And
• Increasing banks’ capital which in turn enhances supervisors’ ability to sanction banks ex-post
What does introducing a leverage ratio in addition to IRB-like risk weights do?
- Reduces room for regulatory arbitrage
* Offers protection vs risk weights’ shortcomings
What are the 3 main features of banking that the modeling strategy?
• Banks differ in risk
o Safe vs risky banks
• Bank assets are opaque
o Ex-ante: banks’ risk type is private information
o Ex-post: supervisor can verify bank’s risk type with some probability
• Negative externalities of bank failures
o Risky banks tend to hold too little capital
o Due to limited liability, sanctions cannot exceed bank’s amount capital
What are the supervisor’s characteristics in the modeling strategy model ?
- Cannot observe ban’s risk type ex-ante
- May detect bank’s risk type ex-post with probability q
- Has ability to impose fine F on non-compliant bank
- Induces no cost of suupervision
What are the conclusion of the modeling strategy model for the First-Best financing structure?
- Safe banks = no capital at all
- Risky banks hold some capital to avoid social costs of bankruptcy
- Risky banks financed by x units of capital and 1-x units of deposits
Why do all banks finance assets with deposits only without any capital regulation?
- Capital = costlier than deposits
* Holding capital has no private but only social benefits
What happens when there is a simple leverage ratio restriction requiring that all banks hold at least x unit of capital?
- Prevents insolvencies, but safe banks hold too much capital
- Distortion of excessive risk-taking removed at expense of introduction another distortion by rising safe banks’ financing costs above first-best level
What happens in the case of IRB-like risk-weighted capital requirements without sanctions for dishonest banks?
- All banks, irrespective of risk type, claim to be safe
* Banking regulation only makes sense if banks do not voluntarily behave in socially efficient manner
What are the two effects of leverage ratio restriction?
- Ex-ante: mitigates banks’ incentive of understating their risk
- Ex-post: by increasing banks’ capital it increases supervisors ability to punish misbehaving banks
What are the policy implications of risk-weighted requirements and leverage ratio restriction?
- To implement risk-weighted requirements where banks report risks correctly, supervisors need to be able to detect and sanction dishonest banks
- If supervisors’ abilities = limited, additional risk-independent leverage ratio = necessary
- Resistance from banks = unavoidable
