Chapter 18: Advanced Capital Regulation (Sections 18.1–18.4) Flashcards
(9 cards)
What is the main goal of capital regulation?
To ensure banks have enough loss-absorbing equity to survive unexpected losses, protecting depositors and the wider financial system.
How do risk-weighted assets (RWAs) work?
Each asset on a bank’s books is assigned a weight (e.g., 100% for corporate loans, 50% for mortgages) based on its riskiness. Regulators require banks to hold a percentage of equity against the total RWAs, so riskier portfolios demand more capital.
What is Tier 1 capital, and why is it so important?
Tier 1 capital is the highest-quality equity (common shares and retained earnings). It’s the first line of defense against losses and must meet a minimum ratio (e.g., 6% of RWAs under Basel III).
Why do regulators impose a leverage ratio floor in addition to risk weights?
Because RWAs can be underestimated, the leverage ratio (equity divided by total assets, unweighted) prevents banks from becoming too large by forcing a minimum equity buffer against all assets.
What is the countercyclical capital buffer?
A dynamic extra equity requirement (up to 2.5% of RWAs) that rises in credit booms to curb excessive lending and falls in downturns to prevent a credit squeeze.
During 2018 the UK built up a buffer, then released it in 2020 to ease bank lending in the pandemic.
How can higher capital ratios sometimes lead banks to take more risk?
When regulators raise equity requirements, deposit funding becomes cheaper relative to equity. Banks then seek higher returns by concentrating on correlated (all-or-nothing) assets to maximize their net interest margin.
Before Basel II, some large banks used advanced internal models to lower measured risk-weights but actually increased exposures to booming markets like real estate.
Why might banks choose asset reduction over issuing new equity when capital rules tighten?
Equity issuance dilutes owners and can be costly. Instead, banks often sell loans or bonds, shrinking their balance sheet to meet the new ratio—at the expense of credit supply, especially to SMEs.
After EU banks faced a higher capital surcharge in 2011, many announced cuts in small-business lending rather than tapping equity markets.
What is the idea of a self-regulating financial sector with contingent capital?
Replace fixed capital rules with instruments that automatically convert to equity when a bank’s capital falls below a trigger: Equity-recourse notes (ERNs) or Contingent convertible bonds (CoCos). This ensures loss absorption without constant regulatory tweaks.
Several European banks issued CoCos before 2008; holders saw bonds convert to equity in distress, bolstering the bank’s capital buffer.
What are the practical challenges of CoCos and ERNs?
Determining the right trigger and conversion mechanics is complex, pricing them correctly is hard, and investors demand high yields—so uptake has been underwhelming despite clear theoretical benefits.
