Global Issues for the Finance Professionals
Part A:
Risk and Risk Management
International banking regulation has been identified as one among various policy instruments to mitigate credit risk and moral hazard. Recent years have witnessed increased banking regulation in a bid to tame the risk appetite of large interconnected banks and their perspective on credit risk. The regulatory framework has experienced continued review, complexity, and overarching in sovereign reach. Balthazar L. (2006) states that trends in international banking regulation can be traced from Basel I to Basel III. Basel I dealt at length with credit risk while Basel II dealt with inefficiencies due to capital arbitrage and the rise of operational risk. Basel III was in response to the global financial crisis of 2007-2008 to deal with systemic risk.
Systemic risk is associated with the collapse of an entire financial system. Schwarcz (2008) associates systemic risk with diminished incentives by market players and insufficient regulation. He opines that the law has a role in reducing systemic risk. This view is supported by BIS (2017) that asserts that Basel III was to strengthen the regulatory framework that comprised of; improving regulatory capital, ramping up capital buffers, recalibration of risk, limiting leverage in the banking sector and creating internationally comparable risk weighting of capital and various risks including credit risk.
Understanding Credit Risk and Moral Hazard in Banking
Credit risk is the most significant risk in banking. It comprises of retail and corporate credit risk. Modern portfolio theory acknowledges risk is inherent to reward, it advocated for diversification (Huberman, 2005). BCBS (2000) defines credit risk as the risk given default of a borrower or a counterparty failing to meet its obligation. A sample bank, Deutsche Bank, risk profile is presented. The risk asset approach determines restrictions on loan-to-value, probability of default and loan origination standards. In assessing the portfolio, diversification by industry and region among other considerations is stipulated. Portfolio risk mitigation strategies are the identified including hedging and derivatives.
Figure 1: Risk Profile: Deutsche Bank
The concept of moral hazard has increasingly drawn debate given the recent collapse of large banks leading to the global financial crisis. Arnott and Stiglitz (1988) define moral hazard as risk arising from actions that are imperfectly unobservable. The collapse of banks in the US has been attributed to subprime mortgage lending. In analyzing moral hazard and credit cycles, Myerson (2012) constructs a model from a micro agency foundation, in conformity with the ‘Lucas critique’ put forth by Lucas (1976) that advocated for micro-founded models. This model shows how moral hazard can cause credit cycles. The author postulates that the solution to financial moral hazard-induced cycles is the formation of long term relationships among bankers and investors (McCoy, 2017). The paper draws a timeline of the interplay of booms and recessions, describing recessions as periods with decline is productivity due to scarcity in trusted financial intermediaries. The paper makes a justification for government bailouts to maintain stability.
The role of financial moral hazard in causation of business cycles is further elaborated by Acharya, Viral and Viswanathan (2011) who construct a financial sector model with short term debt instruments with a roll over option that shifts risk or results in asset substitution problem. The model explains the liquidity problem arising from sale of assets or deleveraging, the impact to potential buyers and the adversity of asset shock and how the impact severally affects holders of assets and potential buyers. The authors attribute high leveraging to low interest rates during boom and associated deleveraging during boom to asset shock and illiquidity during busts. The authors identify the relationship between endogeneity of distribution of leveraging and business cycles as a key component to understand crises.
Business cycles are a form of market failure. Often when markets fail, governments intervene through regulations. This gives a rise to prudential regulations. Hellmann et al. (2000) taking cognizance of prudential regulation in mitigating moral hazard risks, propose a two period model under financial liberalization and prudential regulation. They posit that financial liberalization tends to increase competition giving greater freedom to banks to choose assets and allocate interest rates, thereby leading to gambling. The paper presents contrasting findings by identifying capital requirements as yielding prudential behavior while yielding pareto inefficient outcomes that may lead to risk activities in a bid not to disenfranchise the bank’s return on capital. The paper proposes two prudential regulations; capital requirements and deposit rate controls. These complementary regulations are observed as creating some sort of flexibility that reduces capital requirements and reducing the cost of capital as a result (Osborne et al, 2012) The paper identifies other policy instruments that could be used to reduce moral hazard problem. For instance; asset class restriction, restricting investment in risky assets, risk based deposit insurance premiums and limiting speed on bank growth.
In banking, moral hazard occurs in several ways. Firstly, moral hazard may occur from a rating agency providing misleading information to lending entities. Secondly, in the event of systemic risk, governments may decide to bail out the banking sector to stem the total collapse of the industry, or rather bail out banks that if were to collapse would lead to macroeconomic instability. In the latter, big and influential banks would have the incentive to assume too much risk on the backdrop of being ‘too big to fail’. However, this view has been challenged by Allen et al (2015), who question whether public bailout is detrimental to the financial system. Their analyses concludes that well designed government guarantees can be effective in stemming instability. They provide evidence that government guarantees do not always lead to higher bank risk appetites and that taxes and other policy instruments may be at the disposal of governments to correct market distortions if any.
A succinct depiction of moral hazard is where one firm rates assets and clients but the banks are eventually responsible for their risk levels and asset quality. BCBS (2000) avers that pre-crises practice was the mechanistic reliance on credit rating agencies. International regulation was justified by standardizing the credit rating mechanism and inherently placing risk assessment in the banks purview, to determine capital levels given their asset quality and risk profile. The aspect of moral hazard is further highlighted by innovation in banking sector regulation, leading to the rise of bail-in concept. Avgouleas and Goodheart (2015), describe the bail-in approaches as regimes requiring the participation of creditors. It can be observed that a form of moral hazard creeps in by way of high returns during economic boom and guaranteed returns in the event of collapse. Bail-ins have been identified as an innovative way to replace less favorable bail outs.
Mitigating Credit Risk and Moral Hazard
At best, these risks can only be mitigate. As earlier highlighted interventions proposed in theory comprise prudential regulation and financial liberation. Other policy instruments comprise; corporate governance, entry restrictions, closure of undercapitalized banks and bailout of failed bank shareholders. Additionally, long term relationship between banks and investors has been proposed by Myerson (2012).
Firstly, the adoption of corporate governance structures has been fronted to address long term relationships between banks and stakeholder. In addressing the principal-agent problem and moral hazard arising as a result, adoption of corporate governance structures is deemed appropriate. Corporate governance is defined by OECD (2004) as procedures and processes according to which an organization is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organization – such as the board, managers, shareholders and other stakeholders – and lays down the rules and procedures for decision-making. In determining the purview of corporate governance, the institution takes into account the benefits of a corporation in creation of jobs, generation of taxes, provision of goods and services as well as securing savings and retirement benefits. This provides a wide view of corporate governance. This concept leads to banking institutions not only being accountable to their shareholders but to the industry at large.
The financial crisis of 2008 exposed the underbelly of global financial institutions in terms of corporate governance. While asset prices rose due to the growth in asset prices, corporations in the financial sector were flatfooted in internal controls and risk management systems. Kirkpatrick (2009) presents a case of mismatch between incentives, risk and internal controls. The mismatch between incentives and risk controls can be attributed to short-termism, a focus on immediate profit such as Return on Equity and the disregard for the investors’ long term objectives.
Secondly, implementing deposit insurance has been touted as a policy that would guarantee stability albeit with certain short comings. Anginer and Demirguc-Kunt (2018) appreciate that deposit insurance may ensure depositor confidence but may result in unintended consequences by encouraging banks to take on excess risks. The advocate for deposit insurance schemes that advocate for banks incorporating internalized risk-taking, complemented by strict capital regulation and effective and strong supervisory institutions.
Thirdly, financial liberalization leads to increased competition among banks. To harmonize reporting and safeguard stakeholder interests, certain international financial reporting standards were adopted among financial institutions. For instance, standardization in the recent past has been achieved by the implementation of IFRS standards. In credit management, IFRS 9 has been introduced that caters for greater standardization in reporting, granularity in the measurement of risks and incorporation of macroeconomic. Forward Looking Information, as opposed to the prior use of historical data that led to inaccurate risk metrics is also one of the methods that have been embraced. Farkas (2016), in studying the interaction of IFRS 9 and financial stability, notes that increased disclosure by banks are likely to lead to greater market disciple thus enhancing financial stability. Credit risk and moral hazard can be reduced by more standardization in risk measurement, more regulation and disclosure, capital buffers and innovation.
Finally, regulation by way of minimum capital requirement is observed as mitigating against credit risk. Minimum capital requirement has seen an increase compared to the pre-crisis period. Anginer et al (2019) observe that high income OECD countries posted an increase from 14.6% to 18.7% mean increase in risk-weighted assets (RWA). However in developing countries, there was no statistically significant increase in regulatory capital.
Figure 2: Regulatory Capital Holding
Regulation can be viewed as an external intervention while strengthening corporate governance and risk-asset approaches can be viewed as internal measures to curb credit risk and moral hazard. This two-prong approach would serve as a system of checks and balances, distributing responsibilities across the banking sector spectrum of stakeholders.
Part B: Operational Aspects of Financial Institutions
The interplay between bank lending operations and increased capital requirements raises questions regarding profitability. Increased banking regulation has led to banks maintaining capital levels commensurate with their risk profile and asset quality. Significant credit risk and increased globalization and interconnectedness has led to the rise of systemic risk as was witnessed in the 2007-2008 financial crisis. Increased regulation has however come under criticism for its effect on profitability and shifting of banks traditional focus on risk and return trade off.
This paper draws illustrations from three theoretical models to illustrate the market expectation of investors regarding banking, risk and their profitability. The three models comprise; Capital Pricing Model (CAPM), Arbitrage Pricing Model and Multifactor model.
Firstly, the Capital Asset Pricing Model is a simple model used to make predictions on risk and expected return. Fama and French (2004) describe CAPM as simple and attractive to use but suffers from shortcoming in its assumptions. The model assumes that investors are risk averse and rational, markets are perfect and there are no transaction costs. The model explains both security returns and portfolio returns. The model can be used to test cross sectional variation in asset return.
Secondly, the Arbitrage Pricing Model provides an alternative to the CAPM. Shanken (1982) observes the model’s assumption of investors being rational, no transaction costs and the existence of a no arbitrage condition under well diversified portfolio. The arbitrage pricing model is applicable in situations where there are deviations in fair market value. This is in contrast to CAPM that assumes perfect market. This relaxes the assumption of perfect market and identifies that arbitrageurs can take advantage of such deviations.
Finally, the Multifactor Model accounts for the possibility of other macroeconomic indicators having an effect of the expected return. Fama and French (1996) broaden the expected return from relying only on systematic risk and introduce independent factors that would affect the expected return. They improve on the model by introduce market capitalization and high to book market stocks.
It is safe to assume that as banks reallocate their assets to high quality assets, their level of risk declines. Suppose all banks comply with minimum capital requirements and shift their activities to high quality asset fund allocation, it is expected that the systemic risk in banking would depict a decline. For this reason, there is a need to test the theoretical model s and determine whether high quality assets lead to less systemic risk. Return on Equity (ROE) will serve as a good proxy in the measurement of investor’s’ return. Berger (1995) in a causal study, regresses Capital Adequacy Ratio to ROE, he determines that higher capital is often followed by higher earnings. The study models a bankruptcy hypothesis that postulates a risky position where capital is below the optimal level. The study concludes by stating that an optimal capital position exists above which banks depict a negative relationship between capital adequacy and ROE. On the other side a positive relationship exists between capital adequacy ratio and ROE where capital is below the optimal capital level.
Emphasis on asset quality would imply that the investors’ expected return declines as they hold onto a low risk portfolio in line with rational expectations. However, banks’ internal operations may hamper this expectation. In a depiction of allocative inefficiency in US banks, Weber et al (2004) using data from 1990-1994 determine that profit loss may result from allocative inefficiency. The authors determine that profit efficiency deviations may result from technical inefficiencies as a result of lack of managerial oversight and allocative inefficiency. The possibility of loss from such inefficiency may drive up investors’ expected return on investments despite imposition of minimum requirements. This is bound to increase the Weighted Average Cost of Capital (WACC), weighing down on banks profitability.
Under the multifactor model, book to market ratio compares the book value to the market value. One main determinant of market value is the level of leveraging. Suppose a bank decides to ramp up capital through debt, investors view this as a high risk bank compared to a bank that uses more of retained earnings or equity. Scarcity of capital may necessitate the acquisition of capital buffers through debt financing. This view is shared by Niresh and Velnampy (2012) who determine that a negative relationship was evident between capital structure and profitability. The authors use data from Sri-lankan banks between 2002 and 2009. Further, they observe banks were highly leveraged institutions, with debts representing 89% of total assets. While a bank may focus on asset improvement, a negative perception on its debt level may lead to higher level of investors required rate of return. These scenarios lead to a raging debate on banks’ traditional role on risk and return trade off and the implications of minimum capital requirements; both intended and unintended consequences.
Argument for Minimum Capital Requirement
Minimum capital requirements are bound to affect loan portfolio growth that contributes to Net Income Margin. Adesina (2019), assesses the impact of Basel III in 38 African countries using data from 381 banks and utilizing static and dynamic panel analyses, observes that the Net Stable Funding Ratio set by the new accord has significant positive effects on bank loan growth rates. Additionally, the author determines that Net Stable Funding Ratio reduces the poor performance of loan portfolios on bank loan portfolio growth. The study concludes by identifying the liquidity thresholds are beneficial to overall lending in Africa.
The impact of regulation on asset quality is noted to be positive. Increase regulation leads to higher asset quality. However, increased minimum requirement leads to higher profitability in developing countries and lower profitability in developed countries. This could be attributed to higher risk assets in developing countries compared to developed countries and as a result banks demanding a higher return in comparison.
Increased minimum capital requirement leads to less diversification and in some instances to niche banking. Banks would need higher minimum capital if their business structure is diversified. However, more niche market banks need relatively lower minimum capital. For instance a bank offering only mortgage loans would have a lower minimum capital requirement compared to an over diversified counterpart.
Despite the downside to increased minimum capital requirements, the concept of banking crises and the need for stabilization leads to the need for a long term view of minimum capital requirements. Osborne, Fuertes and Milne (2012) present evidence on US banking sector spanning from 1970 to 2010. This period is characterized by economic cycles. Their empirical results show that on average there exists a negative relationship between minimum capital requirements and profitability. However, by allowing for heterogeneity over time, they determine that holding of minimum capital requirements is less costly for banks during economic downturn. They conclude by offering a policy recommendation of large minimum capital by BASEL III to achieve macro prudential smoothing of cycles.
Argument against Minimum Capital Requirement
An opposing hypothesis exists against regulation and depicts the effect of those regulations on the firms’ ability to arbitrage on opportunities. It is expected with increased capital requirement tied to risk levels, the level of capital available to pursue lending opportunities is significantly reduced. It can be expected than in the short run, the opportunity cost of lending is high as well as compliance costs by banks. Banks invest a significant amount to up skill their staff to wade in an increasingly regulated environment.
Sasso (2016) reckons that capital regulations, despite being a solution may become part of the problem if implemented too severely. Too severe a framework would lead to limited arbitrage opportunities and constraining banks’ risk management policies. The author cautions that for regulation to be functional for the market, a trade off needs to be satisfied such that the regulatory framework is flexible and robust as well as setting of enforceable standards. This view is shared by Stovrag (2017) who observes that Sweden’s large banks’ profitability measured by Return of Equity had a strong negative correlation to capital requirement ratio. However, a stark contrast is observed by niche banks in Sweden, where capital requirement ration had a strong positive correlation to their Net Interest Margins.
In assessing the capital requirements as a result of Basel III in European banking, Härle et. al (2010), determine that additional funding, 60% of all European and US capital outstanding, was required for banks to proceed with operations. It notes that Basel II would impact, negatively, Return on Equity by about 4% in Europe and 3% in US. In this case, it can be observed that regulation not only negatively impacted profits but capital and liquidity needs. However, the study highlights opportunities that banks can use to reform. It assesses that there would be greater balance sheet utilization and efficiency, innovative products to cut cost and business model adjustment in light of capital scarcity.
Increased minimum capital requirements would lead to scarcity. Scarcity in the capital market is associated with an increase in the cost of capital by banks. Banks would then increase their banking spread pricing their products at higher costs and stifling economic growth. Recent monetary policy developments, quantitative easing, have ensured that markets are awash with liquidity. Despite increased liquidity, Fatou et al (2019) state that banks in the UK favored lending in the mortgage sector rather than small business due to a risk weighted regime under Basel III.
Basel III’s impact on economic growth can be assessed in either the short term, medium term or long term. In the medium term, Slovik and Cournede (2011) determine that BASEL III implementation led to a decline in GDP in the range of 0.05-0.15% per annum. The authors determine that as capital becomes scarce, the cost to banks increases and in turn banks raise their banking spread. These costs passed to bank clients lead to a decline in GDP, at least in the medium term. However, that effect could be offset by expansionary monetary policy.
Traditional lending practices and the primacy of risk-return trade off have been observed as leading to proclycality. To this end, the need for macroeconomic financial sector stabilization is realized. This framework is achieved by regulation that leads to minimum capital requirements amongst other measures. These measures are advanced to improve asset quality, reduce volatility and maintain robust and sound international financial systems.
There is general consensus that increased regulation and disclose requirements would usher in an era of improved risk models, improved data quality and better alignment of data quality. Additionally, banks would be at the fore in streamlining policies addressing risk. This is bound to stem funding of subpar assets deemed to be of low risk and committing disproportionate capital to high risk asset classes. However Anginer & Demirguc-Kunt (2018) in a cautionary note, warn against the risk of regulatory bodies allowing for Tier 1 capital additions that is bound to undermine the quality of assets banks maintain.
In conclusion, it can be deduced that regulations are bound to be part of the financial sector in the foreseeable future. A long term view, by way of macroeconomic stability, lends credence to the foregoing of immediate profits by way of traditional risk-return trade off in place of improved asset quality. It would be prudent for banks to determine ways to maximize on the capital available and continuously seek to improve their asset quality and risk assessment and monitoring. In the short run banks will face higher costs in implementation and the opportunity cost. However, there as immense benefits to be realized through increased regulation, supervision and transparency. These benefits are captured by BCBS (2010) assessment of long term economic impact of stronger capital and liquidity requirements that observed increased minimum levels of capital and liquidity would raise the safety and soundness of the global banking system.
References
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