Abstract
We consider the impact of a mandatory information disclosure on bank safety in a spatial model of banking competition, in which a bank’s probability of success depends on the quality of its risk measurement and management systems. Under Basel capital requirements, this quality is at least partially disclosed to market participants by the Pillar 3 disclosures. We show that the regulator can improve the safety of the banking system by tightening the disclosure requirements. Furthermore, the stricter the disclosure requirements are the bigger is a positive impact of an increase in capital requirements on bank safety.
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Notes
The Pillar 3 disclosure requirements include both quantitative and qualitative disclosures, for example, on banks’ capital structure; the risks to which banks are exposed and the techniques that banks use to identify, measure, monitor and control those risks; risk management objectives and policies; geographic, industry and counterparty type distribution of exposures; structure of internal ratings system and relation between internal and external ratings; description of the internal ratings process; information about risk parameters such as probabilities of default (PD) and loss given default (LGD) in a portfolio level; the process for managing and recognizing credit risk mitigation, and the bank’s role in the securitization process and the amount of securitized exposures. Most of the disclosures should be made on a semi-annual basis (see Basel Committee 2006, Part 4).
Tarullo (2008, ch. 7) surveys both the extreme and more moderate proposals for mandatory subordinated debt.
This is a reduced way to capturing the fact that the quality of a bank’s risk measurement and management systems affects the bank’s riskiness. When insiders put more effort in improving risk management, the bank improves its ability to select high-quality customers, to use risk mitigation techniques, to design and enforce financial contracts etc., which reduce its probability of failure.
The assumption \( C\left( {{q_i}} \right) = q_i^2 \) together with the assumption 1 < R < 2 ensures that, at an equilibrium, q < 1.
In our set-up, the minimum capital-to-loans ratio is essentially similar to a leverage ratio restriction. For a model with both leverage rate restrictions and risk-based capital requirements, see Blum (2008).
This technical assumption implies that the amount of deposits that a representative bank raises, D i , is equal to its lending, L i . This result simplifies our analysis without qualitatively affecting the results. The assumption is broadly in line with the Basel Committee’s (2010a,b,c) proposed changes to the Basel Capital Accord, which require banks to improve the loss absorbency of their own funds. In addition, the proposed new global minimum liquidity standard, the Liquidity Coverage Ratio, requires banks to hold a substantial amount of funds in liquid forms, such as cash and government bonds.
In the following sections, we show that banks indeed never hold any excess capital.
The first-best action q FB maximizes the social payoffs of the project, \( \pi_i^{{FB}} = {q_i}R - q_i^2 \). The first-order condition with respect to q i is \( \partial \pi_i^{{FB}}/{q_i} = R - 2{q_i} = 0 \) and the first-best quality q FB = R/2. It can be shown that the assumption that deposits markets are always covered implies that q FB > q B .
In our model, the amount of loans that a bank provides, L i , is equal to the amount of deposits it has raised, D i . Therefore, we can express both a bank’s regulatory capital requirement and its actual holdings of capital as multiples of the bank’s deposits base, kD i and k i D i , respectively.
The analysis of Matutes and Vives (1996) suggests that outsiders’ different possible prior expectations on q i , i = 1, …n, could become self-fulfilling and lead to multiple equilibria. However, to avoid these complexities, we only focus on the interior symmetric rational expectations Nash equilibrium.
Deposit markets are covered, when a depositor in the midpoint of two adjacent banks is indifferent between depositing and investing in the outside asset. Her distance from the nearest bank is 1/2n and her cost of travelling there is μ/2n.
That is, \( R - 3\mu /2n - k\,\left( {2\rho \,{n^2}/\mu - 1} \right) - 1 > 0 \).
For a fuller discussion on the importance of this assumption, see Repullo (2004, p. 157–158, 176).
There is a large literature on other channels through which capital requirements may affect banks’ risk-taking incentives. For a survey, see e.g. VanHoose (2007).
The quadratic equation (11) has two roots. We can concentrate on the bigger root as the smaller root is negative by the facts that \( \partial {G_P}(q)\,/\partial q < 0,\,\,for\,\,q < \mu /4{n^2} \) and G P (0) < 0.
A higher quality of banks’ risk management systems and the associated lower probability of default implies a higher level of welfare. The equilibrium values of deposit rates, capital levels and the cost of capital do not affect the total welfare, as they only determine how the final payoffs are divided between the risk-neutral parties.
The result q P > q N implies, by (6b), that r P < r N .
As capital is costly, very high capital requirements would obviously drive banks out of the market. Our model should thus be regarded as a model of relatively small or “normal” capital requirements.
There are a number of justifications for concentrating on flat capital requirements. First, the so-called standardized approach of the Basel II, which is available to smaller banks, is not much different from the previous Basel I approach, and may well be approximated by flat capital requirements. Second, Basel II has not yet been implemented in all major jurisdictions, most notably in the USA. Third, there are capital floors in the transition period following the implementation of the IRB approach of the Basel II. Capital floors prevent banks’ IRB capital requirements from deviating too far from the old Basel I requirements during the transition period lasting several years.
For example, the US authorities make publicly available certain fixed format banking regulatory reports. According to a survey by Federal Reserve Board’s Study Group on disclosure (2000), the users of the disclosed information, such as securities analyst, rating agencies and institutional investors, value these reports as they allow direct comparison among banks whereas banks’ voluntary disclosures are not so easily comparable.
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Acknowledgement
I would like to thank Esa Jokivuolle, Alistair Milne, Jouko Vilmunen, Matti Virén, seminar participants at the Bank of Finland, and especially Tuomas Takalo and an anonymous referee for their very helpful comments and suggestions. All the remaining errors are mine.
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Vauhkonen, J. The Impact of Pillar 3 Disclosure Requirements on Bank Safety. J Financ Serv Res 41, 37–49 (2012). https://doi.org/10.1007/s10693-011-0107-x
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DOI: https://doi.org/10.1007/s10693-011-0107-x