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The Evolving Complexity of Capital Regulation

Journal of Financial Services Research volume 53, pages 183–205 (2018)Cite this article

Abstract

This article traces the growing complexity of capital regulation with emphasis on decisions of the Basel Committee on Banking Supervision and bank regulators in the US. The pattern is one of increasingly complex regulations as each round of reform attempts to correct perceived weaknesses in the earlier regime. The outcome is a regulatory framework that is remarkably opaque, costly to monitor and enforce, and imposes heavy compliance costs on the regulatees, which are inevitably passed on in part to users of financial services. After a discussion of the most recent round of reforms, the article presents a table organized by five different regulatory capital numerators and five different denominators that define thirtynine different regulatory capital requirements, which Globally Significant US banks must meet. This way of organizing the various capital requirements shows how the number of capital ratios could be reduced by 75% with no loss of rigor. The conclusion speculates about why regulatory simplification seems so much more difficult to accomplish in the US than in other countries with much longer regulatory traditions.

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Fig. 1

Notes

  1. See IMF (1989), p. 56) for estimates of trends in capital-asset ratios in several industrial countries from 1982 to 1987. The ratios could not be meaningfully compared across countries because the definitions of capital and accounting conventions differed markedly across countries, but the trend within each country is more significant. In each country apart from France and Japan the ratios rise over the period.

  2. See Goodhart (2011) for an authoritative account of the early years of the Basel Committee.

  3. It should also be noted that these concepts were measured using different accounting standards, a problem that remains.

  4. Ironically, the German position regarding the role of equity in regulatory capital has shifted 180 degrees since the negotiations surrounding the Original Accord. In the most recent negotiations, the German authorities have strongly resisted increases in the equity component of regulatory capital.

  5. The definition of regulatory capital the US authorities adopted in 1981 was closer to the French than the German end of the spectrum. It included two kinds of capital: “(1) primary capital consisting of common stock, perpetual preferred stock, capital surplus, undivided profits, reserves for contingencies and other capital reserves, mandatory convertible instruments, and an allowance for possible loan losses; and (2) total capital, which is primary capital plus limited-life preferred stock and qualifying subordinated notes and debentures of bank subsidiaries” (Wall 1989, p.19). Although the Basel definitions of capital differed from the US concept, the precedent of setting two minimum ratios was adopted.

  6. The Accord (Basel Committee 1988) provided for an additional 10% category that could be applied at national discretion to securities issued by OECD central governments to account for investment risk. This option was not widely adopted.

  7. An exception was made for bi-lateral contracts such as swaps. The Committee took the view that since most counterparties tended to be “first-class names,” a 50% weight would be applied to counterparties that would otherwise have been subject to a 100% risk weight (Basel Committee, 1988, p.27).

  8. As Dowd et al. note, a mere 8 sigma event should occur less than once in the entire history of the universe. A 22-sigma event has an astonishingly lower probability of occurrence. The regulators arrived at this standard by (1) assuming positions could not be liquidated in fewer than ten days (assuming a 10-day σ is 3.16 times the 1-day σ); (2) Insisting on a 99% level of confidence (2.32*σ); and (3) requiring a multiplication factor of at least 3 to compensate for possible model error. This yields a standard that is 3.16*2.32*3*σ or approximately 22*σ.

  9. Subsequently concerns have been raised about the extent of the variation in internal-models based measures of RWA of market risk across banks that cannot be explained by variations in actual risks taken or in business models (Basel Committee 2013a). This has led to a fundamental review of the trading book and a revised market risk framework (Basel Committee 2013c).

  10. TruPS are hybrid securities that combined features of both debt and equity. In 1996, the Federal Reserve Board ruled that TruPS satisfying specified conditions could meet a portion of bank holding companies’ (BHCs’) Tier 1 capital requirements. TruPS are a financing structure in which a BHC creates a wholly owned special purpose entity (SPE) that issues cumulative preferred stock to investors. The BHC then borrows the proceeds from the SPE using a long-term subordinated note. Looking through the SPE, in effect the BHC issues term subordinated debt into the market place and this subordinated debt was being permitted as Tier 1 capital. For additional details see French et al. (2010).

  11. This is a conservative estimate. The ratio of RWA to total assets varies widely across G-SIBs. At yearend 2014 the ratio for 19 G-SIBs based in Europe and the US varied from 22.93% to 73.66%, with the median at 36.49% (Verma 2015).

  12. It should be noted that US banks remained subject to a leverage constraint that limited this kind of behavior to some extent, but many other countries did not regulate bank leverage directly.

  13. Cynics might argue that bank lobbyists were continuing their efforts to weaken the force of the Basel Accord by reducing the risk weights in the denominator of the regulatory risk-weighted capital requirement.

  14. See Jones (2000) for an analysis of several different regulatory arbitrage techniques. He notes that cosmetic improvements in reported regulatory capital ratios may be obtained through two means: (1) overstating the numerator, which generally makes use of accounting flexibility through gains trading or underprovisioning for loan loss reserves or (2) understating the risk-weighted asset denominator through restructuring loans to achieve a lower risk weight without a commensurate decline in exposure to risk. The avoidance of regulatory capital requirements through regulatory capital arbitrage erodes effective capital standards. Acharya et al. (2012) show that the use of liquidity-guaranteed conduits was “highly suggestive” of regulatory arbitrage allowing banks to increase their exposures to insolvency risk while maintaining stable regulatory capital ratios.

  15. Although agreement on the Basel II framework was not reached until 2004, the general outlines of the new approach were apparent as early as 1999.

  16. The Economist (2012) derided this approach as “Do it yourself capital requirements”.

  17. These credit default swaps were intended to be a temporary means for banks to reduce RWA until the banks could obtain authorization to base their capital requirements on their own models, which would reduce RWA substantially below the previous, official measure. Masera (2012) has observed that the disparity in the regulatory treatment of credit risk between regulations of the banking book and the trading book fueled the growth in credit default swaps.

  18. These investment banks joined this voluntary regime because the EU threatened to impose a consolidated regime on their European activities if they could not show that they were regulated on consolidated basis by a competent supervisory authority. The SEC managed to convince the EU that it could play such a role.

  19. Large, internationally-active US banks could have started the three-year parallel run required before the AIRB approach could be authorized as early as April 1, 2008. But by 2009, only one bank had entered the parallel run and others did not follow until 2010. The US had established stringent standards for banks to qualify for the parallel run and implementation of AIRB and several banks were reluctant to commit the necessary resources until the GFC was winding down.

  20. Although accounting reforms are outside the scope of this paper, it should be noted that both the Financial Accounting Standards Board and the International Financial Reporting Standards Board have implemented measures to sharply limit the extent to which banks can use accounting discretion to overstate asset values. In addition, Wall (2013) argues that the use of supervisory stress tests to evaluate capital adequacy obliges banks to consider how asset values may deteriorate in under adverse economic and financial conditions and further counters the tendency for banks to understate the deterioration in asset values.

  21. Of course, some of this difference may also be attributable to understated risk weights.

  22. Paraphrasing Oscar Wilde, Dowd et al. (2008) commented “to experience a single 25-sigma event might be regarded as a misfortune, but to experience more than one does look like carelessness.” More fundamentally, these results suggested that the underlying distribution had shifted markedly or, more likely, that the assumed distribution was wrong.

  23. The regulators did succeed in eliminating some of the more dubious account entries such as deferred tax losses from the computation of regulatory capital.

  24. As noted below, the adoption of Total Loss Absorbing Capital Requirements makes the Tier 2 distinction seem entirely redundant.

  25. Mariathasan and Merrouche (2012) report that the leverage ratio is a more reliable predictor of bank failure when the risk of a crisis is high, while the Basel II risk-weights prove superior when the risk of a crisis is low. In other words, the Basel II risk weights are least reliable when they are most needed to monitor the capital adequacy of individual banks.

  26. Wall (2013) makes the additional important point that part of the failure of the Basel standards was attributable to overstated asset values. As noted above, both the FASB and IFASB are implementing accounting reforms to mitigate this problem. Wall (2013, p.12) notes the implementation of supervisory stress tests will also curb the tendency from banks to overstate the value of their assets: “Although the stress tests as currently implemented also rely on accounting measures of capital, the longer time horizon of the stress tests can force a bank to eventually recognize its losses.”

  27. Even though none of the banks drew on CAP, the presence of the backstop was critical. It enabled the Fed to disclose that 10 banks had failed without fear of setting off a destabilizing run on these institutions. Moreover, the fact that a significant number of institutions failed enhanced confidence in the rigor of the exercise. The European Union tried to emulate the SCAP program, but without a credible backstop. The market lost confidence in the rigor of the EU stress test when only a few months after the results of the test were announced the Irish banking system collapsed. In the absence of a credible way to provide a capital backstop, the EU officials may have been reluctant to apply rigorous standards.

  28. Section 165(i)(2) of the Dodd-Frank Act requires banks with total consolidated assets of more than $10 billion to conduct annual stress tests. Early in each year (no later than February 15), the supervisory authorities specify three scenarios: a base-line, adverse and severely adverse scenario. Each scenario includes economic variables such as macroeconomic activity, unemployment, exchange rates, price, incomes and interest rates. The adverse and severely adverse scenarios are not intended to be forecasts. Instead they are hypothetical scenarios designed to test the strength and resilience of financial institutions.

  29. They must also be able to show that they will remain in compliance under the base line, severe and severely adverse regulatory stress scenarios. Banks that can meet the severely adverse scenario generally have no trouble demonstrating that they will remain in compliance with capital requirements under these scenarios even though the severe adverse stress scenario may involve shocks that differ in kind from the severely adverse scenario.

  30. To some extent banks have always felt obliged to maintain capital above regulatory minimums to meet supervisory expectations, such as the additional capital required to be deemed “well-capitalized”. Moreover, the consequences of falling short of the regulatory minimum incentivize banks to maintain higher regulatory capital ratios as a precaution against unanticipated losses.

  31. Table 1 assumes that all capital requirements have been fully implemented. The table would have been even more complex if transitional arrangements had been considered.

  32. Of course, banks must deal with many other regulatory requirements and constraints in addition to these required capital ratios.

  33. Alternatively, if CETI and additional Tier 1 are deemed equivalent in their ability to sustain the bank as a going concern, it is not necessary to set requirements about CETI.

  34. Since the Dodd-Frank Act requires the DFAST stress tests, Congressional action may be required to exempt banks subject to CCAR stress test from the DFAST filings.

  35. The Collins amendment expressed Congressional skepticism that the regulators would maintain rigorous capital standards by specifying a floor for the leverage ratio and the RWA ratio. The behavior of the regulatory authorities over the last eight years may have reduced concerns that the regulators would permit capital adequacy standards to erode.

  36. In this respect, the innovation of publicly-disclosed supervisory stress tests is a major advance. The CCAR tests show how the same stress scenario will affect comparable banks in ways that are readily understood by market participants. Although banks are required to comply with four different regulatory ratios, the results are described in terms of the evolution of income statements and balance sheets over a nine-quarter period. This provides much higher quality information than the capital ratios reveal, which at best showed the current condition of the bank, but did so in a way that made comparisons across banks difficult.

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Acknowledgments

I am grateful to Sheila Bair, Robert Eisenbeis, Gillian Garcia, Joe Hughes, Edward Kane, Jack Reidhill, and Paul Tucker for helpful comments.

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  1. The Wharton School, University of Pennsylvania, 2444 Steinberg Hall-Dietrich Hall, 3620 Locust Walk, Philadelphia, PA, 19104-6367, USA

    Richard J. Herring

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Herring, R.J. The Evolving Complexity of Capital Regulation. J Financ Serv Res 53, 183–205 (2018). https://doi.org/10.1007/s10693-018-0295-8

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Keywords

  • Capital regulation
  • Basel committee
  • Basel accord
  • Basel II
  • Basel III
  • Leverage ratio
  • Market risk
  • Regulatory arbitrage
  • Financial crisis
  • Regulatory complexity