Capital Requirements and Prudential Regulation
Featured Piece
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How Shape-Shifting Banks Foil Dodd-Frank Act" by Professor Thomas F. Cooley, Paganelli-Bull Professor of Business and International Trade, and Professor Kim Schoenholtz, Professor of Management Practice.
Deutsche Bank AG (DBK) recently separated its U.S. investment bank from its bank holding company, removing it from supervision by the Federal Reserve.
So far, U.S. regulators have reacted passively to such moves by foreign banks to avoid the heightened capital requirements mandated by the Dodd-Frank Act....Read More
How Shape-Shifting Banks Foil Dodd-Frank Act" by Professor Thomas F. Cooley, Paganelli-Bull Professor of Business and International Trade, and Professor Kim Schoenholtz, Professor of Management Practice. Deutsche Bank AG (DBK) recently separated its U.S. investment bank from its bank holding company, removing it from supervision by the Federal Reserve.
So far, U.S. regulators have reacted passively to such moves by foreign banks to avoid the heightened capital requirements mandated by the Dodd-Frank Act....Read More
In the Media
“How Shape-Shifting Banks Foil Dodd-Frank Act,” by ProfessorsThomas Cooley, Kim Schoenholtz, Bloomberg, April 16, 2012.
“The Dodd-Frank Act, Systemic Risk and Capital Requirements,” by Professors Viral Acharya, Matthew Richardson, The Future of Banking, Vox eBook, October 2011.
“Why bankers must bear the risk of ‘too safe to fail’ assets,” by Professors Viral Acharya, Arvind Krishnamurthy, FT, March 17, 2010.
“Bank dividends in the crisis: A failure of governance,” by Professors Viral Acharya, Hyun Song Shin, Irvind Gujral, Vox (voxeu.org), March 31, 2009.
Public Appearance
“How Banks Played the Leverage Game and What Can be Done About it,” by Professor Viral Acharya, Testimony for US House of Representatives, Committee on Financial Services, Subcommittee on Oversight and Investigations.
Papers
ABSTRACT (Click Here for Paper)
One “narrative” of the financial crisis of 2007-2009 is that poor corporate governance at financial institutions was a major cause of the crisis. An immediate implication of this narrative is that better corporate governance a better alignment of the interests of senior management with the interests of their shareholders would have prevented (or at least ameliorated) the crisis. This chapter argues that this corporate governance narrative is largely misguided and reflects an inadequate understanding of modern finance and financial theory. Because of the protections of limited liability, it is in the interests of diversified shareholders of a corporation (including financial institutions) to encourage senior managers to undertake greater risks than is in the interests of the corporation's creditors (or of regulators who may represent depositor creditors or the interests of society more generally). Consequently, public policy should look to improved prudential regulation, rather than improved corporate governance, for restraining the excessively risky activities of systemically important financial institutions.
One “narrative” of the financial crisis of 2007-2009 is that poor corporate governance at financial institutions was a major cause of the crisis. An immediate implication of this narrative is that better corporate governance a better alignment of the interests of senior management with the interests of their shareholders would have prevented (or at least ameliorated) the crisis. This chapter argues that this corporate governance narrative is largely misguided and reflects an inadequate understanding of modern finance and financial theory. Because of the protections of limited liability, it is in the interests of diversified shareholders of a corporation (including financial institutions) to encourage senior managers to undertake greater risks than is in the interests of the corporation's creditors (or of regulators who may represent depositor creditors or the interests of society more generally). Consequently, public policy should look to improved prudential regulation, rather than improved corporate governance, for restraining the excessively risky activities of systemically important financial institutions.
ABSTRACT (Click Here for Paper)
The headline numbers appear to show that even as banks and financial intermediaries suffered large credit losses in the financial crisis of 2007-09, they raised substantial amounts of new capital, both from private investors and through government-funded capital injections. However, on closer inspection a large part of the newly raised capital came from debt-like hybrid claims such as preferred equity and subordinated debt. The erosion of common equity was exacerbated by large scale payments of dividends especially in the former part of the crisis, in spite of widely anticipated credit losses. Dividend payments represent a transfer from creditors (and potentially taxpayers) to equity holders in violation of the priority of debt over equity. The dwindling pool of common equity in the banking system may have been one reason for the continued reluctance by banks to lend over this period. We draw conclusions on how capital regulation may be reformed in light of our findings.
The headline numbers appear to show that even as banks and financial intermediaries suffered large credit losses in the financial crisis of 2007-09, they raised substantial amounts of new capital, both from private investors and through government-funded capital injections. However, on closer inspection a large part of the newly raised capital came from debt-like hybrid claims such as preferred equity and subordinated debt. The erosion of common equity was exacerbated by large scale payments of dividends especially in the former part of the crisis, in spite of widely anticipated credit losses. Dividend payments represent a transfer from creditors (and potentially taxpayers) to equity holders in violation of the priority of debt over equity. The dwindling pool of common equity in the banking system may have been one reason for the continued reluctance by banks to lend over this period. We draw conclusions on how capital regulation may be reformed in light of our findings.
ABSTRACT (Click Here for Paper)
We address the following questions concerning bank capital: why are banks so highly levered, what are the consequences of this leverage for the economy as a whole, and how can robust capital regulation be designed to restrict bank leverage to levels that do not generate excessive systemic risk? Bank leverage choices are a delicate balancing act: credit discipline argues for more leverage so that creditors have adequate skin in the game, while balance-sheet opacity and ease of asset substitution by bank managers and shareholders argue for less. Disturbing this balance are regulatory safety nets that promote ex post financial stability but also create perverse incentives for banks to engage in correlated asset choices ex ante and thus hold little equity capital. We discuss how a two-tier capital requirement can cope with these distortions: a core capital requirement like existing capital requirements, and a special capital account that must be invested in Treasuries, accrues to the bank's shareholders as long as the bank is solvent, and accrues to the regulators (rather than the creditors) if the bank fails. The special capital account requirement ensures creditors have skin in the game and also provides the second margin of safety in the calculation of capital adequacy—a buffer for the regulator's own “model risk” in calculations of needed capital buffers.
We address the following questions concerning bank capital: why are banks so highly levered, what are the consequences of this leverage for the economy as a whole, and how can robust capital regulation be designed to restrict bank leverage to levels that do not generate excessive systemic risk? Bank leverage choices are a delicate balancing act: credit discipline argues for more leverage so that creditors have adequate skin in the game, while balance-sheet opacity and ease of asset substitution by bank managers and shareholders argue for less. Disturbing this balance are regulatory safety nets that promote ex post financial stability but also create perverse incentives for banks to engage in correlated asset choices ex ante and thus hold little equity capital. We discuss how a two-tier capital requirement can cope with these distortions: a core capital requirement like existing capital requirements, and a special capital account that must be invested in Treasuries, accrues to the bank's shareholders as long as the bank is solvent, and accrues to the regulators (rather than the creditors) if the bank fails. The special capital account requirement ensures creditors have skin in the game and also provides the second margin of safety in the calculation of capital adequacy—a buffer for the regulator's own “model risk” in calculations of needed capital buffers.
ABSTRACT (Click Here for Paper)
We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking.
We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking.
ABSTRACT (Click Here for Paper)
During this current financial crisis, the terms “capital” and “leverage” have figured prominently in discussions about the causes of and the possible solutions to alleviate the crisis. They also provide important tools for understanding some of the causes of bank “runs.” This Mercatus on Policy clarifies these concepts as they apply to financial institutions and the debacle of 2007-2008 and explains how these concepts should affect the roles that prudential regulators can play in maintaining the safety and soundness of the banking system.
During this current financial crisis, the terms “capital” and “leverage” have figured prominently in discussions about the causes of and the possible solutions to alleviate the crisis. They also provide important tools for understanding some of the causes of bank “runs.” This Mercatus on Policy clarifies these concepts as they apply to financial institutions and the debacle of 2007-2008 and explains how these concepts should affect the roles that prudential regulators can play in maintaining the safety and soundness of the banking system.
ABSTRACT (Click Here for Paper)
This paper is an essay from my Ph.D. dissertation. I have benefited from encouragement and guidance of Yakov Amihud, Douglas Gale, Marty Gruber, Kose John, Anthony Saunders, Marti Subrahmanyam, and Rangarajan Sundaram. I am especially indebted to Rangarajan Sundaram for introducing me to the topic, to Douglas Gale for many insightful discussions, and to Ken Garbade and Anthony Saunders for detailed comments on an earlier draft. In addition, I am grateful to Franklin Allen, Edward Altman, Allen Berger, Mitchell Berlin, Alberto Bisin, Menachem Brenner, Steve Brown, Qiang Dai, Darrell Duffie, Nikunj Kapadia, Simi Kedia, Anthony Lynch, Vojislav Maksimovic, Paolo Pasquariello, Enrico Perotti, Alex Shapiro, William Silber, Philip Strahan, Martin Summer, Suresh Sundaresan, Narayanan Vaghul, Lawrence White, my colleagues in the doctoral program, and seminar participants at Bank of International Settlements (BIS), Baruch College, Federal Reserve Board of Governors, Federal Reserve Bank of New York, Inter-University Student Conference Series at University of Pennsylvania, Lehman Brothers Fellowship Presentation, and Stern School of Business - NYU, for their comments and suggestions. I also acknowledge the help of Mickey Bhatia and Blythe Masters of J.P.Morgan; Lev Borodovsky of Global Association of Risk Professionals (GARP) and CSFB; and, Erik Larson and Mitch Stengel of the Office of the Comptroller of the Currency (OCC) for enriching my understanding of the various institutions of bank regulation. All errors remain my own.
This paper is an essay from my Ph.D. dissertation. I have benefited from encouragement and guidance of Yakov Amihud, Douglas Gale, Marty Gruber, Kose John, Anthony Saunders, Marti Subrahmanyam, and Rangarajan Sundaram. I am especially indebted to Rangarajan Sundaram for introducing me to the topic, to Douglas Gale for many insightful discussions, and to Ken Garbade and Anthony Saunders for detailed comments on an earlier draft. In addition, I am grateful to Franklin Allen, Edward Altman, Allen Berger, Mitchell Berlin, Alberto Bisin, Menachem Brenner, Steve Brown, Qiang Dai, Darrell Duffie, Nikunj Kapadia, Simi Kedia, Anthony Lynch, Vojislav Maksimovic, Paolo Pasquariello, Enrico Perotti, Alex Shapiro, William Silber, Philip Strahan, Martin Summer, Suresh Sundaresan, Narayanan Vaghul, Lawrence White, my colleagues in the doctoral program, and seminar participants at Bank of International Settlements (BIS), Baruch College, Federal Reserve Board of Governors, Federal Reserve Bank of New York, Inter-University Student Conference Series at University of Pennsylvania, Lehman Brothers Fellowship Presentation, and Stern School of Business - NYU, for their comments and suggestions. I also acknowledge the help of Mickey Bhatia and Blythe Masters of J.P.Morgan; Lev Borodovsky of Global Association of Risk Professionals (GARP) and CSFB; and, Erik Larson and Mitch Stengel of the Office of the Comptroller of the Currency (OCC) for enriching my understanding of the various institutions of bank regulation. All errors remain my own.
ABSTRACT (Click Here for Paper)
Why did the popping of the housing bubble bring the financial system rather than just the housing sector of the economy to its knees? The answer lies in two methods by which banks had evaded regulatory capital requirements. First, they had temporarily placed assets such as securitized mortgages in off-balance-sheet entities, so that they did not have to hold significant capital buffers against them. Second, the capital regulations also allowed banks to reduce the amount of capital they held against assets that remained on their balance sheets if those assets took the form of AAA-rated tranches of securitized mortgages. Thus, by repackaging mortgages into mortgage backed securities, whether held on or off their balance sheets, banks reduced the amount of capital required against their loans, increasing their ability to make loans many-fold. The principal effect of this regulatory arbitrage, however, was to concentrate the risk of mortgage defaults in the banks and render them insolvent when the housing bubble popped.
Why did the popping of the housing bubble bring the financial system rather than just the housing sector of the economy to its knees? The answer lies in two methods by which banks had evaded regulatory capital requirements. First, they had temporarily placed assets such as securitized mortgages in off-balance-sheet entities, so that they did not have to hold significant capital buffers against them. Second, the capital regulations also allowed banks to reduce the amount of capital they held against assets that remained on their balance sheets if those assets took the form of AAA-rated tranches of securitized mortgages. Thus, by repackaging mortgages into mortgage backed securities, whether held on or off their balance sheets, banks reduced the amount of capital required against their loans, increasing their ability to make loans many-fold. The principal effect of this regulatory arbitrage, however, was to concentrate the risk of mortgage defaults in the banks and render them insolvent when the housing bubble popped.
ABSTRACT (Click Here for Paper)
The merit of international convergence of bank capital requirements in the presence of divergent closure policies of di¡erent central banks is examined. The lack of a complementary variation between minimum bank capital requirements and regulatory forbearance leads to a spillover from more forbearing to less forbearing economies and reduces the competitive advantage of banks in less forbearing economies. Linking the central bank's forbearance to its alignment with domestic bank owners, it is shown that in equilibrium, a regression toward the worst closure policy may result: The central banks of initially less forbearing economies also adopt greater forbearance.
The merit of international convergence of bank capital requirements in the presence of divergent closure policies of di¡erent central banks is examined. The lack of a complementary variation between minimum bank capital requirements and regulatory forbearance leads to a spillover from more forbearing to less forbearing economies and reduces the competitive advantage of banks in less forbearing economies. Linking the central bank's forbearance to its alignment with domestic bank owners, it is shown that in equilibrium, a regression toward the worst closure policy may result: The central banks of initially less forbearing economies also adopt greater forbearance.
ABSTRACT
The design of prudential bank capital requirements interacts with the industrial organization of the banking sector, in particular, with the level of competition among banks. Increased competition leads to excessive risk-taking by banks which may have to be counteracted by tighter capital requirements. When capital requirements are internationally uniform but the levels of competition among banks in different countries are not, international spillovers arise on financial integration of these countries. This result begs a more careful analysis of the effect of financial liberalization on the stability of banking sectors in emerging countries. It also calls into question the merits of employing uniform capital requirements across countries that diverge in the industrial organization of their banking sectors.
The design of prudential bank capital requirements interacts with the industrial organization of the banking sector, in particular, with the level of competition among banks. Increased competition leads to excessive risk-taking by banks which may have to be counteracted by tighter capital requirements. When capital requirements are internationally uniform but the levels of competition among banks in different countries are not, international spillovers arise on financial integration of these countries. This result begs a more careful analysis of the effect of financial liberalization on the stability of banking sectors in emerging countries. It also calls into question the merits of employing uniform capital requirements across countries that diverge in the industrial organization of their banking sectors.
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