The IUP Journal of Bank Management
Leverage and Risk-Weighted Capital in Banking Regulation

Article Details
Pub. Date : Feb, 2020
Product Name : The IUP Journal of Bank Management
Product Type : Article
Product Code : IJIT10220
Author Name : Rainer Masera
Availability : YES
Subject/Domain : Finance
Download Format : PDF Format
No. of Pages : 51

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Abstract

This paper offers a critical survey of the swings in banking regulation, notably with reference to leverage and Risk-Weighted Ratios (RWR). At the outset, a distinction is made between economic and Regulatory Capital (ReC) and between private and social costs/benefits of equity finance for banking firms. The inherent limitations of the transformation process of assets into a combined size-risk metric, amplified by Negative Nominal Interest Rates (NNIRs), are brought to the fore, as well as the relative ease of circumventing the rules. The complexity of regulatory risk weighting creates significant (fixed) compliance costs. Unless appropriate tiering is adopted, a competitive distortion is created in favor of large banking institutions. These shortcomings were especially evident in the Basel II standard. With reference to the Basel III/IV framework, it is argued that the two regulatory ratios (leverage and risk-weighted capital) can be complementary, but require close and constant supervision, rather than the quest for an optimal (steady state) ex ante calibration, which may prove time inconsistent. Emphasis should be placed on corporate governance and on the effective interaction between supervisory activity and internal controls. This is usefully complemented by stress-testing techniques which are less model-dependent. Potential drawbacks inherent in recent regulatory changes in the US (community banks have now the option of abandoning tiered risk-weighted requirements and adopting exclusively a leverage constraint, higher than 9%) are indicated.


Description

With the demise of the Glass and Steagall (1933) regulatory framework based on structural separations and reserve requirements on banks' assets, surveillance swung to capital requirements on the liabilities side. Leverage and risk-based ratios became intertwined with capital constraints. This paper shows that the lack of clarity can have important drawbacks. The two ratios have been-and are-monitored by credit institutions for internal risk management and control purposes. Large international banks pioneered techniques to estimate risk (economic) capital. The transformation process which converts assets into a size-risk measure is crucially dependent on the risk methodology adopted. The Economic Capital (EcC)1 approach is also shaped by the (private) cost of capital for the banking firms. With the adoption of capital standards, if the constraints are regarded excessively and unduly tight, an inevitable attempt to circumvent the rules is set in motion (the Goodhart Law and/or the Lucas critique, see Box 2). This behavior is inversely related to the quality of corporate governance. In any event, compliance costs to complex risk-weighted, one-size-fits-all, constraints create competitive distortions for small banks. The dangers of inadequate recognition of these points were shown notably by the Basel II standard. It appeared as a major advance, it was instead marred by model deficiencies: the risk sensitivity morphed into an incentive for large banks to economize required capital through innovative financial products/structures, thereby reducing the density ratio. The build up of both systemic risk and excessive leverage, while apparently maintaining tight risk-based requirements, was also not recognized as a result of principle-based supervision. The coexistence and overlap of leverage and risk-weighted requirements in Basel III represent a complementary approach, but they can create supervisory challenges. Circumvention of the rules may occur in respect of both ratios: their surveillance requires a time process of close monitoring.


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