Peter Eckley and Liam Kirwin.
In the world of bank capital regulation, minimum requirements grab all the headlines. But actual capital resources are what absorb unexpected losses. Banks and building societies typically hold resources substantially in excess of requirements – called the capital surplus. One reason is to avoid breaching the minimum due to unforeseen shocks. Another is to build resources in anticipation of requirements arising from growth or regulatory change. The chart shows how capital surpluses (on total requirements including Pillars 1 and 2, and all types of capital) have varied in recent decades. It is based on historical data from regulatory returns.
Saleem Bahaj, Jonathan Bridges, Cian O’Neill & Frederic Malherbe.
It’s not just what you do; it’s when you do it – many decisions in life have “state contingent” costs and benefits. The payoffs from haymaking depend crucially upon the weather. Putting fodder away for a rainy day can be quick, cheap and prudent when skies are blue. But results may take a soggy and unproductive turn, if poorly timed. The financial climate is similarly important when assessing the costs and benefits of macroprudential policy changes. We argue that it is best to build the countercyclical capital buffer when the macroeconomic sun is shining. We find strong empirical evidence to support our claim.
Roy Zilberman and William Tayler.
Last year the Bank organised a research competition to coincide with the launch of the One Bank Research Agenda. In this guest post, the authors of the winning paper in that competition, Roy Zilberman and William Tayler from Lancaster Business School, summarise their work on optimal macroprudential policy.
Can macroprudential regulation go beyond its remit of financial stability and also contain inflation and output fluctuations? We think it can and argue that macroprudential regulation, in the form of countercyclical bank capital requirements, is a superior instrument to both conventional and financially-augmented Taylor (1993) monetary policy rules. This is especially true in responding to financial shocks that drive output and inflation in opposite directions, as also observed at the start of the recent financial crisis (see Gilchrist, Schoenle, Sim and Zakrajsek (2016)). This helps to effectively shield the real economy without the need for a monetary policy interest rate intervention. Put differently, a well-designed simple and implementable bank capital rule can achieve optimal policy associated with zero welfare losses.
Arzu Uluc and Tomasz Wieladek.
Following the global financial crisis of 2007-08, financial reform introduced time-varying capital requirements to raise the resilience of the financial system. But do we really understand how this policy works and the impact it is likely to have on UK banks’ largest activity, mortgage lending? In a recent paper we investigated the UK experience of time-varying microprudential capital requirements before the financial crisis. We found that an increase in this requirement intended to make a bank more resilient actually induced it to shift into riskier mortgage lending.
What do the Cold War powers of the United States and the USSR have in common with modern day asset managers? The capacity for mutually assured destruction. During the 1950s game theorists described a model of strategic interaction to demonstrate how it might be that two nations would choose to annihilate each other in nuclear conflict. Simply put, each nation had an incentive to strike first, as there was no incentive to retaliate. Both would race to push the button. Asset managers face a similar set of incentives.
Paolo Siciliani, Nic Garbarino, Thomas Papavranoussis and Jonathan Stalmann.
Systemically important banks are material providers of critical economic functions. The Global Financial Crisis showed how distress or failure of one of these firms may have a severe impact on the financial system and the real economy. Systemic capital surcharges protect the economy from these negative spillovers by decreasing systemically important firms’ probability of distress or failure. A graduated approach facilitates effective competition to the extent that the capital surcharges faced by firms are more proportionate to the scale of systemic risks that they pose. This post illustrates some of the competition implications with respect to the methodology used to set the number and level of thresholds.
Karen Braun-Munzinger, Zijun Liu and Arthur Turrell.
If a boat is unstable and someone jumps out, does it capsize the boat for everyone else? In a novel application of agent-based modelling, we examine how investors redeeming the corporate bonds held for them by open-ended mutual funds can cause feedback loops in which bond prices fall further, posing risks to financial stability. In our model, reducing the speed with which investors pull out their investments over time helps to keep prices stable and remaining investors’ savings on an even keel.
Matthew Osborne, Alistair Milne & Ana-Maria Fuertes.
Does the risk appetite of banks vary over the cycle? Our recent research paper sheds light on this issue by examining the time-varying correlation between banks’ capital ratios and lending rates which cannot be explained by bank characteristics, such as capital requirements, portfolio risk, size and market share, or macroeconomic factors. The relationship notably differs between episodes of rapid credit expansion (“good times”), and episodes of crisis with moderate or negative credit growth (“bad times”). This is difficult to reconcile with traditional theories of bank intermediation, but is consistent with recent theories emphasising cyclical variation in bank leverage and risk appetite.
Iñaki Aldasoro, Ester Faia, Gerardo Ferrara, Sam Langfield, Zijun Liu and Tomohiro Ota.
We make the case for a macroprudential approach to liquidity requirements in the cross-section of banks. Currently, the liquidity coverage requirement is applied uniformly across banks. This microprudential approach overlooks externalities: owing to their size, complexity and position in the interbank funding network, some banks can cause inordinate damage to the rest of the banking system. When externalities are taken into account, we show that these systemically important banks should be subject to more stringent liquidity requirements. This cross-sectional macroprudential approach promises “more bang for the buck”: systemic risk can be reduced without increasing the stringency of liquidity requirements for the banking system as a whole.
James Cloyne, Ryland Thomas and Alex Tuckett.
The financial crisis has thrown up a huge number of empirical challenges for academic and professional economists. The search is on for a framework with a rich enough variety of financial and real variables to examine both the financial shocks that caused the Great Recession and the unconventional policies, such as Quantitative Easing (QE), that were designed to combat it. In a new paper we show how using an older structural econometric modelling approach can be used to provide insights into these questions in ways other models currently cannot. So what are the advantages of going back to an older tradition of modelling?