Mounir Kenaissi and Mariana Gimpelewicz.
A key feature of the post-crisis regulatory reform agenda has been the introduction of a leverage ratio to complement the risk-weighted framework. The FPC designed the UK leverage ratio to mirror risk-weighted capital requirements so the two frameworks move in lock-step over time and across firms. For the sake of simplicity however, the FPC did not reflect Pillar 2 capital charges, which aim to capture risks that cannot be modelled adequately in the risk-weighted framework, in the leverage ratio framework. In this post we explore what happens to leverage and risk-weighted requirements once Pillar 2 are taken into account. We find that in keeping the leverage ratio simple, the perfect lock-step interaction with risk-weighted requirements no longer holds, which could prompt riskier banks to take on more risk.
Sebastian J A de-Ramon, William Francis and Qun Harris
Shakespeare first coined the term ‘sea change’ in The Tempest to describe King Alonso’s lasting transformation after his mystical death by drowning. Resting five fathoms deep, Alonso suffers a sea change into something rich and strange, with coral for bones and pearls for eyes. In a recent working paper, we explore for evidence of a possible sea change in UK banks’ balance sheets using data spanning the 2007-09 crisis. Our initial dive into the still murky, post-crisis waters shows signs of something strange and unrecognizable, with UK banks, in response to higher capital requirements, increasing the level and in particular the quality of capital more after the crisis. This post describes our dive and its findings.
Last autumn, Charles Goodhart gave a special lecture at the Bank. In this guest post he argues that regulators should focus more on the incentives of individual decision makers.
The incentive for those in any institution is to justify and extol the virtues of the decisions that they have taken. Criticisms of current regulatory measures are more likely to come from outsiders, perhaps especially from academics, (with tenure), who can play the fool to the regulatory king. I offer some thoughts here from that perspective. I contend that the regulatory failures that led to the crisis and the shortcomings of regulation since are largely derived from a failure to identify the persons responsible for bad decisions. Banks cannot take decisions, exhibit behaviour, or have feelings – but individuals can. The solution lies in reforming the governance set-up and realigning incentives faced by banks’ management.
Caterina Lepore, Caspar Siegert, Quynh-Anh Vo
The 2016 Nobel Prize in economics has been awarded to Professors Oliver Hart and Bengt Holmström for their contributions to contract theory. The theory offers a wide range of real-life applications, from corporate governance to constitutional laws. And, as the post will hopefully convince you, contract theory is also helpful in regulating banks! To this end, we will unpack the outline of the theory and apply it to a number of real-world conundrums: How to pay banks’ chief executives and traders? How to fund a bank’s balance sheet? How to regulate banks?
Matteo Benetton, Peter Eckley, Nicola Garbarino, Liam Kirwin and Georgia Latsi.
Do financial regulations change bank behaviour? Does this create new risks? Under Basel II, some banks set capital requirements based on their internal risk models; others use an off-the-shelf standardised approach. These two methodologies can produce very different capital requirements for similar assets. See Figure 1, which displays a snapshot of recent risk weights for UK mortgages. In a new working paper we show empirically that this discrepancy causes lenders to adjust their interest rates and to specialise in which borrowers they target.
There are two ways people can make their resources go further when buying a home.
One is to increase the loan-to-value (LTV) ratio and hence increase the amount available to buy a house for a given deposit.
The other is to lengthen the term over which the mortgage is repaid, which increases the size of loan associated with a given level of monthly repayments.
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.
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.
Deposit insurance schemes guard against bank runs by reducing or removing individual depositors’ incentives to withdraw their funds if they believe their bank to be in trouble. They help protect depositors but they risk also protecting risky bank business models by removing depositors’ incentives to avoid riskier banks. What can be done about this? In the past the answer was sometimes to make small depositors bear part of the risk through “co-insurance”. This was proven not to be credible. In this blog I consider some of the options available, including the risk-based levies currently being introduced in the EU and elsewhere, and increased transparency, drawing on recent literature on the saliency of tax in consumer choices.
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.