Ebook Bank regulation, Business Cycle, and Market Discipline
The 1988 Basel Accord was seriously criticized for being insufficiently sensitive to banks’ asset risk faced by the bank, resulting in regulatory capital arbitrage. In part in response to this criticism, Basel II has been designed to much more accurately reflect banks’ risk taking in the calculation of capital requirements. However, while this may substantially reduce the ability of banks to engage in regulatory arbitrage, the high risk sensitivity may lead to large swings in minimum capital requirements along the business cycle : high capital requirements during recessions and low capital requirements during booms. If banks have difficulties in raising fresh capital during recessions and instead are forced to reduce lending, economic cycles may be exacerbated (”procyclicality”). Borio , Furfine and Lowe (2001), and Lowe (2002) find two main explanations to procyclicality. The first one is that risk-based capital requirements, as said previously induce large changes in minimum requirements, especially if the risk measurement is based on market prices. This has the potential to amplify business cycles. The second explanation is that credit risk models pay little attention to changes in the business cycle leading to the underestimation of risk during booms, and the contrary during economic downturns.
Although there is no consensus on the welfare cost generated by business cycles (see Lucas (1987)), there is a strong evidence in the literature of procyclicality in bank lending. Segoviano and Lowe (2002) exhibit large swings in required capital for Mexican banks during second half of the 1990s. Heid (2003) models a closed loop between banking sector and industry in Germany and shows evidence of procyclicality induced by Basel II regulation.
In this article, we interpret the first Pillar of the New Basel Accord (capital requirements) as an intervention threshold set by the regulator. Once the bank falls below this threshold, it is closed by the regulator. Third Pillar (Market Discipline) is concerned with the mandatory disclosure by banks of key features concerning their portfolios : risk profiles, counterparts. Proposal are at this stage not very precise yet. Therefore, following the proposals of several US economists (see e.g. Calomiris, 1999), we modify the third Pillar which in Basel II is limited to mandatory disclosure requirements, as a mandatory subordinated debt requirement for which the regulator can determine the frequency of renewal.
In this article, we raise two questions : first, how should regulation (that is, capital requirements) integrate business cycle features, and then, to which extend can subordinated debt requirements partly offset the variation of capital requirements along the business cycle.
In our model, we assume that banks are run in the interest of their shareholders (that is, we neglect potential agency problems between shareholders and managers). Banks are financed by equity, retail deposits, and possibly by subordinated debt. In contrast to long term retail deposits which are fully insured by a Deposit Insurance Fund, subordinated debt has junior status and is continuously renewed at a frequency chosen by the regulator. Banks face a moral hazard problem: they make a choice of the technology they invest in. One has a positive net present value, but requires costly monitoring to succeed whereas the second technology has a negative net present value but does not require any monitoring cost. Liquidation is always preferable to this technology. The regulator then has two objectives. First, he chooses capital requirements such that banks have sufficient incentives to invest in the profitable technology, and second he tries to reduce the variability of intervention thresholds over the business cycle.
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