The mitigation role of collaterals and guarantees under Basel II

Under the Basel II framework for capital adequacy of banks, regulatory financial collateral and guarantees (C&G ) can affect lending policy in both a micro and a macro perspective. This paper aims at assessing these effects throught the modelling of the impact of C&G on credit spreads. In doing this we assume the perspective of a bank adopting a Foundation Internal Rating Based approach to measure credit risk and we apply a comparative-static analysis to a pricing model, based on the intrinsic value pricing approach as in the loan arbitrage-free pricing model (LAFP) suggested by Dermine (1996). Our results show that financial collaterals are more effective than guarantees in reducing credit spreads, this differential impact becoming greater as the borrower’s rating worsen. Moreover, the effects of C&G on credit spreads can be more effective than an improvement of borrower’s rating, this possibly leading to negative outfits on credit industries’ allocative efficiency.JRC.G.1-Scientific Support to Financial Analysi

Deposit Insurance Schemes: target fund and risk-based contributions in line with Basel II regulation

This paper discusses a deposit insurance model recently developed by De Lisa et al. (2010), highlighting its policy implications. Compared to existing ones, the model proposed by De Lisa et al. (2010) presents the important advantage of taking into account Basel 2 banking regulation, thus linking two pillars of financial safety net: banks' capital requirements and deposit insurance. The model, which estimates the potential loss hitting a Deposit Insurance Scheme (DIS) under several economic scenarios, can be used to establish the target size of the fund, which is the amount of money that the DIS should have available in case of need. Moreover the model can be used to estimate the contribution (to this loss) that each bank should pay to the fund according to its degree of riskiness.JRC.DG.G.9-Econometrics and applied statistic

Does Debt Concentration Depend on the Risk-Taking Incentives in CEO Compensation?

[EN] Coordination problems amongst creditors are reduced when a firm’s debt structure is concentrated in fewer debt types. Using a sample of US non-financial firms, we show that an increase in risktaking incentives in CEO pay is associated with a greater debt concentration by debt type. This result holds in various settings that account for endogeneity and is primarily driven by pay incentives embedded in vested options that are expected to favor business choices with more immediate negative effects on debtholders’ wealth. Further, our findings are stronger for firms with a higher default risk where coordinated efforts amongst creditors become more pressing. A final test documents that a more concentrated debt structure reduces the negative influence of CEO risk-taking incentives on debtholder wealth thus highlighting the advantages of lower coordination problems amongst creditors

CEO Bonus Compensation and Bank Default Risk: Evidence from the U.S. and Europe

We investigate the link between the incentive mechanisms embedded in CEO cash bonuses and the riskiness of banks. For a sample of U.S. and European banks, we employ the Merton distance to default model to show that increases in CEO cash bonuses lower the default risk of a bank. However, we find no evidence of cash bonuses exerting a risk-reducing effect when banks are financially distressed or when banks operate under weak bank regulatory regimes. Our results link bonus compensation in banking to financial stability and caution that attempts to regulate bonus pay need to tailor CEO incentives to the riskiness of banks and to regulatory regimes

Do Banks Issue Equity When They Are Poorly Capitalized?

Debt overhang and moral hazard predict that poorly capitalized banks have a lower likelihood to issue equity, while the presence of regulatory and market pressures posits an opposite theoretical prediction. By using an international sample of bank seasoned equity offerings (SEOs), we show that the likelihood of issuing SEOs is higher in poorly capitalized banks and that such banks prefer SEOs to alternative capitalization strategies. A series of tests exploring the variation of capital regulation and market discipline show that market mechanisms rather than capital regulation are the primary driver of the decision to issue by poorly capitalized banks

The Risk Sensitivity of Capital Requirements: Evidence from an International Sample of Large Banks

Using an international sample of large banks between 2000 and 2010, we evaluate the risk sensitivity of minimum capital requirements. Our results show that risk-weighted assets (the regulatory measure of portfolio risk, which determines minimum capital requirements) are ill-calibrated to a market measure of bank portfolio risk. We show that this low-risk sensitivity of capital requirements permits banks to build up capital buffers by underreporting their portfolio risk and undermines banks’ ability to withstand adverse shocks. While the risk sensitivity of capital requirements is higher for banks that have adopted Basel II, it remains low across banks and countries

CEO pay incentives and risk-taking: Evidence from bank acquisitions

We analyze how the structure of executive compensation affects the risk choices made by bank CEOs. For a sample of acquiring U.S. banks, we employ the Merton distance to default model to show that CEOs with higher pay-risk sensitivity engage in risk-inducing mergers. Our findings are driven by two types of acquisitions: acquisitions completed during the last decade (after bank deregulation had expanded banks' risk-taking opportunities) and acquisitions completed by the largest banks in our sample (where shareholders benefit from ‘too big to fail’ support by regulators and gain most from shifting risk to other stakeholders). Our results control for CEO pay–performance sensitivity and offer evidence consistent with a causal link between financial stability and the risk-taking incentives embedded in the executive compensation contracts at banks