The New Basel Accord: some potential implications of the new standards for credit risk

This paper discusses some potential implications – both intended and unintended – of The New Basel Accord, which is to be finalized by the end of 2001. Our focus is on the reforms of the rules for determining minimum capital requirements for credit risk. The discussion is divided into effects at the level of an individual bank, effects on the structure of the financial markets, and macroeconomic implications. We present a survey of potential effects rather than a profound analysis of any of them. Therefore conclusions are inevitably preliminary, and in many cases they are likely to be controversial. Although the new capital accord as a whole is a major improvement on many properties of the current framework, our aim is to find potential problems that might need to be considered in the implementation and application of the new rules. Overall, the new accord will be largely an experiment, of which many of the consequences remain to be seen.capital adequacy requirements; credit crisk; banking stability

Simulation-based stress testing of banks’ regulatory capital adequacy

Banks’ holding of reasonable capital buffers in excess of minimum requirements could alleviate the procyclicality problem potentially exacerbated by the rating-sensitive capital charges of Basel II. Determining the required buffer size is an important risk management issue for banks, which the Basle Committee (2002) suggests should be approached via stress testing. We present here a simulation-based approach to stress testing of capital adequacy where rating transitions are conditioned on business-cycle phase and business-cycle dynamics are taken into account. Our approach is an extension of the standard credit portfolio analysis in that we simulate actual bank capital and minimum capital requirements simultaneously. Actual bank capital (absent mark-to-market accounting) is driven by bank income and default losses, whereas capital requirements within the Basel II framework are driven by rating transitions. The joint dynamics of these determine the necessary capital buffers, given bank management’s specified confidence level for capital adequacy. We provide a tentative calibration of this confidence level to data on actual bank capital ratios, which enables a ceteris-paribus extrapolation of bank capital under the current regime to bank capital under Basel II.Basel II; Pillar 2; bank capital; stress tests; procyclicality

Portfolio effects and efficiency of lending under Basel II

Although beneficial allocational effects have been a central motivation for the Basel II capital adequacy reform, the interaction of these effects with Basel II’s procyclical impact has been less discussed. In this paper, we investigate the effect of Basel II on the efficiency of bank lending. We consider competitive credit markets where entrepreneurs may apply for loans for investments of different risk profiles. In this setting, excessive risk taking typically arises because low risk borrowers cross-subsidize high risk borrowers through the price system that is based on average success rates. We find that while flat-rate capital requirements (such as Basel I) amplify overinvestment in risky projects, risk-based capital requirements alleviate the cross-subsidization effect, improving allocational efficiency. This also suggests that Basel II does not necessarily lead to exacerbation of macroeconomic cycles because the reduction in the proportion of high-risk investments softens the cyclicality of bank lending over the business cycle.Basel II; bank regulation; capital requirements; credit risk; procyclicality

Leverage ratio requirement, credit allocation and bank stability

We study the effects on credit allocation and bank stability of introducing a leverage ratio requirement (LRR) on top of risk-based capital requirements, as in Basel III. For the current 3% LRR, both low-risk and high-risk loan rates and volumes remain essentially unchanged, because banks previously specializing in low-risk lending can adapt by granting both low-risk and high-risk loans. For sufficiently high LRRs, low-risk lending rates would significantly increase and high-risk lending rates would fall. In the presence of severe ‘model risk’ concerning low-risk loans, as happened in the subprime crisis, the current 3% LRR might even reduce bank stability, counter to regulatory intentions. This is because the allocational effect caused by the LRR, which makes bank loan portfolios more alike, may turn beneficial risk spreading into harmful risk contamination. For higher levels of LRR, however, bank stability is likely to be improved even in the presence of model risk.bank regulation; Basel III; capital requirements; credit risk; leverage ratio

Trading Nokia: The roles of the Helsinki vs the New York stock exchanges

We use the Autoregressive Conditional Duration (ACD) framework of Engle and Russell (1998) to study the effect of trading volume on price duration (ie the time lapse between consecutive price changes) of a stock listed both in the domestic and the foreign market. As a case study we use the example of Nokia’s share, which is actively traded both in the Helsinki Stock Exchange and the New York Stock Exchange (NYSE). We find asymmetry in the volume-price duration relationship between the two markets. In the NYSE the negative relationship is much stronger and exists both during and outside common trading hours. Outside common trading hours no such relationship is significant in Helsinki. Based on the theory of Easley and O’Hara (1992), these results could be interpreted in that informed investors in Nokia mainly trade in the US market whereas Helsinki is the more liquidity-oriented trading place.cross-listing; Autoregressive Conditional Duration; market microstructure

Rating targeting and the confidence levels implicit in bank capital

The solvency standards implicit in bank capital levels, as reported eg in Jackson et al (2002), are much higher than those required for top ratings, if standard single period economic capital models are taken se-riously. We explain this excess capital puzzle by forward looking rating targeting behaviour by banks, which aims at maintaining rating above a minimum target in future periods. We calibrate to data on actual bank capital the confidence level used by the median US AA rated bank to maintain at least a single A rating. The calibrated confidence level is in line with the historical probability of an AA rated bank to be downgraded below A.bank capital; credit rating; value-at-risk; economic capital; capital structure

Simulation-based stress testing of banks’ regulatory capital adequacy

Banks’ holding of reasonable capital buffers in excess of minimum requirements could alleviate the procyclicality problem potentially exacerbated by the rating-sensitive capital charges of Basel II. Determining the required buffer size is an important risk management issue for banks, which the Basle Committee (2002) suggests should be approached via stress testing. We present here a simulation-based approach to stress testing of capital adequacy where rating transitions are conditioned on business-cycle phase and business-cycle dynamics are taken into account. Our approach is an extension of the standard credit portfolio analysis in that we simulate actual bank capital and minimum capital requirements simultaneously. Actual bank capital (absent mark- to-market accounting) is driven by bank income and default losses, whereas capital requirements within the Basel II framework are driven by rating transitions. The joint dynamics of these determine the necessary capital buffers, given bank management’s specified confidence level for capital adequacy. We provide a tentative calibration of this confidence level to data on actual bank capital ratios, which enables a ceteris- paribus extrapolation of bank capital under the current regime to bank capital under Basel II.Basel II, Pillar 2, bank capital, stress tests, procyclicality

GDP at risk in a DSGE model: an application to banking sector stress testing

We suggest a complementary tool for financial stability analysis based on stochastic simulation of a dynamic stochastic general equilibrium model (DSGE) of the macro economy. The paper relates to financial stability research in which financial aggregates crucial to financial stability are modelled as functions of macroeconomic variables. In these models, stress tests for eg banking sector loan losses can be generated by considering adverse scenarios of macro variables. A DSGE model provides a systematic way of generating coherent macro scenarios which can be given a rigorous economic interpretation. The approach is illustrated using a DSGE model of the Finnish economy and a simple model of Finnish banking sector loan losses.DSGE models; financial stability; loan losses; stress testing

Credit allocation, capital requirements and procyclicality

Although beneficial allocational effects have been a central motivator for the Basel II capital adequacy reform, the interaction of these effects with Basel II’s procyclical impact has been less discussed. In this paper, we investigate the effect of capital requirements on the allocation of credit and its interaction with procyclicality, and compare Basel I and Basel II type capital requirements. We consider competitive credit markets where entrepreneurs of varying ability can apply for loans for one-period investment projects of two different risk types. The risk of a project further depends on the state of the economy, modelled as a two-state Markov process. In this type of setting, excessive risk taking typically arises because higher-type borrowers cross-subsidize lower-type borrowers via a pricing regime based on average success rates. We find that risk-based capital requirements (such as Basel II) alleviate the cross-subsidization effect and can be chosen so as to implement first-best allocation. This implies that the ensuing reduction in the proportion of high-risk investments may mitigate the procyclical effect of Basel II on economic activity. Moreover, we find that optimal risk-based capital requirements should be set lower in recessions than in normal times. Our simulations show that when measured by either cumulative output or output variation, Basel II type capital requirements may actual be slightly less procyclical than flat capital requirements. The biggest reduction in procyclicality is however achieved with optimal risk-based capital requirements which are considerably higher than Basel II requirements and which are adjusted downwards in recession periods.Basel II; bank regulation; capital requirements; credit risk; procyclicality

Credit allocation, capital requirements and output

We show how banks’ excessive risk-taking, stemming from informational asymmetries in loan markets, can lead to an excessive output loss when a recession starts. Risk-based capital requirements can alleviate the output loss by reducing excessive risk-taking in ‘normal’ times. Model simulations suggest that the differentiation of risk-weights in the Basel framework might be further increased in order to take full advantage of the allocational effects of capital requirements. Our analysis also provides a new rationale for the countercyclical elements of capital requirements.bank regulation; Basel III; capital requirements; credit risk; crises; procyclicality