The cyclicality of bank credit losses and capital ratios under expected loss model

We model the evolution of stylised bank loan portfolios to assess the impact of IFRS 9 and US GAAP expected loss model (ECL) on the cyclicality of loan write-off losses, loan loss provisions (LLPs) and capital ratios of banks, relative to the incurred loss model of IAS 39. We focus on the interaction between the changes in LLPs charges (the flow channel) and stocks (the stock channel) under ECL. Our results show that, when GDP growth doesn’t demonstrate high volatility, ECL model smooths the impact of credit losses on profits and capital resources, reducing the pro-cyclicality of capital and leverage ratios, especially under US GAAP. However, when GDP growth is highly volatile, the large differences in lifetime probabilities of defaults (PDs) between booms and busts cause sharp increases in LLPs in deep downturns, as seen for US banks during the COVID-19 crisis. Volatile GDP growth makes capital and leverage ratios more pro-cyclical, with sharper falls in both ratios in deep downturns under US GAAP, compared to IAS 39. IFRS 9 ECL demonstrates less sensitivity to lifetime PDs fluctuations due to the existence of loan stages, and hence can reduce the pro-cyclicality of capital and leverage ratios, even when GDP is highly volatile

Leverage ratio, risk-based capital requirements, and risk-taking in the United Kingdom

We assess the impact of the leverage ratio capital requirements on the risk-taking behaviour of banks both theoretically and empirically. Conceptually, introducing binding leverage ratio requirements into a regulatory framework with risk-based capital requirements induces banks to re-optimise, shifting from safer to riskier assets (higher asset risk). Yet, this shift would not be one-for-one due to risk weight differences, meaning the shift would be associated with a lower level of leverage (lower insolvency risk). The interaction of these two changes determines the impact on the aggregate level of risk. Empirically, we use a difference-in-differences setup to compare the behaviour of UK banks subject to the leverage ratio requirements (LR banks) to otherwise similar banks (non-LR banks). Our results show that LR banks did not increase asset risk, and slightly reduced leverage levels, compared to the control group after the introduction of leverage ratio in the UK. As expected, these two changes led to a lower aggregate level of risk. Emperical results indicate that credit default swap spreads on the 5-year subordinated debt of LR banks decreased relative to non-LR banks post leverage ratio introduction, suggesting the market viewed LR banks as less risky, especially during the COVID 19 stress

Carbon Emissions Announcements and Market Returns

The paper investigates the impact of carbon emissions on stock price returns of European listed firms. This relationship is assessed across all three emissions scopes, as well as using expectations to detect if future emissions impact contemporary returns. Our findings show that firms with higher expected future emissions deliver lower contemporary returns after controlling for market capitalization, profit and other known return predictors. This result is statistically significant in the post Paris Agreement period for two- to three-year expectations of Scope 2 emissions. However, there is marginal to no significant negative relationship between current emissions and current returns. Overall, the results suggest that more environment-minded investors look further ahead and would expect lower returns from a polluting firm compared to a firm with no carbon emissions after the Paris Agreement