Book-valued capital ratios and regulatory inertia are some of the causes, write Mark J. Flannery and Emanuela Giacomin

Flannery, Mark J

Giacomini, Emanuela

English

LSE Research Online

11/3/2015Large EU banks have remained undercapitalised for longstretches of timeblogs.lse.ac.uk /businessreview/2015/11/03/large-eu-banks-have-remained-undercapitalised-for-long-stretches-of-time/The Basel Committee on Banking Supervision ( BCBS) has designed complex rules for defining sufficientcapital at internationally active financial institutions. Pillar II of the Basel Accord requires national supervisors toassure continuous compliance with capital standards, which require a minimum ratio of the book value of equitycapital to a bank’s risky assets. An adequate Tier 1 capital ratio would stand at 5% or 6%. At the end of 2007, the vastmajority of EU banks and bank holding companies easily complied with minimum capital requirements.Unfortunately, the book value of equity can substantially understate a bank’s ability to absorb further losses.Between 2008 and 2011, European governments’ support of troubled banks included €1084.8 billion (8.6 percent ofEU GDP) of guarantees on banks’ bonds and deposits, €322.1 billion (2.5 percent of EU GDP) of capitalcontributions, €119.9 (0.9 percent of EU GDP) of impaired assets purchased, and €89 billion (0.7 percent of EUGDP) of liquidity support. The UK government took stakes in Lloyds Banking Group and Royal Bank of Scotland,whose year-end 2007 Tier 1 ratios were 9.5 percent and 7.3 percent respectively — therefore above the minimumrequired. The Belgian-French financial holding company Dexia received government support in October 2008despite its Tier 1 ratio of 9.10 percent at the end of 2007. Similarly, UBS and Unicredit Group turned to their nationalgovernments for financial support after reporting Tier 1 ratios of 8.8 percent and 6.55 percent in 2007.How could a system that defined and monitored bank capital positions so carefully have permitted such catastrophiclosses? Although there are many reasons, one major cause was the supervisors’ reliance on book equity measures,which do not capture the firms’ true ability to absorb losses. Financial accounting reports follow either GenerallyAccepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Combined withregulatory accounting rules, either accounting standard provides managers with discretion to overstate assets andmanage earnings and capital. There is also evidence that some banks may understate their risk-weighted assets.Banks’ incentives to manipulate accounting valuations are strongest as their capital ratios approach mandatedminima. Huizinga and Laeven provide evidence that banks used their accounting discretion during the financial crisisto understate impairments of their real estate loans and mortgage-backed securities (MBS), and that accountingdiscretion was more pronounced for large financial institutions.In our study, we estimate annual default probabilities for the largest 25 European banks over the period 1997-2011,using the method of Ronn and Verma (1986) to estimate each bank’s asset value and portfolio return volatility(standard deviation). We find that some of the sample banks are insolvent at year end, in the sense that their assetsare worth less (in market value) than the face value of their liabilities. Figure 1 indicates that insolvencies becameespecially common in 2008, and they did not disappear very quickly in subsequent years.Figure 1: Number of insolvent banks1/4Another way to summarize the sample banks’ capital adequacy is to compute their annual default probabilities fromour estimated asset values and return volatilities. Figure 2 plots the mean, median, and maximum default probabilityamong sample banks each year.Figure 2: Mean, median and maximum probabilities of default (PD) for solvent banks, 1997-2011Even before the financial crisis, the mean default probability was surprisingly high in many years. These high defaultprobabilities made government guarantees particularly valuable to bank shareholders among these largest 25European banks over the period studied (1997-2011). We find that the estimated value of government guaranteesaveraged 28.5 percent of the banks’ equity market value. Moreover, banks operated repeatedly with relatively highdefault probabilities. Whereas the Basel capital standard was calibrated to produce an annual default probability ofabout 0.1%, we find that ten of our sample banks operated with a default probability exceeding one percent in ten ormore years of our 15-year sample (Table 1). This evidence leads us to conclude that supervisory discretion has beenunable to maintain adequate capitalization for these banks.2/4Table 1: Banks with Multiple Years of High Default Probability (PD). An “offense” is a year-end at which a bank has a probability of default higher than the values indicated atthe top of each column.How much added capital would have been required to maintain low default probabilities for large European banksover the past fifteen years? To answer this question, we hypothesize a “Timely Recapitalization” policy, whichcomputes how much additional capital banks should have kept in order to maintain low one-year default probabilitiesat each year-end. Unsurprisingly, banks would have required a massive amount of additional capital during the crisisto reduce the value of government guarantees very much.Even before the crisis (1997-2006), Timely Recapitalization would have reduced the average bank’s governmentguarantee value from 7.4 percent to 0.31 percent of equity market value. We conclude that book-valued capital ratiosand regulatory inertia combined to permit large European banks to be, and to remain, undercapitalised for longstretches of time. Supervisors have not assured that large European banks continuously maintain market-valuedequity cushions that place their solvency beyond question.What does this state of affairs imply for “better” capital regulation in the future? Orderly resolution and “bail in” debt(which is also called “total loss-absorbing capacity”, or TLAC) have prominent places in current policy circles.Unfortunately, the need for supervisors to declare a bank “non-viable” in order to set off such a re-organization reliescrucially on the same type of supervisory discretion that has performed poorly in the past. We must find an alternativeto supervisory discretion if capital regulation is to become an effective regulatory process. The legal/regulatory focuson book capital measures makes it difficult for supervisors to force equity additions in advance of a possible run. Theresulting pressure on governments to support their banks has been expensive, but is probably unavoidable under thepresent regulatory structure.As one alternative, supervisors might think in terms of maintaining adequate equity market value to protect bankclaimants from failure. Contingent capital bonds that convert automatically on the basis of the issuing bank’s equitymarket value might be a more reliable mechanism for assuring continuous solvency. Conversion based on equity’smarket value raises some important issues about trading and price efficiency, but there are suggested methods tominimize or eliminate many of those issues.Critics have also asserted that market assessments of bank equity value can change quickly and needn’t beaccurate. Yet we know that book equity measures can also misrepresent a bank’s ability to absorb further losses,and book value distortions are probably biased upwards and become worse when the bank’s true condition hasdeteriorated. Finally, regardless of their accuracy, market assessments drive both equity values and depositor runs.Some method for incorporating market valuations into bank capital regulation seems like a very attractive policyoption.♣♣♣3/4Notes:This post is based on the authors’ paper Maintaining adequate bank capital: An empirical analysis of thesupervision of European banks, published in the Journal of Banking & Finance, Volume 59, October 2015,Pages 236–249.The post gives the views of the authors, and not the position of LSE Business Review or the London School ofEconomics.Mark J. Flannery is the Chief Economist at the U.S. Securities and Exchange Commission, onleave from his faculty position at the University of Florida. The Securities and ExchangeCommission, as a matter of policy, disclaims responsibility for any private publication or statementby any of its employees. The views expressed herein are those of the author and do notnecessarily reflect the views of the Commission or of the author’s colleagues and the staff of theCommission.Emanuela Giacomini is a 5th year PhD student of Finance at the University of Florida (USA) andan assistant professor at the Catholic University of the Sacred Heart (Milan). Her research interestsare in banking and corporate finance with an emphasis on banking regulation and bank lending.Emanuela received her MS degree in Real Estate and Finance from the University of Florida.Copyright © 2015 London School of Economics4/4

Large EU banks have remained undercapitalised for long stretches of time

Flannery, Mark J.

GIACOMINI, EMANUELA

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Large EU banks have remained undercapitalised for long stretches of time

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