The regulation of bank capital, lecture by Professor Geoffrey Miller, New York University

Professor Geoffrey Miller from New York University was invited on December^13th at ESCP-Europe business school to talk about a particularly burning topic, namely « the regulation of bank capital. » Some of us were here to discuss this issue and share the insights gained from this conference with you.

• 1. Why do we need regulation? Some reasons

Professor Miller began this conference by recalling the problems associated with debt as a contract. Bankruptcy costs are, of course, the first one. What he calls the « risk-taking problem » is another. When managing a company, managers take risks. If the risks pay off, then shareholders get some money and debt holders get their money back. If the risks don’t pay off, then shareholders don’t bear all the costs: they share them with debt holders. Thus, debt can be seen as insurance: if losses arise, then shareholders pay for part of them (up to the level of the firm’s capital) and debt holders have to make up for the rest. If the market has enough power (that is, enough information on the one hand, and enough means of pressure on the other), then it can easily deter the company from taking too many risks by setting higher interest rates. This is perfectly the case for general companies, Professor Miller stated: when a firm does not have enough capital compared to its debt, it tends to pay more interest on its debt. But this is too simple a reasoning for banks, Professor Miller says.

Banks have three special features when compared to ordinary companies. First, they are the only companies that have explicit insurance on part of their liabilities, namely deposit insurance. Deposit insurance provides a guarantee for depositors to get their funds back in the event of bankruptcy. This scheme, widely discussed in the literature, has the shortcoming of encouraging depositors not to monitor banks (the famous problem of moral hazard deriving from insurance). A second special feature that applies to larger banks is the implicit insurance resulting from their size: the fact that they are considered « too big to fail » makes them less sensitive to the risk of insolvency. This will result in low elasticity of the interest rates paid on the bank’s debt to its leverage (assets/capital). A third special feature is that the leverage of banks can generally, according to Professor Miller, be higher than that of ordinary companies, insofar as their expected return is, in general, easier to predict than the expected return of any other company. However, Professor Miller pointed out that this analysis does not hold when banks have risky and non-transparent assets, as is still the case today.

These three specific features help us understand why we need regulation. We could summarize the main reasons for having strong government regulation for banks as follows:

– weak private regulation (mainly because of the insurance described above)

– high leverage

– significant external costs of failure (the financial crisis demonstrated this argument…)

• 2. From Basel 1 to Basel 3: a brief review of the improvement of the regulation

Professor Miller then drew a review of the evolution of the Basel regulation.

The first leverage ratio that came up with Basel 1 in 1988 was in the following form:

Capital / (Credit) risk-weighted assets

or more formally;

capital / sum (alpha * asset i)

where just four levels of risks (α) were distinguished, depending on the nature of the asset. This oversimplification regarding the risk classification was the main deficiency of Basel 1 as a capital regulatory tool: the risk weight for every OECD country bond was the same, that is, Turkish bonds were considered to bear the same risk as German bonds. This system was to be improved and new capital regulatory agreements arose with Basel 2.

Basel 2 had many objectives, putting aside the regulation of bank capital (enhancing disclosure requirements to strengthen market discipline and improving the bank supervision framework were, for example, some of these other objectives). It enhanced the Basel 1 capital regulation in several ways:

– it took into account operational and market risks in the above ratio

– it allowed for more precise weights regarding the risks of banks’ assets (more possibilities for α in the above ratio)

– it took into consideration a « wonderful tool »—as Professor Miller considers it—namely the analysis of banks regarding their asset risks. This « wonderful tool » can indeed be used by the bank to compute the risk weight α of any asset in the regulatory leverage ratio (besides, this is known as the FIRB and AIRB approach[2]).

– it added a distinction between core capital and capital by setting different ratios depending on the type of capital (details on the relevance of this distinction can be found in Acharya et al (2010))

Nevertheless, the crisis brought to light the remaining shortcomings of Basel 2. Professor Miller summarized these deficiencies as follows:

– excessive reliance on credit ratings

– inaccurate risk weighting (the crisis indeed showed that tail events were not as rare as any risk modeler could think)

– the required capital is too low: many banks encountered several difficulties during the crisis, which means that the required capital was at least ‘too low to go through this crisis’

– the ratios are pro-cyclical: they tend to be higher when the economic situation is thriving and lower when it worsens (when risks get higher, α gets larger)

– it lacks a leverage ratio (see the exhaustive article by Blum (2008) on this issue[4])

– too much complacency associated with it, according to Prof. Miller

– The Basel 3 capital regulation framework addresses most of these issues:

The Basel 3 capital regulation framework addresses most of these issues: it tries to take into account tail events in the capital requirements (with measures such as stressed VaRs[5] for example), to address pro-cyclicity (with capital cushion requirements), to deal with systemic risk (additional capital requirement for SIFIs[6] for example), it includes a leverage ratio (3% of Tier 1 capital) and it increases the overall capital requirements.

• 3. What about the future?

Basel 3 therefore seems to have many advantages for financial stability when looking at the past. From this perspective, we might be tempted to think that Basel 3 would save us once and for all from future financial instability. But this would be overestimating our knowledge about the factors affecting capital needs: we do not know what an optimal level of bank capital is for the present situation, and even if we knew it, there is no reason to believe that this optimal level of capital will depend on the same factors in the future. The conclusion is well summarized by Prof. Miller : « Basel 3 fights the last war, but what about the next war? »

A short question and answer session concluded the conference. It is regrettable that neither the debate on the economic costs of Basel 3 nor the international political issues surrounding its adoption were addressed.

NB: we should keep in mind that capital regulation is just one part of the regulatory framework: it must be associated with other reforms to have a deep overview of the potential efficiency of the regulation. The recent measures tackling the size of banks and the links between their different activities (known as the Liikanen report, Vickers report, Dodd Frank Act, and Volcker rule) will have impacts that cannot be ignored when thinking about capital regulation.

To explore this issue further, here are some interesting articles:

Acharya, Gujral, Kulkarni, and Shin (2011) « Dividends and bank capital during the financial crisis of 2007-2009 » NBER Working Paper No. 16896

Blum (2008) “Why Basel II may need a leverage ratio restriction” Journal of Banking and Finance

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, Paul Pfleiderer Fallacies (2011) “Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive” Stanford Graduate School of Business Research Paper No. 2065