Ex ante capital position, changes in the different components of regulatory capital and bank risk

Abstract

We investigate the impact of changes in capital of European banks on their risk-taking behaviour from 1992 to 2006, a time period covering the Basel I capital requirements. We specifically focus on the initial level and type of regulatory capital banks hold. First, we assume that risk changes depend on banks’ ex ante regulatory capital position. Second, we consider the impact of an increase in each component of regulatory capital on banks’ risk changes. We find that, for highly capitalized, adequately capitalized and strongly undercapitalized banks, an increase in equity or in subordinated debt positively affects risk. Moderately undercapitalized banks tend to invest in less risky assets when their equity ratio increases but not when they improve their capital position by extending hybrid capital or subordinated debt. On the whole, our conclusions support the need to implement more explicit thresholds to classify European banks according to their capital ratios but also to clearly distinguish pure equity from hybrid and subordinated instruments.

Keywords:

• bank risk
• bank capital
• capital regulation
• European banks

JEL Classification:

• G21
• G28

Acknowledgements

We are very grateful to the anonymous reviewers, Kevin Davis, Robert DeYoung, Douglas Evanoff, Phil Molyneux, Stephano Puddu, Philippe Rous, Nuria Suárez, Hsiangping Tsai and delegates at AFSE, Orléans, 2010; CEA, Quebec City, 2010; Infiniti, Dublin, 2010; GdRE Symposium on Banking and Finance, Bordeaux, 2010; ICEFA, Taipei, 2010; IBEFA/WEAI, Portland, 2010; FMA Annual Meeting, New York, 2010; EFA, Frankfurt, 2010; EWG-EPA, Chania, 2010; MFA, Chicago, 2011; SWFA, Houston, 2011; GFC, Bangkok, 2011; IFABS, Rome, 2011 for constructive comments on earlier versions of the article.

All errors, of course, rest with the authors and the opinions expressed in the article are only those of the authors and do not necessarily reflect those of the Autorité de Contrôle Prudentiel.

Notes

For details on Basel II and Basel III, see Basel Committee on Banking Supervision: ‘International Convergence of Capital Standard, a Revised Framework, Comprehensive Version’, Bank for International Settlements, June 2006, and Basel Committee on Banking Supervision: ‘Basel III: A global regulatory framework for more resilient banks and banking systems’, Bank for International Settlements, June 2011.

We check if this restriction leads us to exclude banks that are classified as ‘in bankruptcy’ or ‘in liquidation’ or ‘dissolved’ or ‘dissolved for mergers’ by BankScope over our period of analysis. Out of the 73 banks that are classified as ‘in bankruptcy’ or ‘in liquidation’, 11 are present in our final sample. Our sample includes 311 banks that were dissolved out of the 1744 listed by BankScope. 1422 banks are not included in our final sample because BankScope does not report information on their total risk-based capital ratio and their risk-weighted assets.

As BankScope provides few information on total capital ratio and risk-weighted assets for German banks, we end up with only 27 banks for this country. All these German banks have been established before 1989, so the capital requirement required by the regulator over our period of analysis is 8% (and not 12.5% as it holds for new established banks).

Throughout our sample period which ranges from 1992 to 2006, the ratio of risk-weighted assets to total assets we use is computed on a homogeneous basis. European banks have introduced the new methods allowed under Basel II after this period.

It could be argued that the Z-score indicator might be inappropriate to investigate the relationship between capitalization and bank default risk because it is positively related to the capitalization variable by construction. However, the correlation between the Z-score measure and the ratio of capital to total assets is very low (0.125) in our sample. Its correlation with the annual changes in capital is also insignificant (–0.045). Because the Z-score variable is highly skewed, we use the natural logarithm of the Z-score as in Laeven and Levine (2009) and Houston et al. (2010).

Our approach is based on discrete time. At time t, we consider the value taken by TCR at time t – 1 to assign a bank in a given category. This is because we consider capital changes from t – 1 to t and risk changes from t – 1 to t.

The PCA involves that banks are classified into one of five categories (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) depending on their total risk-based capital ratio, Tier 1 risk-based capital ratio, and Tier 1 leverage ratio. Because a formal corrective action has not been implemented in Europe, we simply use the thresholds defined by PCA in the United States to classify banks according to the level of their regulatory risk-based capital ratio. The minimum capital requirement in Europe is 8% as in the United States, except in Germany where the minimum TCR is equal to 12.5% for newly established banks in the first three years of business. We do not have to deal with such regulatory differences as we do not have in our final sample German banks that are newly established. The Financial Services Authority in the United Kingdom sets additional unpublished capital requirements called ‘trigger’ and ‘higher target’ ratios for each bank; the FSA considers that the basic 8% regulatory minimum capital requirement is only appropriate for a well-diversified bank. This implies that some banks have to comply with a higher capital ratio. However, as this information is not publicly available, we use the same thresholds of 8% and 10% for UK banks. We test the robustness of our results by using other thresholds (see Section IV on robustness checks).

Among the 11 banks listed as ‘in bankruptcy’ or ‘in liquidation’ by BankScope in our sample, only one bank appears as undercapitalized (and more precisely as strongly undercapitalized); similarly, among the 311 banks listed as ‘dissolved’, 28 are undercapitalized (of which nine are strongly undercapitalized).

Mean tests are available from the authors on request.

Two of our measures, SD_ROA and LOG_Z, are computed using a 3-year rolling window making first-order differencing problematic. We do not therefore consider the annual changes for these variables. However, we also perform our estimations using the changes in these variables as robustness checks.

Note that the sum of the coefficients of ΔEQ, ΔSUB and ΔHYB (β₄ + β₇ + β₁₀) in specification (2) equals, for a given sample, the coefficient associated with ΔCAP (α₄) in specifications (1). It is therefore possible to find the results of specification (1) using specification (2). However, to facilitate the interpretation of the results, we present the results obtained for both specifications (1) and (2).

Efficiency could be affected by changes in bank risk. If a manager is not very good at assessing and monitoring loans, she/he will presumably not reach a high level of operating efficiency. Moreover, a bank which wants to maximize its long-run performance can reduce the funds devoted to underwriting and monitoring loans. Such a behaviour will boost efficiency in the short run but will also increase bank risk. See Berger and DeYoung (1997) for more details.

We first regress, using OLS, each presumably endogenous variable on the instrumental variables and a set of exogenous variables not suspected to be endogenous. We then obtain the fitted values (ΔCAP_FIT and EFF_FIT) and the residuals (ΔCAP_RES and EFF_RES) for the two variables suspected to be endogenous that we substitute for ΔCAP and EFF in specification (1). An endogeneity problem potentially exists if ΔCAP_RES and/or EFF_RES are significantly different from zero. We finally run a join test to confirm that we have an endogeneity problem. These estimations are available from the authors on request.

Some of the estimation results discussed in this section are not presented in the article but are available from the authors on request.

We are not able to run our specifications (2a–c) when we differentiate positive and negative equity, subordinated debt and hybrid capital changes due to lack of sufficient observations.

We are not able to run our specifications (1b–c) when we use simultaneous equations due to an insufficient number of observations.