Monday, May 16, 2016

BIS Publishes Survey on Integration of Regulatory Capital and Liquidity Instruments

Author: David Schwartz J.D. CPA

In March 2016, the Bank for International Settlements (BIS) published a paper reviewing the current knowledge and empirical data on the effects of new bank capital and liquidity requirements.  This literature review is comprised of three essays surveying the current body of research and empirical studies on liquidity and its interaction with capital and on other supervisory requirements.


Because the study is a literature review, BIS did not perform empirical analysis of its own. Rather, the authors carefully examined the available studies performed, assessed their scope, methodologies, and results, and drew conclusions regarding what has been learned thus far, noting gaps or areas still in development.  Overall, the literature review’s authors found that, because new capital requirements have been in place for quite awhile, a great deal of research has already been performed on their costs and benefits, as well as their effects on economic activity. In contrast, liquidity requirements and other supervisory tools like buffers and stress tests have only been implemented since the recent financial crisis. As a result, there has been far less time to study their efficacy or their knock-on effects, leaving gaps in the literature.


Capital Requirements


The first of the three essays reviews a relatively large number of studies that assess the costs and benefit of higher capital requirements as well as their effects on economic activity and welfare. The authors found that empirical studies in this area were primarily focused on estimating the benefits of capital requirements: "The literature is almost unanimously focused on the benefits of higher capital requirements as reducing risk-taking by banks and, consequently, reducing the likelihood of a future systemic financial crisis.”   The authors found very few studies focussed on the optimal amount of capital, noting that the available studies on the topic require careful interpretation because of the multitude of complexities associated with assessing what is “optimal.” Among these complexities, they listed:


(1) the difficulty in separating the influence of supply from demand when estimating costs;

(2) the role of the “static-behaviour assumption” (of banks and customers for example) when assessing regulatory changes;

(3) the difficulty in inferring the effect of large changes from looking at small ones, or properly taking into account individual firm behaviour by looking at aggregate measures;

(4) the frequent lack of a proper distinction between the various types of capital (eg common equity Tier 1 (CET1), additional Tier 1 capital (AT1), total capital); (5) the difficulty in controlling for the macroeconomic environment, notably the very accommodative monetary policy stance for the most recent estimates; and

(6) the inability to capture cross border effects and the potential for the costs of global standards to be borne disproportionately by some (particularly emerging) economies.


Furthermore, the authors found very little literature on the effect of total loss absorbing capacity.


Despite these observations and limitations, the authors were able to draw two key conclusions from this review of the literature on capital requirements:

"First, the overall impact of an appropriate increase in capital requirements seems to be positive, at least from pre-crisis levels, as long-run benefits are large and short-term costs are smaller, although the costs may be borne disproportionately by host countries."

"Second, the optimal range for capital requirements is not dissimilar to the current calibration of the Basel III requirements once all regulatory buffers have been included and banks’ own voluntary surplus above these requirements has been taken into account."


Liquidity Requirements


The second of the essays identifies a number of potential channels through which liquidity requirements can affect bank behaviour, balance sheets, and profitability. The literature review in this area revealed significant gaps in relation to most of these channels, most notably, with respect to the effect of liquidity requirements on funding costs and on net interest income. Despite these gaps, some literature does examine the question of whether liquidity requirements result in banks’ substituting high quality liquid assets (HQLA) for loans on their balance sheets, thereby reducing credit.


The most interesting findings in this area relate to the interactions of capital and liquidity requirements.  The author’s found among the available literature support for the notion that liquidity standards may not merely compliment capital standards, but may substitute for capital standards.


"This finding suggests that requiring banks to maintain liquidity buffers, such as the LCR, may have an impact that would be similar to that of increasing capital requirements. In other words, liquidity requirements can substitute for capital requirements rather than merely complement them."


Supervisory Requirements


The final essay surveys the available research regarding supervisory approaches other than capital and liquidity requirements.  In particular, the authors reviewed studies and reports on regulatory buffers and on macro prudential policy, with a particular interest in: (1) whether measures other than capital and liquidity requirements adequately complement these regulations in making the banking system more resilient; and (2) whether simpler regulatory rules may be more robust to extreme stress events than the ones in place, and whether stress testing can enhance robustness.  The study finds some consensus within the literature that suggests that stress testing provides a robustness to otherwise rigid and risk-insensitive measures like capital liquidity requirements, complimenting them, but not substituting for them.


"Both buffers and macroprudential policies can be viewed as an attempt by policymakers to strike a balance between rules and discretion. If rules are less susceptible to forbearance and more likely to deliver consistent decisions, discretion allows policymakers and/or supervisors to adapt to unexpected changes or economic uncertainty."


In addition, the authors found with respect to capital buffers, liquidity buffers, and loan eligibility policies that "such policies are effective at enhancing bank resilience and can provide new levers to curb dangerous credit booms and excessive risk-taking by financial intermediaries."