International spillovers of bank capital requirements

The principle of reciprocity

The Basel Committee has introduced the principle of reciprocity: the capital requirement set by a regulator applies to all bank loans made in its jurisdiction, irrespective of which jurisdiction the bank belongs to.
In this paper, Bahaj and Malherbe examine the way this principle alters the strategic incentives among regulators. They develop a model to study the way equity capital is allocated to lending in different jurisdictions and what the implications are for the strategic interactions between regulators. The model has two dates and two countries (Home and Foreign), in which banks finance loans with a mix of insured deposits and equity capital. These banks face capital requirements in a reciprocity regime. Bank equity capital is mobile and there is global competition for it. Their findings include:

• An increase in the capital requirement in a country does not necessarily generate outflows of bank equity capital – inflows are possible too.
• As bank equity capital is scarce, changes to capital requirements in a country impose, through capital flows, an externality onto the other country. This capital flow externality provides an incentive to national regulators to deviate from a collaborative optimum.
• Under reciprocity and absent coordination, macroprudential capital requirements are likely to be raised too much in good times and cut too much in troubled times, when bank equity capital is particularly scarce.

The Cross-border Effects of Bank Capital Regulation
Authors: Saleem Bahaj, Frederic Malherbe
From: University College London

The internal ratings-based (IRB) approach to map banks’ risk profiles

There are two distinct methodologies for calculating banks’ capital requirements for credit risk as defined by the Basel Committee on Banking Supervision: a) a less risk-sensitive standardized approach which uses external credit assessments based on a predefined classification system; b) the more risk-sensitive internal ratings-based (IRB) approach which is based on a thorough assessment of the asset composition of banks’ balance sheets and their business models. The IRB methodology indicates that differences across banks should lead to higher dispersion in risk-weighted asset (RWA) estimations than obtained when employing the standardized approach. An increase in the RWA density shows that the overall quality of banks’ assets deteriorated from the regulatory perspective.
In this paper, Böhnke et al. investigate quarterly data of 52 listed banks headquartered in 14 European countries that adopted the IRB approach between Q1/2007 and Q4/2019 in order to shed light on why RWA densities, contrary to intuition, converge over time across countries and banks despite their different risk profiles. Their main finding is that the IRB approach reduces differences in RWA densities between countries, which makes internal models less suitable to reflect the country-specific risk factors.

Especially for banks in countries with high country risk and high initial levels of RWA densities, we observe a more significant reduction over time. Moreover, results suggest that authorities do not impose strict supervision in countries with high risk and for low profitability banks, as these cannot cope with high minimum capital requirements. In contrast, banks in countries with strict supervision increase their RWA densities, especially in recent years.

Back to the Roots of Internal Credit Risk Models: Why Do Banks’ Risk-Weighted Asset Levels Converge over Time?
Authors: Victoria Böhnke, Steven Ongenab, Florentina Paraschivc, Endre J. Reited
From: Deutsche Bundesbank, University of Münster, University of Zürich, Zeppelin University, NTNU Department of International Business