Financial Stability and the Capital Adequacy of Large US Banking Organizations

42 Pages·2008·0.62 MB·English

Financial Stability and the Capital
Adequacy of Large U.S. Banking
Organizations: A VAR in VaR Approach
Diana Hancock and Wayne PassmoreΨ
Board of Governors of the Federal Reserve System
Washington, DC 20551
ΨThe views expressed are those of the authors and do not necessarily reflect those of the Board of
Governors of the Federal Reserve System or its staff.

A Presentation of Preliminary Findings at
the Risk Transfer Mechanisms and Financial
Do not cite without the authors’ permission. Stability Conference on May 29-30 2008
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IInnttrroodduuccttiioonn
Basel II : A Risk-Bucketing System
Bank assets will be partitioned by various characteristics.
(cid:132)
For example, by loan type and borrower credit rating.
(cid:132)
Capital charge on a given asset will depend only on its own
(cid:132)
characteristics.
In particular, the capital charge does not depend on the
(cid:132)
characteristics of the portfolio.
∴
Basel II is a “bottom-up” approach for determining capital
adequacy.

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IInnttrroodduuccttiioonn
U.S. Capital-to-Asset Ratio Requirements
Banks with less than 5 percent (tier 1) capital-to-asset ratios
(cid:132)
have restrictions or conditions on certain activities and may also
be subject to mandatory or discretionary supervisory actions.
Under Regulation Y, most bank holding companies must hold a
(cid:132)
minimum ratio of tier 1 capital-to-total assets of 4 percent.
In some circumstances, the minimum for bank holding companies
(cid:132)
is as low as 3 percent.
Remains unchanged whether or not a U.S. banking organization
(cid:132)
is subject to the Basel II framework.
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IInnttrroodduuccttiioonn
Three Common Rationales for
a Minimum Capital-to-Asset Ratio…
Provide a base of capital to absorb losses that could arise as a
1.
result of risks not accounted for by risk-based capital
requirements.
Banks should desire to protect themselves from insolvency, and
(cid:131)
voluntarily hold sufficient capital to absorb losses.
Mispricing of liabilities due to conjectural government guarantees or
(cid:131)
deposit insurance.
Unaccounted social costs associated with illiquidity and insolvency of
(cid:131)
depositories.
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IInnttrroodduuccttiioonn
Three Common Rationales for
a Minimum Capital-to-Asset Ratio
2. The uniform risk-weights for a minimum capital-to-asset ratio
may be less distortionary than imperfect risk-weights for a risk-
bucketing system.
3. The use of the single systematic risk factor assumption that
underpins the Basel II risk-based capital adequacy framework is a
concern.
Portfolio-invariant capital charges may be inappropriate.
(cid:132)
May also result in a significant understatement of the capital needed
(cid:132)
to protect against insolvency (Gordy, 2002).
Costly for banks to account for more than one systematic factor,
(cid:132)
limiting the ability of bottom-up approaches to account for systematic
risks.
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OOvveerrvviieeww
Preview of the Four Steps
of our “Top Down” Framework
Step 1: We use a vector-autoregression (VAR)
(cid:132)
investors’ expectation model.
Translates shocks in the benchmark risk-free rate,
(cid:132)
systematic risk factors and macroeconomic outlook
variables into subordinated debt return surprises.
Step 2: We use a Merton-style contingent claims
(cid:132)
model to translate changes in the value of debt into
changes in the market value of a banking
organization.
Capital adequacy is determined by having enough
(cid:132)
capital to cover the change in market value of the firm
generated by an extremely severe systematic shock.
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OOvveerrvviieeww
Preview of the Four Steps
of our “Top Down” Framework
Step 3: We construct a Value-at-Risk measure using
(cid:132)
the change in banks’ market value in response to large
shocks of systematic risk factors.
Step 4: We adjust our Value-at-Risk measure for
(cid:132)
market liquidity conditions and conjectural government
guarantees.
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OOvveerrvviieeww
Preliminary Finding
Our capital adequacy estimate, adjusted for liquidity conditions,
(cid:132)
averaged 2.1 percent of market value of three large,
systemically important BHCs over 1999:Q3 - 2008:Q1.
It ranged from a high of 6 percent in 2004 to a low of 0.4% in
(cid:132)
2008.
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OOvveerrvviieeww
Why Subordinated Debt?
Subordinated debt holders are likely to be particularly
(cid:132)
sensitive to bank risks.
Unlike stock holders, they are exposed to loss but do not
(cid:132)
benefit from upside gains that accrue due to excessive
risk-taking.
The long maturity of subordinated debt means that these
(cid:132)
debt holders are not able to “run the bank.”
To the extent that subordinated debt is issued in place of
(cid:132)
insured deposits, it provides an extra “cushion” for the
Federal Deposit Insurance Corporation in the event of
bank failure.
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SStteepp 11:: VVAARR IInnvveessttoorrss’’ EExxppeeccttaattiioonn MMooddeell
Modeling Subordinated Bond Yields
Extend the analyses of Campbell and Shiller (1988), Campbell and
(cid:132)
Ammer (1993), Campbell, Lo, and MacKinlay (1997), Bernanke and
Kuttner (2005) and Cochrane (2005).
Following the notation of Campbell, Lo and MacKinlay, the return on
(cid:132)
a long-maturity, coupon-bond can be written as a weighted-average
of price changes and fixed, nominal, coupons (c) or:
r ≈ k + ρp − p − (1− ρ)c ,
(cid:78)c, n, t+1 (cid:8)(cid:11)c, (cid:11)n−1(cid:9), t+(cid:11)1 (cid:11)(cid:10)cnt (cid:8)(cid:11)(cid:9)(cid:11)(cid:10)
return on bond change in price change in value of coupon
where k and ρ are linearization parameters and n denotes a bond’s
remaining period to maturity.

This is based on a present value accounting identity.
(cid:132)
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