Macro-Prudential Supervision

Today we want to highlight the NYU Stern’s Systemic Risk website, Systemically important financial institutions (SIFIs) are typically defined as institutions whose failure would significantly impact the financial and the real economy. International and European regulators and supervisors set up a massive macro prudential system to manage systemic risk. Viral Acharya, Robert Engle and Matthew Richardson argue that publicly available market information can be used to estimate the capital shortfall of a financial firm if a financial crisis occurs. After describing the method to calculate the SRISK measure they show that the method could also serve for the determination of bank individual prudential capital requirements, based on the risk profile of the respective businesses.

SRISK is conceptually similar to the stress tests conducted by US and European regulators: “Expected capital shortfall captures in a single measure many of the characteristics considered important for systemic risk such as size, leverage, and interconnectedness. All of these characteristics tend to increase a firm’s capital…

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On June 29, BIS published its 84th Annual Report. Following we show a summary concerning the evolution of worldwide Bank’s capital ratios:

  • CET1 average increased from 8,5% to 9,5% over the last year, based on fully phased in B3 rules
  • Capital shortfall of banks lagging capital decreased significantly to 82,5 billion EURO
  • Bost of capital ratios is driven by increase in bank capital, mainly by retained Earnings
  • Dividend to earnings ratio decreased to 33%

2014-06_Capital gra6-1


Given their contribution to higher bank capital so far, stable profits will be key to the sector’s resilience in the near future. On average, profits rebounded further from the crisis lows, but recovery remained uneven across countries.

The Net Stable Funding Ratio (NSFR) shall be implemented as a binding minimum ratio from 2018 on. It is defined as available stable funding (ASF) divided by required stable funding (RSF). Its supervisory monitoring started in 2014, according to European CRR-Regulation. Currently, the Basel Committee on Banking Supervisory revises it’s consultation on the final calibration of the NSFR dating from January 2014. Analysis suggests that National characteristics of Asset and Liability Markets matter and shall be taken into account defining a standardised ratio.

One goal of the NSFR is to allow for a better governance of liquidity risk stemming from maturity transformation of less than one year: Banks are required to hold an adequate portion of stable funding sources such as deposits or bond market financing, or even capital, instead of relying on short-term wholesale funding.

In addition to liquidity risk, the NSFR adresses the risk of increased leverage: Analysis shows that the increased leverage in the forefront of the Financial Crisis was often not financed by capital but by short-term wholesale funding. As the NSFR defines different levels of available and required stable funding, balance sheet growth is limited as long as it is based on non stable funding. For example, the available stable funding differs between regulatory capital which enjoys a 100 percent available stable funding (ASF) weight while stable non-maturity deposits receive a 95 percent ASF weight. In contrast, funding from a financial institution with residual maturity less than six months has a 0 percent ASF. Similarly, liquid assets enjoy lower required stable funding (RSF) factors while illiquid assets are assigned higher RSF factors.

This strong impact on asset liability management requires a careful calibration of the stability factors. As Gobat/Yanase/Maloney (IMF, WP/14/106) state, „changes in ASF and RSF factors for important asset and liability components make a substantial difference in the final NSFR figure, underlining the importance of having a proper calibration at the national level.“ One way to balance between the goal implementing a standardised single rule on European level and the flexibility required to take national characteristics into account, „is to allow for some “guided discretion,” particularly by allowing countries to apply more stringent parameters.“ For example „Supervisors will need to take a cautious approach in designing the deposit weights for the NSFR, as deposit stability characteristics will most likely vary among jurisdictions, depending on market and institutional factors.“

14 of the 24 German Banks who are challenged under the ECB Stress Test are represented by the German Bundesverband Öffentlicher Banken (VÖB). This organisation today published a review explaining the main traits of the EU Stress Test 2014. You can find the document under the following link.

Information on the Stress Test scenarios is published on the site of the European Banking Authority (EBA).

The leverage ratio is one of the most discussed regulatory topics. According to the Basel Committee on Banking Supervision (BSCB), a minimum level of 3% shall be obligatory from 2008 on. The Committee (2009, pp. 2-3) argues that a leverage ratio requirement “would help contain the build-up of excessive leverage in the banking system, introduce additional safeguards against attempts to game the risk-based requirements, and help address model risk“.

A recent study from Kiema and Jokivuolle on the question “Does a Leverage Ratio Requirement increase Bank Stability?” concludes that the impact the leverage ratio requirement (LRR) has on financial stability depends on its relative level compared to the average risk-based capital requirements:

  • LRR < average risk-based capital requirement: Banks are expected to adapt their business models to increase the mix of low-risk and high-risk loans in their portfolios. Today, as research suggests, “differences in banks’ general risk profiles are evident, indicating some degree of specialization (in low or high(er)-risk business models). For instance, the share of net loans to customers in relation to trading assets (often seen as riskier business) may vary greatly (for a sample of leading European banks, see Liikanen 2012, Table A3.2). There is also evidence that banks may focus on either corporate or retail loans, the former of which are normally seen as riskier.” Kiema and Jokivuolle also show that the diversification of the loan portfolio in low-risk and high-risk lending can lead to an increase of model risk.
  • LRR > average risk-based capital requirements: Bank failures are expected to decrease because more loss absorbing capital is available. This positive effect on bank stability is accompanied by a significant increase of low-risk lending rates as banks need to balance the higher cost of capital.

The study results indicate the following points: an increase of the leverage ratio requirement over and above 3% (1) might have a significant cost impact for low-risk banks because the LRR would require a higher capital buffer than the risk-based regulation and thus, (2) may require some banks to adjust the business model which will result in more risk-correlated bank portfolios, which (3) might increase model risk due to adjusted business models with similar portfolio risks. On the other hand, a higher LRR can (4) increase bank robustness and thus reduce model failure as more capital is available to absorb unexpected losses in case of stress. Also, a higher leverage ratio can (5) lead to higher low-risk lending rates impacting economic growth. Overall, Kiema and Jokivuolle argue “that a significant increase of the current 3% LRR recommendation, up to the point where the LRR matches the average bank’s risk-weighted capital requirement in the economy (more than 6% in our calibration), could have positive stability effects without compromising lending costs. This is because a higher LRR would simply provide a more sufficient buffer against even very big model risk while banks could (almost) costlessly adjust to it by changing their loan portfolios. As the lower LRR would in any case result in much of the portfolio adjustment, it is better to let this happen with the higher LRR, with higher stability gains.”

With respect to K/J’s policy implications, we want to note that further research should be made before implementing binding rules in Europe, because:

  • the dependence on other Basel proposals such as the fundamental review of the trading book or the new design of the credit risk framework should be carefully studied;
  • the role of different bank business models for the respective national banking system should not be neglected by a one-size-fits-all approach;
  • expected adjustments in business models should be analysed concerning the new IFRS9 impairment rules to better understand the impact on risk-based capital requirements;
  • differences in financial systems such as the size of the securitisation market should be taken into account and addressed first, to ensure a competitive European financial system.

Finally, it is worth looking at the US regulators. They adopted a final minimum level of 5% in April 2014. This additional 2%-rule applies to US top-tier banks only. In addition, the US regulators aim to adapt the calculation of the US leverage ratio to the Basel recommendation, which is the basis for the European leverage ratio.

Central credit registers (CCRs) are granular databases operated by National Central Banks (NCBs). As Almeida and Damia state, “there are three main uses of CCRs: (1) to enable bank supervisors to accurately assess credit risk in supervised financial institutions; (2) to support financial transactions by assisting credit institutions in the evaluation of risk; and (3) for economic analysis.”
On a European level, the ESCB (European System of Central Banks) has been exploring the potential statistical use of CCRs from 2007 on. Related initiatives have proven the analytical usefulness of CCRs. To address remaining issues, the ESCB Task Force on Analytical Credit Data Sets was set up in 2013 to shed light on the following key issues:
(a) What further granular credit data does the ECB require?
(b) What data, including attributes on lenders, borrowers, credits and methodological aspects, should be collected from National Central Banks?
(c) How can data sets be shared across the Eurosystem/ESCB?
In 2014, the ECB decided that the AnaCredit project should have top priority with regard to the upcoming ECB supervisory task. AnaCredit is, simply put, “an IT solution (Analytical System on Credit – AnaCredit) for receiving, storing and disseminating credit and credit risk information on a euro area.” The quality of AnaCredit’s statistical evaluation depends on relevant input. As a consequence, the ESCB must ensure the transfer of European-wide  and harmonised credit data to the ECB by the end of 2016. Though the concrete data request is not yet finalised, it is already evident that banks shall report granular loan portfolio and borrower data on a loan-by-loan level. The statistical evaluation of this data shall support the ECB’s credit and credit-risk analysis which is required for the conduct of monetary policy, micro-prudential supervision and financial stability.

Today, the European Banking Authority (EBA) released the 2014 EU wide stress test methodology and macroeconomic scenarios.

Among others, the methodology states that the stress test is conducted on the assumption of a static balance sheet. The zero growth assumption applies on a solo, sub‐consolidated and consolidated basis for both the baseline as well as the adverse scenario. No workout of defaulted assets is assumed in the exercise. In particular, no capital measures taken after the reference date 31/12/13 are to be taken into account.

The adverse scenario is designed by the ESRB. According to the EBA, it reflects the systemic risks that are currently assessed as representing the most pertinent threats to the stability of the EU banking sector: (i) an increase in global bond yields amplified by an abrupt reversal in risk assessment, especially towards emerging market economies; (ii) a further deterioration of credit quality in countries with feeble demand; (iii) stalling policy reforms jeopardising confidence in the sustainability of public finances; and (iv) the lack of necessary bank balance sheet repair to maintain affordable market funding.

2014_0429 stress test EU

Source: Wall Street Journal

Following, please find an excerpt of the current EBA FAQ.

What is the timeline for the stress test?

The EBA expects to publish the final results of the 2014 EU-wide stress test in October 2014. The timeline has been agreed and coordinated with the ECB and is, therefore, in line with the overall timeline of the Single Supervisory Mechanism (SSM) Comprehensive Balance Sheet Assessment.

Data templates and guidelines will be distributed immediately after the launch of the methodology and scenarios in April 2014. Advance data collection will be started immediately to be completed end of May. First preliminary results are expected to be submitted to the EBA in mid-July and near-final results tentatively early September for the final round of quality checks and then absolute finalisation of the results will be just ahead of publication. Precise deadlines for the data submission of banks will be defined and communicated by the CAs.


How will data and results be published?

The most important aspect of the EBA’s common EU-wide exercise will be the disclosure of comparable and consistent data and results across the EU. Results will be disclosed on a bank by bank basis and the EBA will act as a data for the final dissemination of the outcome of the common exercise. The level of granularity of the data disclosed will be at least consistent with that of the 2011 EU-wide stress test and 2013 EU-wide Transparency Exercise. It will include the capital position of banks, risk exposures and sovereign holdings.

The credibility of the EU-wide stress test rests on transparency; market participants will be able to determine for themselves how supervisors and banks are dealing with remaining pockets of vulnerability.