Capital regulation of financial institutions, the role of ratings and the tension field between regulation and economic reality

Abstract

The capital regulation of financial institutions, the role of ratings and the tension field between regulation and economic reality Over the past decade, the economic environment has been characterised by high-profile business scandals and failures, in which different company stakeholders were involved. In July 2007, the world entered the most profound and disruptive crisis since 1929. Initially originating in the US, it has evolved into a deep and complex crisis at global level, resulting in significant economic damage. Lack of market transparency, the abrupt downgrading of credit ratings and the failure of Lehman Brothers have initiated a global breakdown of trust. In autumn 2008 interbank markets shot down, creating a liquidity crisis that is still having a profound impact on the cost and availability of credit, financial markets and the macro-economy as a whole. Both government and Central Banks have taken numerous measures to address the systemic risk and to refuel the economy. However, it has become clear that the regulatory framework and measures in place were insufficient to tackle the crisis. As such, regulatory and supervisory financial authorities are currently confronted with major challenges. In light of these recent developments, this research contributes to the fundamentals of capital regulation of financial instructions and the use of internal and external ratings in that respect. Chapter 1: On the road to a safer banking system? Theory and evidence on capital regulation in Europe Traditionally capital requirements have been the foundation of regulation for banks. To protect banks against failure and to prevent an economic crisis due to contagion and systemic risk, different stakeholders want banks to maintain a certain level of capital. Rating agencies, supervisors and debt holders want higher capital to support solvency, shareholders want lower capital to boost profitability and even the behaviour of other banks might impact the target capital ratio. As a result of these conflicting interests, bank capital needs to be optimized with as a key purpose to internalise the social costs of potential bank failures. The capital adequacy requirements in place have been found inadequate, and as a reaction major steps to move the banking system are currently being taken. Taking into account these evolutions, it is interesting to know the extent to which recommendations have been adopted and whether the reforms have been and are perceived to be beneficial to the European banking sector. Based on guidance from academics, supervisors and policy makers, we have put together an extensive survey that is used for interviews with various bank managers and chief risk officers from European banks. The first chapter of this PhD presents new evidence on where European banks are with respect to capital regulation and on how the future road to a safer banking system should look like. By commenting on differences and similarities between the financial institutions we have questioned,we describe the present state of affairs with respect to Basel II implementation, regulatory and economic capital calculations and Basel III expectations. In doing so, we also address another objective of the Basel Committee, the creation of a level playing field, albeit in an indirect way. Banks believe that reinforcement and the realization of effective supervision is the main criterion for the realization of a more stable financial market. This confirms the important role our research assigns to the supervisor. One of the major difficulties will be to make a reliable estimate on how far the capabilities of supervisors go. Another difficulty on the subject of supervision is that it is still a national responsibility that will not be centralised very quickly for political reasons. Furthermore, we believe Basel III entails a lot of improvement, but in line with the academics and opinion leaders and regulators and supervisors, we feel that Basel III should look more comprehensively at the risks. We entered a financial crisis because assets that were full of worth suddenly became worthless. With this in mind, regulators should reconsider their way of treating assets on a bank s balance sheet in a more detailed way. Chapter 2: The development of a simple and intuitive rating system under Solvency II Another type of financial institution that has been both victim and cause in the financial crisis are the insurance companies. Notwithstanding the fact that insurance companies are very important players in financial markets who are involved in many credit risk exposures and as a consequence are also prone to high levels of uncertainty and solvency issues, literature on the topic is scarce (Florez-Lopez, 2007). Due to the Solvency II Directive, also insurers are currently being confronted with new regulatory requirements that promote internally developed risk models. This evolution emphasises the importance of credit risk assessment through internal ratings. In light of this new prudential regulation, and taking into account the limited data and modelling experience of insurance companies and the scarcity of academic research on insurance companies, the second chapter of this dissertation suggests a Basel II compliant approach to predicting credit ratings for non-rated corporations and evaluates its performance compared to external ratings. In developing the model, broad applicability is set as an important boundary condition. Even though the model developed is fairly simple and maintains a high level of granularity, it gives high rates of accuracy and is very interpretable. Chapter 3: Analyzing bank ratings: key determinants and procyclicality While upgrading financial regulations and supervision in order to prevent future crises, many authorities are being confronted with the fact that risks taken in the process of financial intermediation are difficult to observe and assess from outside the bank. In the absence of tight regulations, this opaqueness exposes banks to runs and systemic risk. In order to reduce this lack of transparency, credit rating agencies (CRAs) provide information that can help various stakeholders to evaluate the credit risk of issues and issuers. Even though CRAs have been criticized a lot in the latest crisis, for many observers of financial markets, credit ratings continue to play an essential role. Morgan (2002) shows that Moody s and S&P have more split ratings over financial intermediaries, suggesting that banks are more difficult to rate because of their opaqueness. This additional lack of transparency is linked to the banks asset base and their high leverage, which create agency problems and further increase uncertainty over their assets. So far the research linked to ratings of financial institutions is rather limited. The third chapter of this dissertation presents a joint examination of how different factors influence the assignment of S&P and Moody s long term bank ratings using a unique data set covering different regions, bank sizes, and bank types. In doing so, we include new bank and country specific variables. Furthermore, we include measures of the business cycle in our analysis to determine whether long term bank ratings tend to be related to the cycle after conditioning on a set of variables. Using annual data on US and European banks rated by S&P and/or Moody s, we find that the bank ratings of both agencies exhibit a different sensitivity to the business cycle. Finally, we check our findings on a sample of banks that are rated by both rating agencies while controlling for potential sample selection bias. Our findings are highly relevant for various bank stakeholders, who often tend to assume that Moody s and S&P have equivalent rating scales and rating processes. This paper shows clear evidence that this is not necessarily the case. Moody s and S&P seem to have different rating determinants, different sensitivity towards the business cycle and behave differently when rating banks that are rated by both of them. We believe that the findings of this dissertation are highly relevant for various bank stakeholders and academics. As such, we hope that the outcome of our three chapters will be used in further discussions on the regulation of financial institutions, the role of ratings and rating agencies and finally, on how to reduce the tension field between theory, regulation and economic reality.