This paper reviews academic studies of bank capital regulation in an effort to evaluate the intellectual foundation for the imposition of the Basel I and Basel II systems of risk-based capital requirements. The theoretical literature yields general agreement about the immediate effects of capital requirements on bank lending and loan rates and the longer-term impacts on bank ratios of equity to total or risk-adjusted assets. This literature produces highly mixed predictions, however, regarding the effects of capital regulation on asset risk and overall safety and soundness for the banking system as a whole. Thus, the intellectual foundation for the present capital-regulation regime is not particularly strong. The mixed conclusions in the academic literature on banking certainly do not provide unqualified support for moving to an even more stringent and costly system of capital requirements. These widely ambiguous results do suggest, however, that assessing the implications of capital regulation for balance-sheet risk and monitoring effort in diverse banking systems is an important agenda for future theoretical research in the banking area

In moral hazard models, bank shareholders have incentives to transfer wealth from the deposit insurer – that is, maximize put option value – by pursuing riskier strategies. For safe banks with large charter value, however, the risk-taking incentive is outweighed by the possibility of losing charter value. Focusing on the relationship between Tobin’s q and an ex ante measure of the failure probability, this paper develops a semi-parametric model for estimating the critical level of bank risk at which put option value starts outweighing charter value. From these estimates, we infer the prevalence of moral hazard. Examining publicly held bank holding companies (BHC) during the tumultuous 1986–1992 period, we find that shareholders’ risk-taking incentives were confined to a small fraction of highly risky institutions. Furthermore, our analysis shows that the inflection point at which banks begin to tilt in favor of moral hazard increased substantially in 1993–2005. These findings are encouraging to bank regulators and legislators because they indicate that tighter capital rules and more rigorous supervision introduced by several legislative initiatives in the 1990s have helped squeeze a lot of the moral hazard incentives out of the banking system

Motivated by the liberalisation and harmonisation of financial systems in Europe, we investigate whether the observed shift into non-interest income activities improves performance of small European credit institutions. Using a sample of 755 small banks for the period 1997–2003, we find no direct diversification benefits within and across business lines and an inverse association between non-interest income and bank performance. Our findings are robust to a set of sensitivity analyses using alternative samples and controlling for the regulatory environment. Furthermore, the results provide circumstantial evidence for the presence of economies of scale. The absence of benefits of diversification confirms findings for other banking markets and suggests small European banks enter lines of business where they currently lack expertise and experience. These results have implications for bank supervisors, regulators and bank managers

We analyze the optimal portfolio policies of expected utility maximizing agents under VaR Capital Requirement (VaR-CR) regulation in comparison to the optimal policy under exogenously-imposed VaR Limit (VaR-L) and Limited-Expected-Loss (LEL) regulations. With VaR-CR regulation the agent strategy consists of simultaneous decisions on both the portfolio VaR and on the implied amount of required eligible capital. As a result, the performance of VaR-CR regulation depends on its design (the parameter n) and the agent preferences. We show that an optimal VaR-CR regulation allows the regulator on the one hand, to completely eliminate the exposure to the largest losses, which may jeopardize the existence of the institution, and on the other hand, to restrain the portfolio exposure to all other losses. These results rationalize the current Basel regulations. However, the analysis shows also that there is an optimal level of required eligible capital from the regulator standpoint. Counter-intuitively, any requirement above this optimal level is inefficient as it leads to a smaller amount of actually maintained eligible capital and thereby to a larger exposure to the most adverse states of the world. Unfortunately, the current Basel’s range of required levels (n=3–4) is within this inefficient range. Moreover, with an inefficient regulation the agent might employ an inefficient reporting and disclosure procedure

Capital requirements play a key role in the supervision and regulation of banks. The Basel Committee on Banking Supervision is in the process of changing the current framework by introducing risk sensitive capital charges. Some fear that this will unduly increase the volatility of regulatory capital. Furthermore, by limiting the banks’ ability to lend, capital requirements may exacerbate an economic downturn. The paper examines the problem of capital-induced lending cycles and their pro-cyclical effect on the macroeconomy in greater detail. It finds that the capital buffer that banks hold on top of the required minimum capital plays a crucial role in mitigating the impact of the volatility of capital requirements

Previous research has shown that affiliated analysts (those who are working for investment banks that underwrite securities for companies) have an incentive to provide optimistically biased recommendations from selective information they are given by the firm. In an effort to halt such activities, as of October 2000, Regulation Fair Disclosure (RegFD) prohibits selective disclosure of material non-public information by public companies to privileged individuals (such as favored research analysts) and requires broad, non-exclusionary disclosure of such information. We examine firms’ stock price reactions to investment recommendation changes from affiliated analysts versus unaffiliated analysts from October 1998 to November 2002, around the passage of RegFD. Similar to previous research, we find that investors reacted more significantly to recommendation downgrades by affiliated analysts than to those by unaffiliated analysts prior to the passage of RegFD. However, we find that the difference in the reactions to recommendation changes is not present after the passage of RegFD. We also find that stock price reactions to analysts’ (both affiliated and unaffiliated) recommendation changes decreased significantly after the passage of RegFD. Thus, RegFD appears to have curbed the selective disclosure of information (particularly negative information) by firms to affiliated analysts. Further, the smaller reactions to recommendation changes by all analysts after RegFD may reflect a change in analysts’ behavior (irrespective of information that is available) or a response by corporate managers to withhold information rather than risking a violation of fair disclosure rules

We examine the risk and return linkages across US commercial banks, securities firms, and life insurance companies during the 1991–2001 period. After controlling for changes in the broader stock market, interest rates, and foreign currency values, we find that return and risk interdependencies across these financial firms are significant and size-varying; larger institutions display stronger volatility transmission linkages, while smaller ones exhibit more prominent return-related linkages. The tighter link in risk among large financial institutions (FIs) suggests stronger convergence, employment of common models of risk measurement and risk management, and more intense inter-industry competition, particularly between large banks and large securities firms, compared to smaller institutions. Lack of risk spillover among smaller FIs confirms the intuition that they typically assume more localized and idiosyncratic risk. The co-movement of stock returns among smaller FIs has been helped by the effects of locally based factors, such as economic conditions and state regulations, on all such institutions, and a less diversified product set. Differences in spillover patterns between large and smaller institutions have implications on investment choices and mergers and acquisitions in the industry. Introduction of the Gramm-Leach-Bliley Act (1999) has had dissimilar effects on the riskiness of large versus smaller life insurance and securities firms, and an insignificant effect on commercial banks

This paper introduces a new dataset from 100 Dutch institutional investors’ domestic and international asset private equity allocations. The data indicate that the perceived comparative dearth of regulations of private equity funds impedes institutional investor participation in private equity funds, particularly in relation to the lack of transparency. The data further indicate that the perceived importance of regulatory harmonization of institutional investors has increased Dutch institutional investor allocations to domestic and international private equity funds. The Financieel Toetsingskader (regulation of portfolio management standards such as matching of assets and liabilities) has had the most pronounced and robust effect, followed by Basel II (regulation of risk management and disclosure standards) and the International Financial Reporting Standards (regulation of reporting standards and transparency

This paper introduces, prices, and analyzes traffic light options. The traffic light option is an innovative structured OTC derivative developed independently by several London-based investment banks to suit the needs of Danish life and pension (L&P) companies, which must comply with the traffic light solvency stress test system introduced by the Danish Financial Supervisory Authority (DFSA) in June 2001. This monitoring system requires L&P companies to submit regular reports documenting the sensitivity of the companies’ base capital to certain pre-defined market shocks – the red and yellow light scenarios. These stress scenarios entail drops in interest rates as well as in stock prices, and traffic light options are thus designed to pay off and preserve sufficient capital when interest rates and stock prices fall simultaneously. Sweden’s FSA implemented a traffic light system in January 2006, and supervisory authorities in many other European countries have implemented similar regulation. Traffic light options are therefore likely to attract the attention of a wider audience of pension fund managers in the future. Focusing on the valuation of the traffic light option we set up a Black–Scholes/Hull–White model to describe stock market and interest rate dynamics, and analyze the traffic light option in this framework

Our interest here concerns liquidity supply to firms. We first examine the relation between firm value and access to liquidity supply, and then we investigate the existence conditions and efficiency properties of financial contracts with a liquidity covenant in a continuous-time, infinite-horizon stochastic model of a repeated firm-investors relationship where the key problem is the mutual commitment between the two parties. To model this problem we consider liquidity supply as a stochastic “regulator mechanism” that prevents the firm’s ability to pay from falling below a predefined threshold (here the market fixed coupon), and we then apply recent developments in dynamic programming techniques for “regulated processes” to obtain a close form solution for the firm’s value. Our main finding is that efficient, i.e. actuarially fair and renegotiation-proof contracts emerge in the absence of perfect commitment as the firm and the investor can exert mutual threat of termination