Regulatory solutions for bank loans pro-cyclicality Is the cure
27
BIS CCA-003-2010 May 2010 Regulatory solutions for bank loans pro-cyclicality Is the cure worse than the illness? A presentation prepared for the BIS CCA Conference on “Systemic risk, bank behaviour and regulation over the business cycle” Buenos Aires, 18–19 March 2010 Authors*: Verónica Balzarotti and Alejandra Anastasi Affiliation: Central Bank of Argentina Email: [email protected] , [email protected] * This presentation reflects the views of the authors and not necessarily those of the BIS or of central banks participating in the meeting.
Transcript of Regulatory solutions for bank loans pro-cyclicality Is the cure
BIS CCA-003-2010
May 2010
Regulatory solutions for bank loans pro-cyclicality Is the cure worse than the illness?
A presentation prepared for the BIS CCA Conference on
“Systemic risk, bank behaviour and regulation over the business cycle”
Buenos Aires, 18–19 March 2010
Authors*: Verónica Balzarotti and Alejandra Anastasi
Affiliation: Central Bank of Argentina
Email: [email protected], [email protected]
* This presentation reflects the views of the authors and not necessarily those of the BIS or of central banks
participating in the meeting.
Regulatory solutions to pro-cyclicality
Regulatory Solutions to Regulatory Solutions to Bank Loans ProBank Loans Pro--CyclicalityCyclicality
Is the cure worse than the illness?Is the cure worse than the illness?
VerVeróónicanica
Balzarotti Balzarotti --
Alejandra AnastasiAlejandra AnastasiCentral Bank of Argentina Central Bank of Argentina ––
Economic ResearchEconomic Research
March 2010The views are sole responsibility of the authors
Regulatory solutions to pro-cyclicality
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Plan
•
Motivation
/ background
•
Alternative
tools
•
Model
•
Conclusions
Regulatory solutions to pro-cyclicality
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MotivationMotivation
We adopt the view that counter-cyclical mechanisms are desirable
Reinforcing link between the business cycle and credit
Very topical in the wake of the international financial crisis
Less-developed countries: instability is cause and consequence of lack of development.
Debate focused traditionally on the links between monetary policy, credit and the real economy, has lately shifted towards prudential regulation.
Insufficient consideration has been paid to the interplay between accountancy rules, prudential regulation and finance
“To have a banking system that acts as shock absorber rather than shock amplifier”
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AlternativesAlternatives
Traditionally capital pointed out as the main restriction on loan granting
Default losses less capital lower-risk assetsleverage
Solution? To lessen the impact on income statements
Other proposals:
asset valuation methodologies
compensation schemes (bonuses)
quality of capital
TTC risk measures, max leverage, impact of the cycle on financial reports and other regulatory changes
We pick the proposals of the 4th group and analyze them dynamically
Special
focus
on
counter-cyclical
provisions
Regulatory solutions to pro-cyclicality
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IssuesIssues
1.
Conflict between accounting and prudential views + financial and incentive perspectives
2.
There are signaling problems3.
Internally generated cash flows are an important driver
in
pro-cyclical dynamics4.
Biases in credit prices and amounts may drive financial business out of regulated institutions.
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Loan Loss Provisions as a value adjustment and as Loan Loss Provisions as a value adjustment and as a prudential toola prudential tool
1.
Provisioning brings a loan’s accounting value closer to its fair value.
2.
Loan Loss Provisions (LLP) should cover expected losses statistical
concept
2 objectives, 2 points of view, for an instrument that follows...
Accounting rules!
objective evidence financial records
verifiable information a loan quality
Provisions are backward-looking and pro-cyclical
Industry point of view? “banks consider expected losses as a cost of doing business and set product margins to both compensate for them and
earn a
return on capital”. Yet, margins are ignored in regulation.
economic
concept
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CounterCounter--cyclical provisioning cyclical provisioning
Idea: stable LLP at the long-term expected loss level
Smooth out the impact on the bank’s results by temporal distribution of LLP’s
booking
When booked provisions > incurred losses
accounting reserve
When booked provisions < incurred losses
accounting reserve
Spain
(1999)
0,01,0
2,03,04,0
5,06,0
00,010,020,030,040,050,060,07
Defau
lt rate
LLP AC provision reserve Default rate
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Usually mentioned challenges:
Differentiation between macro conditions and idiosyncratic drivers of default
Articulation with other standards
3 potential problems associated with pro-cyclicality:1.
Signaling problems:
asymmetrical information and agency problems
Required rate of return is affected by released information. Two-
fold challenge: (I)
understand the break down between observed
and regulatory losses; (II)
asses if the bank is hiding, deferring or
advancing portfolio risk booking.
Precedent: voluntary smoothing of earnings.
2.
Liquidity dynamics and management.3.
Pricing problems.
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ExerciseExercise
Simulation exercise -
representative bank
Band’s behavior throughout a business cycle under different regulation schemes
Calibration: (as a reference) Argentine banking system
perfect foresight
The bank holds 3 asset classes: (identical) loans, fixed assets and risk- free liquid assets. Its funding comes from deposits and capital.
Loans are bullet with yearly payment of interest, fixed interest
rate and 2-year maturity.
The bank faces a credit demand curve.
ln(Lt
)-ln(Lt-1
)= w [ln(1+r tl)-
ln(1+r
l
t-1
)]– r tl is the lending rate– Lt stock of loans– rb is a benchmark rate–
w is a very crucial elasticity, we carried out an econometric estimation using 2SLS.
Regulatory solutions to pro-cyclicality
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Exercise Exercise
The bank faces a supply of deposits which is a function of the risk assessment made by depositors
rtd=0.005+ rb
+ i
indti
+ Dt
* cycle–
represent sensibilities applied on ind
indicators, corresponding
to capitalization, liquidity, ROE, phase of the cycle and if the
bank has had to raise capital at the previous year end.
–
the rate increase required to raise one additional peso worth of deposits in the economic expansion is lower than the same
increase in the economic contraction (last term).
•
The benchmark rate fluctuates around 5%, with the cycle
Regulatory solutions to pro-cyclicality
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ExerciseExercise
•
identity of the balance sheet: (Lt –APt-1
)+F+Bt
= Kt-1 + Dt–
F represents Fixed Assets (constant).
–
Bt
stands for risk-free liquid assets, (remunerated at a constant rate). –
APt-1
is the stock of provisions at the end of the previous period and –
K is the Net Worth value (Tier 1 capital).
Liquidity and solvency requirements:-
Target capital ratio constant at 9.0%.
-
Tier 1 capital = Net Worth.
-
Tier 2 capital: where (partial) capitalization of anti-cyclical provisioning is admitted.
[(Lt –PAt-1
)+F]<= Kt-1 + PAC t-1
15% liquidity ratio requirement as a percentage of deposits, must be met with liquid assets:
Dt
<=Bt
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Cash-Flow
NL(t+1)
=MNIt
+ L(t-1) (1-dt-1
) (1-dt
)+(Bt
-Bt+1
)+ (Dt+1
-Dt
)-Yt
where
MNIt
= L(t)
(1-dt
) rlt
+ L(t-1)
(1-dt-1
) (1-dt
) rlt-1 – rd
t
Dt
+ rb
Bt
– MNI Net Interest Margin– dt
default rate of the period– Yt
dividend payments
Dividends are paid in cash at the end of each period so as to comply with capital requirements for the next period. In some periods the institution may need to raise capital.
Total Result of the period = NIM + LLP
Pricing: The lending rate must cover expected funding rates, loan losses and ROE. Lending rates are fixed on 2-year loans. When LLP result from an anti-cyclical regulation, this reported level is factored into the pricing formula.
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Initial composition of the balance sheet and interest rates:
With this structure the bank strictly complies with the regulatory ratios and gets the desired level of ROE (15%); balance sheet and interest rates are stable.
Resolution: The bank decides simultaneously, at the end of each period, the variables under its control: new loans, liabilities, capital
and holding of liquid assets and the corresponding interest rates, st the mentioned restrictions.
The bank always gets the funds required though sometimes at a higher cost, It always gets the desired ROE as a long-run average.
B Liquid
assets 13.7 D Deposits 91.1 r l Lending 13.5%
L Loans 67.6 K Net
worth
7.6 rd Deposit 4.5%
F Fixed
assets 17.5 r f Benchmark 5.0%
Total 98.8 Total 98.8
Balance Balance SheetSheet Interest RatesInterest Rates
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SchemesSchemes
“Base”
scenario : Current regulation
Counter-cyclical regulation schemes
Anti-cyclical provisions: 1.
“AP”
–
if there is a balance, it is not allowed for regulatory capital
2. “AP capitalization”
-
anti-cyclical provisions partially allowed as capital
(Tier 2 capital up to 50% of Tier 1 capital)
“Capital”-
time-varying capital ratio: it increases in economic expansions and decreases in economic contractions. The amounts by which the capital increases or decreases are similar to the changes in the anti-cyclical reserve balance under the AP scheme.
“Liquidity”
-
time-varying liquidity requirements: In the expansion, the bank must accumulate liquid assets above the λ
ratio (by an
amount similar to the anti-cyclical reserve balance under the AP scheme) and the opposite occurs during the contraction.
Regulatory solutions to pro-cyclicality
Base ScenarioBase Scenario
Credit and cycle
Interest Rates
66
67
68
69
70
1 3 5 7 9 11 13 15 17 19 21 23 25
Tota
l Cre
dit
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Def
ault
rate
Total Credit Default
Rate
0.00
0.03
0.06
0.09
0.12
0.15
0.18
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Lend
ing,
dep
osit
rate
Default
rate Lending
rate Deposit
rate
Regulatory solutions to pro-cyclicality
Base ScenarioBase Scenario
Cash Flow
Funding with Deposits
0.6 0.08
-0.6
-0.4
-0.2
0.0
0.2
0.4
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25D
epos
itsCh
ange
0
0.02
0.04
0.06
Def
ault,
dep
osits
rate
Deposit
Change Default
rate Deposits
rate
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
1 3 5 7 9 11 13 15 17 19 21 23 25
-0.02
0
0.02
0.04
0.06
Def
ault
rate
Deposit change NIMDividends Liquid
assets
changeDefault rate
Regulatory solutions to pro-cyclicality
Base ScenarioBase Scenario
LLP, NIM and Net Income
ROE and dividends
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
1 3 5 7 9 11 13 15 17 19 21 23 25
0
0.02
0.04
0.06
Defau
ltrate
LLP NIM Net income Default
rate
0.50
0.75
1.00
1.25
1.50
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 390.00
0.05
0.10
0.15
0.20
0.25
Def
ault
rate
, RO
E
Default
rate ROE
0.50
0.75
1.00
0.50
0.75
1.00
1.25
1.50
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 390.00
0.05
0.10
0.15
0.20
0.25
Def
ault
rate
, RO
E
Dividends
Regulatory solutions to pro-cyclicality
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Comparison of Schemes
Credit and cycle
64
65
66
67
68
69
70
Tota
l Cre
dit
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Def
ault
Rat
e
64
65
66
67
68
69
70
Tota
l Cre
dit
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Def
ault
Rat
e
64
65
66
67
68
69
70
1 3 5 7 9 11 13 15 17 19 21 23 25
Tota
l Cre
dit
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Def
ault
Rat
e
64
65
66
67
68
69
70
Tota
l Cre
dit
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Def
ault
Rat
e
64
65
66
67
68
69
70
1 3 5 7 9 11 13 15 17 19 21 23 25
Tota
l Cre
dit
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Def
ault
Rat
e
Total Credit Default Rate
Base
AP
AP capitalization
Liquidity
Capital
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Comparison of Schemes
Cash flow
Base
AP
AP capitalization
Liquidity
Capital
Depos i t ChangeDividendsDefault rate
NIMLiquid
assets change
-5.0
-2.5
0.0
2.5
5.0
7.5
-0.05
-0.03
-0.01
0.01
0.03
0.05
0.07
Def
ault
rate
-5.0
-2.5
0.0
2.5
5.0
7.5
1 3 5 7 9 11 13 15 17 19 21 23 25
-0.05
-0.03
-0.01
0.01
0.03
0.05
0.07
Def
ault
rate
-5.0
-2.5
0.0
2.5
5.0
7.5
-0.05
-0.03
-0.01
0.01
0.03
0.05
0.07
Def
ault
rate
-5.0
-3.0
-1.0
1.0
3.0
5.0
7.0
-0.05
-0.03
-0.01
0.01
0.03
0.05
0.07
Def
ault
rate
-5.0
-2.5
0.0
2.5
5.0
7.5
1 3 5 7 9 11 13 15 17 19 21 23 25
-0.05
-0.03
-0.01
0.01
0.03
0.05
0.07
Def
ault
rate
Regulatory solutions to pro-cyclicality
20-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1 3 5 7 9 11 13 15 17 19 21 23 25
Dep
osit
s Ch
ange
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
Def
ault
, dep
osit
s ra
te
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Dep
osit
s Ch
ange
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
Def
ault
, dep
osit
s ra
te
Comparison of Schemes
Funding with Deposits
Base
AP
AP capitalization
Liquidity
Capital
Deposits Change Default rate
Deposit rate
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Dep
osits
Chan
ge
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
Def
ault,
dep
osits
rate
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Dep
osits
Chan
ge
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
Def
ault,
dep
osits
rate
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1 3 5 7 9 11 13 15 17 19 21 23 25
perod
Dep
osits
Chan
ge
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
Def
ault,
dep
osits
rate
Regulatory solutions to pro-cyclicality
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0.00
0.04
0.08
0.12
0.16
0.20
0.24
0.00
0.04
0.08
0.12
0.16
0.20
0.24
0.00
0.04
0.08
0.12
0.16
0.20
0.24
1 3 5 7 9 11 13 15 17 19 21 23 25
Comparison of Schemes
Interest Rates
Base
AP
AP capitalization
Liquidity
Capital0.00
0.04
0.08
0.12
0.16
0.20
0.24
0.00
0.04
0.08
0.12
0.16
0.20
0.24
1 3 5 7 9 11 13 15 17 19 21 23 25
Default rate Lending rate
Deposits rate
Regulatory solutions to pro-cyclicality
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
0
0.02
0.04
0.06
Defa
ult ra
te
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
1 3 5 7 9 11 13 15 17 19 21 23 25period
0
0.02
0.04
0.06
Defa
ult ra
te
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
1 3 5 7 9 11 13 15 17 19 21 23 25period
0
0.02
0.04
0.06De
fault
rate
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
0
0.02
0.04
0.06
Defa
ult ra
te
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
0
0.02
0.04
0.06
Defa
ult ra
te
Comparison of Schemes
LLP, NIM and Net Income
Base
AP
AP capitalization
Liquidity
Capital
Total Result Default rate
LLP NIM
Regulatory solutions to pro-cyclicality
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Pricing distortions
If the regulation introduces a wedge between future incurred losses and future booked losses, which is the relevant expected default loss for pricing?
-
losses reported in the books a wedge between bank loan rates and financial market rates.
Regulatory arbitrage problems
incentives to “manage the books”
Cost of borrowing from bank vs
cost of borrowing from “capital markets”
regulated unregulated
Regulatory solutions to pro-cyclicality
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Risk Neutral pricing
risk = cap. req.
The other schemes show higher values for bank loans rate during contractions and lower values during expansions
With time-varyingliquidity the discrepanciestake the opposite sign and are sizable.
Incentive for the bankto “manage" its balance sheet.
Price distortions and incentives to Price distortions and incentives to ““manage the booksmanage the books””
0,00
0,05
0,10
0,15
0,20
0,25
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25period
CMR base AP AP_capitalizationliquidity capital Tasa default
the capital market interest rate shows slight difference with the rate of the base scheme
Regulatory solutions to pro-cyclicality
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Concluding RemarksConcluding Remarks
Double-edged swords may be introduced, we should be cautious about:
Liquidity related aspects
accounting changes that do not alter cash flows
encouraging financial statements manipulation.
There is a risk of complacency
d1-t41t
e31t
e2t
rl10
dt L+varIPCEMAE)r-(rL
Regulatory solutions to pro-cyclicality
Thank You!Thank You!
