January 29, 2013

Evaluating Risk-Based Capital Regulation

  • Thomas L. Hogan

    Assistant Professor of Finance, Manuel H. Johnson Center for Political Economy, Troy University
  • Neil Meredith

  • Xuhao Pan

Key materials

I. Introduction

The standard capital ratio of equity over assets has long been used as an important indicator of bank risk. Banks with more equity are less affected by asset depreciation than are other banks because a drop in the value of their assets affects only their equity and not their liabilities. In response to the savings and loan crisis of the 1980s, the Federal Reserve adopted risk-based capital (RBC) regulations in 1991 based on the Basel Committee on Bank Supervision (1988, hereafter “Basel Accords”) to improve the effectiveness of US banking regulation and to standardize the US banking system with other systems around the world. The RBC ratio measures equity as a percentage of risk-weighted assets (RWA); each category of assets is assigned a weight appropriate to its perceived level of risk. Banks with riskier assets must maintain more capital, while banks with safer assets require less capital. However, if this method of assessing risk is flawed, its use may increase, rather than decrease, systemic risk in the banking system.

Critics of the Basel system have pointed out several ways in which RBC regulation has increased risk in the banking system.[1] First, RBC can encourage risk-taking by individual banks, especially if regulators have not properly identified the riskiness of a particular class of assets. Jablecki (2009, 16) shows that the misrating of risky assets in the Basel Accords has encouraged US banks to adopt “regulatory capital arbitrage techniques, in particular securitization.” This problem cannot be resolved simply by reevaluating the assets’ risk weightings, because regulators themselves cannot be certain of all potential risks. Indeed, regulators seriously underestimated the riskiness of mortgage-backed securities (MBS), which were viewed in the 1980s as safe, low-risk assets but are now recognized as very high in risk. Second, risk- weighting systems can create systemic risk by encouraging many banks to invest heavily in the same class of assets. Friedman’s (2011) work explains how RBC regulations give banks an incentive to hold certain classes of risky assets, such as MBS and Greek government bonds, and that this approach has increased systemic risk in the United States and the European Union respectively.[2]

It is possible, however, that the benefits of RBC regulation might outweigh the potential costs. Some studies, such as Estrella, Park, and Peristiani’s (2000), have proposed that optimal banking regulation might utilize some combination of capital and RBC regulations. The Fed currently employs such a system (discussed further in the next section), which is based on the Basel Accords. If the RBC ratio is, in fact, an effective predictor of bank risk, then the RBC ratio might help regulators identify particularly risky banks, and this advantage might offset the disadvantage of increased systemic risk. However, if the RBC ratio does not improve the predictive power of the capital ratio, then RBC regulation may cause significant harm without providing any added benefit. Therefore, we must turn to the empirical question of whether or not the RBC ratio is better than the capital ratio as a predictor of bank performance.

Avery and Berger’s (1991) paper is among the first empirical studies to validate the use of RBC as a measure of bank performance, and it is widely cited in support of RBC regulation.[3] This study uses FDIC Call Report data to calculate the RWA of all US commercial banks from 1982 to 1989. The authors find that RWA is correlated with several indicators of bank performance, such as income, nonperforming loans, and bank failures.4 In addition to evaluating RWA as a predictor of bank risk, Avery and Berger (1991) examine the levels of capital required under the new and old regulatory capital standards. Banks whose levels of capital failed to meet the new standard were found to have significantly worse performance than banks whose levels of capital failed to meet the old standard, leading the authors to conclude that the new RBC standards provide a better indication of risk. However, there are shortcomings in their method of analysis. First, the RWAs calculated by Avery and Berger (1991) differ significantly from those reported by the banks themselves. We use instead the RWA values reported by banks in their FDIC Call Reports. Second, this approach compares specific policies rather than comparing the capital and RBC ratios as analytical tools. For example, comparing a 6% capital ratio with an 8% RBC ratio may only tell us that an 8% ratio is better than a 6% ratio, and not necessarily whether the capital ratio or the RBC ratio is a better indicator of performance. Third, the regression analysis of Avery and Berger (1991) examines the influence of RWA separately from capital requirements, whereas RBC regulations depend crucially on the interaction between capital and RWA. (For example, banks with higher RWA may still be considered safe if they are highly capitalized.)

We contribute to the debate on bank regulation by comparing the capital and RBC ratios reported by US commercial banks in their Call Reports as indicators of performance. Contrary to Avery and Berger (1991), we find evidence that the capital ratio is a better indicator of bank performance than the RBC ratio. The next section discusses our sample of bank-income and balance-sheet data, including some summary statistics. In section 3, we describe the analysis used by Avery and Berger (1991) and discuss some shortcomings of their approach. Section 4 proposes a more direct method of comparing capital and RBC ratios. Section 5 provides the results of our analysis, which indicate that the standard capital ratio is a significant predictor of the measures of bank performance used by Avery and Berger (1991). In contrast, the RBC ratio is not a significant predictor of performance, even when used in conjunction with the capital ratio. Section 6 concludes our study.

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