Banks' risk taking under Basel II capital requirements: does mandatory information disclosure affect banks' risk taking?

2/2009

Banks' risk taking under Basel II capital requirements: does mandatory information disclosure affect banks' risk taking?

One conclusion that has been drawn from the ongoing financial crisis, and in particular from the original subprime crisis, seems to be that there were serious shortcomings in financial institutions’ risk management and the transparency of their actions. This is despite the perhaps more controversial observation that it was the realization of adverse macro or aggregate shocks that triggered the crisis and that the relatively long period of apparent macroeconomic stability was conducive to the perception of reduced macroeconomic risks. Perhaps more alarmingly, risk management appeared to have failed in some of the biggest and most sophisticated financial institutions. Moreover, the lack of transparency in financial institutions’ exposures to securitized instruments and off-balance sheet vehicles has surely contributed to making risk management, both in individual financial institutions and throughout the whole financial system, more complex and difficult. Lack of transparency has consequently also contributed to the severity of the crisis.

The policy conclusion from this piece of analysis must then be that financial institutions’ risk management and the disclosure of their on- and off-balance sheet exposures must be improved. The new Basel II framework and, in particular, banks’ capital requirements are widely believed to be a step in the right direction in this respect, as Pillar 3 of the new framework – market discipline – requires banks to disclose detailed information on their risk profile, capital adequacy and risk assessment processes. One of the objectives of Pillar 3 is to help investors in identifying changes in banks’ conditions and incorporating these changes into banks’ security prices. This, in turn, is intended to enhance banks’ incentives to behave prudently and improve their risk management.

It is somewhat surprising that most of the academic research on Basel II has hitherto concentrated mainly on the effects of minimum capital ratios, ie on Pillar 1 of the new framework, despite the potential importance of Pillar 3 in light of the current financial crisis. In a forthcoming Bank of Finland discussion paper, Banks’ risk taking under Basel II capital requirements, Jukka Vauhkonen takes steps to extend the existing literature on Basel II by examining the combined effects of minimum capital requirements and information disclosure requirements incorporated in Pillar 1 and 3 respectively on banks’ risk-taking behaviour.

Vauhkonen employs a Salop-type spatial model of imperfect banking competition with four types of agents, banks’ inside and outside shareholders (insiders and outsiders), depositors and the regulator or supervisor. Insiders, who are either owner-managers or old shareholders and maximize their own payoffs, make the decisions in the banks. Banks are funded by fully insured deposits and capital and compete for deposits by setting their deposit rates. Banks’ pricing or market power is the result of depositors having to incur transportation costs when travelling to their banks. There is a single loan portfolio that banks invest their funds in. Whether a bank is successful in its investment policy depends on the quality of its risk measurement and management systems, which, for brevity, Vauhkonen, in presenting his analysis, dubs ‘quality of risk management’ or just ‘quality’.

The success probability of a bank is chosen by the bank’s insiders. Without common disclosure requirements and criteria such as Pillar 3, this quality is unobservable to outside market participants, as Vauhkonen assumes that the incentives for voluntary disclosure are not sufficiently strong, thus making voluntary disclosure effectively unfeasible. Furthermore, in the absence of disclosure and regulation, the equilibrium quality of risk management is lower than in the first-best case, as insiders do not internalize the cost of deposit insurance and, consequently, the full social cost of a bank failure. This, as usual, is the efficiency cost generated by the underlying moral hazard problem.

The regulator’s aim, on the other hand, is to alleviate the moral hazard problem by requiring banks to raise capital. By setting capital requirements, the regulator attempts to increase banks’ shareholders’ losses in the event of default and induce banks to reduce the probability of failure by improving their risk management systems.

Given this set-up, Vauhkonen models three different Basel-type regulatory capital approaches for credit risk – the previous Basel I capital requirements and the two options of the new Basel II capital requirements, the standardized approach (SA) and Basel II internal ratings-based (IRB) approach – in a stylized fashion and investigates their effects on the equilibrium quality of banks’ risk management.

As Vauhkonen notes in his paper, one can conclude from the existing literature that capital requirements may potentially influence bank insiders’ incentives through two effects, the dilution effect and the capital-at-risk effect. The dilution effect typically affects incentives adversely, the reason being that capital requirements force banks to raise new capital, which erodes bank insiders’ payoffs and reduces their incentives to put effort into improving the quality of risk management. On the other hand, the larger a bank’s capital-to-deposit ratio is, the larger will be the downside risk that bank insiders bear. This capital-at-risk effect tends to improve insiders’ incentives. Vauhkonen emphasizes the capital-at-risk effect plays a key role in his analysis.

In his model set-up, Vauhkonen first characterizes Basel I by its usual key features of a flat-rate minimum regulatory capital-to-deposits ratio. He also assumes that, under Basel I, the quality of banks’ risk management is unobservable to outsiders. Given these assumptions, Vauhkonen shows that Basel I has no effect on bank risk-taking relative to the benchmark of no regulation, as neither the dilution effect nor the capital-at-risk effect are at work. By way of confirming some of the existing results, Vauhkonen notes that the dilution effect does not operate, since the cost of capital requirement is fully transferred to depositors. At the same time, the capital-at-risk effect does not operate either, since insiders have no own capital at stake and since the risk of an individual bank is unobservable to outsiders. Consequently, these results suggest that flat-rate capital requirements, such as Basel I, can be fairly ineffective in reducing excessive risk-taking by banks, if there are serious conflicts of interests between banks’ insiders and other equity-holders and if insiders’ actions are not transparent to market participants.

Vauhkonen proceeds to examine a scenario in which all banks are required to use the Basel II standardized approach, which, as he rightly notes, can be regarded as a refinement of the Basel I approach. The difference between the approaches in the paper’s set-up is that, under the standardized approach, the quality of banks’ risk management systems is made either fully or partially observable by the Basel II Pillar 3 disclosure requirements. Vauhkonen is able to show that by making the risk of an individual bank observable, disclosure affects the bank’s cost of capital and increases the equilibrium quality of banks’ risk management systems. Consequently, Vauhkonen’s analysis nicely supports the argument put forward by some other researchers in the field[1] that the ultimate success of Pillar standards rests on how well Pillar 3 functions.

In the next step, Vauhkonen examines a scenario in which all banks must choose the IRB approach, under which banks can use their own internal estimates of risk components to compute capital requirements for their exposures. However, as Vauhkonen rightly notes, a full-blown analysis of the risk-sensitive IRB capital requirements is not possible in the paper’s set-up with a single asset. Vauhkonen proposes a way out of this dilemma by considering a reduced version of the IRB approach where he models three key elements of it.

Firstly, to be eligible to enter into and use the IRB approach a bank has to satisfy an extensive set of qualifying requirements. In Vauhkonen’s model, these requirements amount to defining the minimum quality of banks’ risk management systems under the IRB approach. Secondly, the minimum capital requirement for banks is generically[2] lower under the IRB approach than under the standardized approach. Thirdly, in line with the standardized approach of Basel II, the quality of banks’ risk management systems is made either fully or partially observable by the Pillar 3 disclosures.

Given these assumptions, Vauhkonen shows that superiority between the IRB approach and the Basel II standardized approach in reducing banks’ risk-taking depends crucially on the stringency of the Pillar 3 disclosure requirements and the IRB qualifying requirements. More specifically, he shows that under stringent Pillar 3 disclosure requirements and lax IRB qualifying requirements, the equilibrium quality of banks’ risk management systems is higher and hence their equilibrium risk-taking lower under the Basel II standardized approach than under the IRB approach. Under lax Pillar 3 disclosure requirements, in turn, the IRB approach induces lower bank risk-taking at the equilibrium than the standardized approach.