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The Pro-Cyclical Impact of Basel III Regulatory Capital on Bank Capital Risk

The Pro-Cyclical Impact of Basel III Regulatory Capital on Bank Capital Risk

Song, Guoxiang (2014) The Pro-Cyclical Impact of Basel III Regulatory Capital on Bank Capital Risk. In: Batten, Jonathan A. and Wagner, Niklas F., (eds.) Risk Contemporary Studies in Economic and Financial Analysis: A Period of Monetary Easing. Contemporary Studies in Economic and Financial Analysis, 96 . Emerald Group Publishing Limited, pp. 59-81. ISBN 978-1-78441-027-8 ISSN 1569-3759 (doi:https://doi.org/10.1108/S1569-375920140000096002)

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Abstract

To raise the quality of regulatory capital, Basel III capital rules recognize unrealized gains and losses on all available-for-sale (AFS) securities in Common Equity Tier 1 Capital (CET1). However, by examining the correlations between U.S. GDP growth rate, interest rates and regulatory capital ratios computed using Basel III regulatory capital definition for six U.S. global systemically important banks (G-SIBs) since 2007, this chapter finds that Basel III regulatory capital will enhance the pro-cyclicality of Basel III leverage ratio and Tier 1 capital ratio and their sensitivity to long-term interest rates. Therefore, Basel III capital standards may have significant implications for bank supervision and bank capital risk management in the near future. As banks will hold more high-quality liquid assets (HQLAs) as required by Basel III Liquidity Coverage Ratio (LCR), the weight of unrealized gains and losses arising from fair value accounting will increase in Basel III Tier 1 capital base, the consequent increase of pro-cyclicality in a bank’s regulatory capital ratios may distort the true picture of bank capital adequacy. If an expected loss approach (EL) is used as the provisioning model, such capital risk may be increased further. Moreover, as U.S. monetary policy has started tapering quantitative easing, long-term interest rates will increase inevitably. This may increase the negative impact of unrealized gains and losses on AFS securities on bank capital. As a result, it may be difficult for banks to maintain appropriate capital ratios to meet regulatory requirements and support business activities.

Item Type: Book Section
Uncontrolled Keywords: Basel III; Regulatory capital; Pro-cyclicality; Capital risk; Quantitative easing
Faculty / Department / Research Group: Faculty of Business
Last Modified: 14 Oct 2016 09:29
Selected for GREAT 2016: None
Selected for GREAT 2017: None
Selected for GREAT 2018: None
Selected for GREAT 2019: None
URI: http://gala.gre.ac.uk/id/eprint/12574

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