The role and impact of Capital Prudential Policy on the financial stability of European systemic banks capital parity and risk-disincentivizing mechanism

Abstract

This thesis delves into scrutinizing empirically the effectiveness of regulatory capital, particularly minimum capital requirements and capital buffers, in disincentivizing banks from undertaking excessive risks. Regulatory capital is purported to contribute to the safety and resilience of individual banks and the financial system. How it serves this purpose is usually not explained beyond the role of capital as a buffer against unexpected losses (Capital-Buffer Mechanism). It is rarely the case when regulatory capital is claimed to disincentivize banks from taking on more risk (Risk-Disincentivizing Mechanism). To evaluate this relationship, we performed panel data analysis from 2000 to 2020, utilizing Bloomberg data. The research evolves through three essential empirical analyses.
The first quantitative analysis examines the impact of regulatory capital on bank riskiness at an aggregate level. The panel fixed effect model is estimated using three econometric approaches: The Feasible Generalized Least Squares (FGLS-baseline model), Spatial Covariance Correction (SCC), and Panel-Corrected Standard Errors (PCSE). The results indicate a significant positive relationship between minimum capital requirements and bank riskiness, suggesting that higher minimum capital requirements do not effectively deter banks from taking on more risk. Thus, it does not serve as a risk-disincentivizing mechanism. However, minimum capital requirements do serve as a Capital-Buffer Mechanism, because a high level of riskiness requires banks to hold larger capital, providing a buffer against unexpected losses. Besides that, the baseline model findings not only reveal a significant negative association between capital buffer and bank riskiness but also indicate that capital buffer Granger causes bank riskiness and not the other way around. This effect, although small, suggests that capital buffers are more effective in discouraging excessive risk-taking compared to the minimum iv

capital requirements. Therefore, Capital Buffers do serve as a risk-disincentivizing mechanism.
In contrast, the second empirical analysis delves deeper into the relationship between regulatory capital and risk-weighted assets on the quantile level. The study's novel approach involved constructing subsamples from the population dataset, akin to quantile regression. Four subsamples were created based on the direction of variable changes. This approach delves not only deeper into the dataset but also restricts data variations to specific directions. Thereby resulting in more accurate, reliable, and insightful results. Overall, the quantile analysis yielded similar evidence to the aggregate analysis, albeit with additional insights. The positive correlation dataset reveals that a unit change in minimum capital requirement has a slightly higher impact on bank riskiness in the uptrend than in the downtrend. The results also indicate that a unit change in capital buffer has a larger impact on bank riskiness in the uptrend than in the downtrend. One interpretation of this is that requiring a unit increase of capital buffer in an expansionary business cycle will result in a large decrease in a bank’s risk-weighted assets relative to an extra unit of capital buffer in a contractionary business cycle (same role as countercyclical capital buffer). Almost similar results were found in the negative correlation dataset.
Finally, the third empirical analysis introduces a novel risk parity approach to determine banks’ optimal capital levels. By integrating regulatory capital with the risk parity framework, the study sheds light on the complex interplay between capital contributions and risk exposure in the banking sector. The analysis identifies banks exhibiting excessive risk-taking behavior and those operating with insufficient capital, offering insights for regulatory intervention and oversight. Overall, this thesis contributes to the ongoing discourse on capital prudential policies and their efficacy in fostering a safer and more resilient banking sector. It calls for further academic research and a deeper understanding of the relationship between regulatory capital and bank risk, urging regulators and researchers to refine methodologies and enhance regulatory frameworks for a more stable financial landscape.

Date of Award	25 Jul 2024
Original language	English
Awarding Institution	Northumbria University
Supervisor	Scott Ellis (Supervisor) & Rajesh Tharyan (Supervisor)