Banks' regulatory risk tolerance
Summary
Focus
The evolution of the management capital buffer – the headroom above regulatory requirements – reflects banks' tolerance to the risk of a regulatory breach. To analyse this tolerance, we use a data set comprising 17 large US banks and 17 large euro area banks, covering 34 quarters before and 34 quarters after the Great Financial Crisis (GFC). We estimate long-run management buffer targets, speeds of reversion to these targets and volatilities of management buffer shocks. We derive the estimates separately for the pre- and post-GFC periods and at the level of both individual banks and bank groups.
Contribution
We contribute to the literature on bank capital management in four ways. First, we seek evidence of clearly defined capital management strategies by drawing on long time series of bank regulatory requirements and balance sheet ratios. Second, we introduce a "regulatory risk tolerance" (RRT) metric, which decreases with the management buffer target and the speed of reversion to that target but increases with the volatility of management buffer shocks. We test for a common RRT across individual banks and across bank groups based on nationality, size, business model, riskiness and performance. Third, we study whether – by altering the trade-offs inherent in capital management – the post-GFC tightening of international regulatory standards shaped the evolution of RRT and its dispersion across banks. Fourth, we investigate whether the RRT metric carries information about the channels through which banks adjust towards their buffer targets – notably, capital or lending – and thus about real-economy effects of capital management.
Findings
RRT is a useful metric for interpreting banks' capital management behaviour. RRT increased systematically after the GFC, mostly reflecting reductions in management buffer targets. In a sign that RRT is a conscious choice, banks with more volatile management buffer shocks set higher management buffer targets and higher speeds of reversion after the GFC. This suggests a strategy to avoid standing out in terms of capital management. In addition, banks facing larger post-GFC hikes in capital requirements raised their RRT by more. Only high-RRT banks tend to respond to management buffer depletion by cutting lending, thus highlighting real-economy implications of capital management choices.
Abstract
In managing their capital, banks balance the risk of breaching regulatory requirements against the cost of maintaining and speedily restoring "management" buffers. Using 68 quarters of data on 17 US and 17 euro-area banks, we find systematic reductions in steady-state management buffer targets and attendant rises in regulatory risk tolerance (RRT) following the Great Financial Crisis (GFC). This phenomenon is particularly pronounced at banks with higher capital requirements post GFC. In parallel, banks facing more volatile management buffer shocks set higher management buffer targets, suggesting that RRT is a conscious choice. High-RRT banks tend to respond to a depletion of their management buffers by cutting lending, whereas low-RRT banks reduce the riskiness of their assets in other ways - thus highlighting real-economy effects of capital management strategies.
JEL classification: G21, G28, E51, G31
Keywords: capital management, management buffer target, speed of reversion, regulatory regimes
