Bank Risk Measurement: A Pragmatic Approach

A healthy and vibrant banking system is an essential pillar for global economic progress. Far too often in the recent past, banking crises have deteriorated into global catastrophes. As such, measuring and managing banking risk has become an important topic amongst international banking professionals. Many analytical tools and banking practices have been proffered to mitigate potential banking distress. However, within this cacophony of new analytics, is there a simple measurement that would predict financial distress with a high degree of confidence? If there is such a risk measurement that would foreshadow financial distress, what is the cost of putting the global banking system on a safer footing based on such assessment and the usefulness of mandated leverage ratios are useful topics to ponder. Kevin Buehler, Christopher Mazingo and Hamid Samandari have come up with an interesting observational study on measuring banking risk and the ‘gist’ of it is as follows.

Among the various ratios, the one that offers the greatest clarity into the likelihood of bank distress actually measures ‘Tangible Common Equity (TCE)’ (the portion of equity that is neither preferred equity nor intangible assets) against risk-weighted assets (RWA). Tangible Common Equity, like Tier 1 capital, can absorb losses because it offers banks the contractual flexibility either to eliminate repayments entirely or to defer them for extended periods of time. It can also absorb losses whether or not a bank remains a going concern. The measures most commonly regulated currently—those based on the combined Tier 1 plus Tier 2 capital levels—are the least useful, in part because banks can seldom use Tier 2 capital to absorb a loss if they are to continue operating. For example, unrealized gains on securities may be unavailable in times of severe economic stress, and subordinated debt may trigger default if payments are deferred. In addition, banks have successfully arbitraged capital ratios traditionally watched by regulators through the banks’ increasing use of non-common-equity instruments, such as cumulative preferred stock and trust-preferred securities that qualify for treatment as Tier 1 capital but could be issued at lower cost than common equity. This practice weakens the ability of an institution to absorb losses and the ability of regulations to limit its riskiness.

Mandated leverage ratios would not offer any insight into the likelihood of bank distress beyond that provided by the TCE/RWA ratio. This does not prove that regulating leverage ratios is a bad idea. It does suggest, however, that the rationale must be based on other considerations. For example, leverage ratios might protect the liability side of the balance sheet against greater-than-expected haircuts on repurchase (or repo) financing, which could precipitate a systemic crisis. They also might help prevent future errors in risk weighting and regulatory arbitrage of risk weightings. But the use of leverage ratios has also arguably created an incentive for the growth of off-balance-sheet activities, which remove certain assets from the leverage ratio calculation and increase risk while circumventing additional capital requirements.

While it is possible to lower a bank’s level of risk by increasing its TCE/RWA ratio, the trade-off is higher costs. Reducing the number of banks at risk through a higher capital base decreases the returns on equity (ROE) for the industry. For instance, a TCE/RWA ratio of 10 percent would have affected all of the banks that became distressed during the recent crisis but would have required an incremental $1.45 trillion in capital and reduced industry-wide average ROEs by an extraordinarily high 560 basis points. In addition to the impact on ROEs, increasing the required capital levels would likely have macroeconomic costs, including the effects of a short-term contraction in the availability of credit and the potential long-term effects of reduced lending levels, which result in lower GDP growth.

(Author: Dinesh Kumarajeeva)

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About kumarajeeva

World Bank - International Finance Corporation (IFC) consultant and Harvard Business School (HBS) senior research/teaching fellow. Training and education in international and development economics, knowledge management & international executive education/training.
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