Bank Capital Regulation and Secondary Markets for Bank Assets

How to design bank capital requirements when banks can misreport the value of their assets? We show that the answer depends critically on the existence of secondary markets for bank assets. Without secondary markets, capital requirements based on banks’reporting are more socially desirable than a fixed capital requirement if savings on costly bank capital are suffi ciently high. Yet with secondary markets, banks can reduce the burden of a fixed requirement by selling their assets. And they have stronger incentive to misreport and game capital requirements based on their reporting, because low quality assets can be sold for elevated prices. We argue that the contemporary banking system, where many bank assets are tradable, can benefit from simpler but harder to game forms of capital regulation. ∗The paper is a revised version of the first chapter of my dissertation at the University of Mannheim. I thank Franklin Allen, Thorsten Beck (discussant), Patrick Bolton, Elena Carletti, Denis Gromb, Martin Hellwig, David Martinez-Miera, Chuck Morris, Jorge Ponce, Lev Ratnovski, Rafael Repullo, Javier Suarez, Ernst-Ludwig von Thadden (my PhD supervisor), and participants of seminars at the University of Frankfurt, CEMFI, MPI in Bonn, Riksbank, CERGE-EI, Manchester Business School, Kansas City Fed, Carlos III Madrid, and Riksbank, 2008 Finlawmetrics, EEA/ESEM 2008 and WB/IMF Conference on Risk Analysis for helpful comments. I also thank the German Science Foundation (DFG) and European Corporate Governance Training Network for the financial support during my PhD studies. The views expressed herein are those of the author and do not necessarily represent those of the Federal Reserve Bank of Kansas City or the Federal Reserve System. The paper circulated previously under the title "How To Make the Banks Reveal Their Information." †Federal Reserve Bank of Kansas City, 1 Memorial Drive, Kansas City, MO 64198, tel.: 816-881-2963, fax: 816-881-2135, email: [email protected] “We have a good deal of comfort about the capital cushions at these firms at the moment.”Christopher Cox, then-chairman of the Securities and Exchange Commission, March 11, 2008. High levels of leverage of investment and commercial banks prior to 2007 have been blamed for the severity of the financial crisis that started in 2007 (IMF (2008), Acharya et al. (2009), CGFS (2009)). Although high levels of leverage might have had many causes, existing regulatory and accounting frameworks tied the capital ratios of investment and commercial banks to their own judgment about the value and the riskiness of their assets.1 Such frameworks were intended to align bank capital ratios more closely with their exposures and to increase transparency. However, these frameworks may contribute to bank leverage because banks have an incentive to misreport the value and the riskiness of their assets to save on costly equity capital and to shape favorably investors’perception about them.2 Recently, to limit bank leverage and discretion, the regulators introduced a leverage ratio in the Basel III Accord and standardized haircuts to the SEC’s net capital rule for broker-dealers (BCBS (2010), Shapiro (2010)). In this paper, we explore a bank’s incentive to misreport value of its assets and its consequence for bank capital requirements.3 We do so under two scenarios: without and with a secondary market for bank assets. In the years before the crisis banking systems underwent a dramatic change as tradability of banks’traditional assets (loans) has increased. We argue that the secondary market matters for design of capital requirements for two reasons. First, banks can use its capital more effi ciently by selling its assets for which capital requirements are too high from its perspective.4 Second, if capital requirements depend on banks’reporting, the banks’incentive to misreport is stronger when they can sell their assets than when they keep them. The reason is that the benefit 1The 1998 amendment to the Basel I Accord and the 2004 amendment to the SEC’s net capital rule addressing market risk as well as the Basel II Accord addressing credit risk allow banks to use their internal risk management models to determine their capital requirements. In accounting, determination of loan loss provisions, treatment of repo transactions, and classification of Level 1-3 assets are the most prominent examples of how the banks can use their judgment to adjust their leverage. 2The effect of banks’discretion on their leverage is well documented empirically and anecdotally. Gunther and Moore (2003) use an example of loan loss provisions. Huizinga and Laeven (2010) use Level 1-3 assets. Valukas (2010) describes Lehman Brothers’use of repo 105 and McLean (2011) the MF Global’s use of repo-to-maturity. Shapiro (2010) comments on banks’discretion over assumptions in their internal risk management models that lowers capital requirements. Vaughan (2011) reports on the banks’practice of "risk-weighted asset optimization." 3Our approach is general enough to encompass the specific case of risk-based capital requirements such as the Basel Accords and SEC’s net capital rule, as well as the accounting examples from footnote 1. 4Bank capital requirements are a prominent motive for loan sales by banks, and for credit risk transfer in general (see e.g. Acharya, Schnabl and Suarez (2010), Berger and Udell (1993), Demsetz (2000), Drucker and Puri (2009), Duffi e (2007), Parlour and Plantin (2008), Saunders and Cornett (2006)).