Banks’ Credit Portfolio Choice And Risk-Based Capital Regulation

Caren Yinxia Nielsen

Lund University

October 7, 2015

Abstract:

In order to address banks’ risk-taking during the recent financial crisis, we develop a model of credit portfolio optimization and study the impact of risk-based capital regulation (Basel Accords) on banks’ asset allocations. The model shows that, when a bank’s capital is constrained by regulation, regulatory cost (risk weightings in Basel Accords) alters the risk and value calculations for the bank’s assets. The model predicts that the effect of a tightening of the capital requirements — for banks for which these requirements are (will become) binding — will be to skew the risky portfolio towards high-risk high-earning assets (low-risk low-earning assets), provided that the asset valuation, i.e. reward-to-regulatory-cost ratio, of the high-risk asset is higher than that of the low-risk asset. Empirical examination of U.S. banks supports the predictions applicable in the dataset. In addition, our tests show the characteristics of banks with different levels of risk taking. In particular, the core banks that use the internal ratings-based approach under Basel II invest more in high-risk assets.

Banks’ Credit Portfolio Choice And Risk-Based Capital Regulation – Introduction

The recent financial crisis has put a sharp spotlight on banks’ risk-taking. Banks are blamed for shrugging off risk concerns while pursuing higher earnings, such as on loans with high credit risk.

To investigate banks’ risk-taking on credit risk, we look into banks’ total assets with different levels of credit risk, defined by the risk weightings under the Basel Accords 1. To value the overall risk of a bank’s assets, the Basel Accords adopt the total risk-weighted assets, where a higher weight is assigned to assets with higher credit risk.

Banks' Credit Portfolio Choice And Risk-Based Capital Regulation

Figures 1 and 2 display the sum of the assets with a certain risk weighting for all U.S. banks that are insured by the Federal Deposit Insurance Corporation (FDIC) from 2002 to 2012. According to Figure 1, there is a distinct increase in the amount of assets with the highest credit risk, namely 100% risk weighting, although the trend of its proportion is not obvious. Notice that, from the second quarter in 2008, there is an apparent increase in the assets with the lowest credit risk, namely 0% risk weighting, measured in dollars or in proportion, which verifies the phenomenon of “flying to safety” since the crisis. Figure 2 shows banks’ total allocation among risky assets whose risk weightings are non-zero. The proportion of assets with 100% risk weighting, i.e. high-risk assets, increases through the years, compared to the sum of assets with 20% and 50% risk weightings, i.e. low-risk assets. The maximum of the difference in their allocations is 17.9% of risky assets, that is 1.62 trillions of dollars. This could be due to “flying to earnings” targeting the assets with 100% risk weighting.

Banks' Credit Portfolio Choice And Risk-Based Capital Regulation

One question that arises from the above observations is how banks allocate resources (deposits and capital) in assets with different credit risks conditional on the information on assets’ payoffs and default probabilities. Our paper addresses this question. Moreover, the risk-based capital adequacy requirements under the Basel Accords3 pose additional costs to riskier assets, since banks have to reserve more capital for assets with a higher credit risk. However, how banks react to this regulation is ambiguous. Banks also have incentives to take more risk in order to gain higher earnings and compensate for the higher costs of their capital reserves. Thus, we are not certain that a tightening capital requirement would have the desired effect.

We regard a bank as its assets’ manager and develop a model of portfolio allocation with a minimum regulatory capital requirement as a possible binding condition. Then we examine how the bank reshuffles the portfolio basket when the conditional information, i.e. assets’ payoffs, default probabilities, default correlation, or regulation, changes. This allows us to examine explicitly the banks’ credit risk-taking from the point of view of asset portfolio management and to study specifically the impacts of the risk-based capital requirements on banks asset choice.

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