Capital Requirements and Risk Behavior of Banks - Essay Example

Research Study on the Capital Requirements and Risk Behavior of Banks This dissertation takes an assessment of how financial supervision uses the constraints of capital requirements on banks and other financial institutions to shape their risk preference behavior. The research delves into the review of observed substantiation of the relationship between capital requirements and risk behavior of banks. It concentrates on the how setting the minimal levels of capital requirements results in certain banks maintaining high capital ratios compared to their performance without setting stipulated requirements. Situations without minimum capital requirements could entail reduced lending and increasing capital as well. Furthermore, the chapter reviews the success of fixed capital requirements in terms of maintaining the relations between desired capital and risk taking. It also analyzes ways through which banks reduce effectiveness by taking to riskier assets. Chapter 1: Introduction Capital requirements are also referred to as capital adequacy or regulatory capital. This is the amount of capital that commercial banks hold due to the requirements of the financial regulator. These requirements are necessary for the financial industry; to ensure that commercial banks do not accumulate excess leverage which leads to insolvency. Commercial banks have some behavioral preference when allocating loans to individuals. However, the capital constraints can make the banks to review the behavioral preference. This means that the financial regulator could utilize the strong constraints in capital adequacy to; review the fluctuations of the Micro economy and direct the economy to the required direction through the financial intermediaries like banks (Altunbas)1. Based on the approval of the Basel II model, this discourse defines the research question in the following way: Are rigid pressures exerted by minimum capital requirements efficient in minimizing the risk-taking behavior of banks? The framework of the Basel II structure in the subprime crisis forms the basis within which professionals question the proposals. This area covers the inadequacy of the level of capital requirements. The focus on examining the efficiency of regulatory capital requirements during the implementation of the proposals in Basel I model report executed from 2002 is part of the entire discourse. However, the discourse does not aim at testing the Basel I framework. Instead, it assess the efficiency of the regulatory pressure in relation to the degree of capital cushion in cutting down on the risk-taking behavior of financial institutions in the context of decreased capital buffers. The discourse tests the hypotheses listed as follows: H.i.1: Increasing the regulatory pressure influences the level of capital (risk) positively (negatively). H.i.2: Enhancing the regulatory pressure influences the speed used by financial institutions to amend positively to their risk and capital levels. H.i.3: Financial institutions experiencing enhanced regulatory pressure following amendments on risks and capital will reconstruct their cushion through the increase capital and decrease of risks. Definition of Terminologies Activity-Based Costing: It entails a method of accounting that outlines operations of a business company in terms of activities. In the process, it dispenses indirect costs to products. The system takes into consideration the relationship between operations and products, as well as costs. The dispersion of indirect costs to products is not as arbitrary as other methods considered traditional. Activity Cost Pool: A group of costs incurred during operations within a business company is activity cost pool in managerial accounting. It is easier to allocate the costs to products in the process of arriving at precise cost estimates of products when using the activity cost pool. It is constitutes the total costs required in all operations including production. Activity Cost Driver: This factor influences the expense of particular business activities. It contributes to the rise of a specific activity in activity based costing (ABC). Trait Theory: Traits are differentiating characteristics of the personality of a person and his or her culture. The world does not have any two people with identical traits precisely (Allen and Gale)2. Methodology The discourse applies various approaches as it progresses to comprehend the relationship between capital constraints and the risk behavior of banks. The paper applies multilateral game in the process of deducing loan features of banks. The analysis of behavior options of banks pegs on the use of vector and void coordinates during capital supervision. The dissertation also prepares an index applicable in describing risk inclinations of banks. The empirical model Experts define regulatory capital ratios as a threat weighted capital ratio with the capital of banks occupying the numerator and denominator sat on with risk-weighted assets: Capital Ratio (CR) = Capital (C)/ Risk weighted assets (RWA) = c/Total Assets (A)/ (RWA/A) = Level of capital or leverage/Level of risk (Basle Committee on Banking Supervision, 1988, p. 63). Chapter 2: Description Capital regulation thrives based on the fear that a bank might hold in its reserve less capital compared to its optimal levels. The comparison pegs on riskiness being a negative externality capable of leading to the financial institution defaulting that capital requirement cannot capture. Theoretically, the option-pricing framework supports the steadying influence of capital requirements. This model provides that unrestricted banking institutions could take excessive assortment and advantage risks with the aim of maximizing the value for shareholders disregarding the deposit insurance. Capital restrictions have the capacity to minimize the moral perils incentives by directing shareholders to take up the large portion of losses in the process cutting down the value of the deposit insurance put alternative. The capacity of capital requirements to enhance the stability of the banking institution receives challenges from frameworks operating on the mean-variance option. One of the implications of this research is that it is difficult to outline the choices of behavior shown by banking institutions in addition to the complexity of the identifying the sample supervision approach that requires adjustments. Practically, this research concludes that banks demonstrate risk inclinations of credit framework leading to great influences from the capital requirements. Therefore, authorities charged with the responsibility of regulating operations in banking institutions ought to protect them from capital requirement softening. This dissertation borrows a lot from previous scholarly articles by other research in the area and other related topics to come up with an exemplary report on the relationship between capital requirements and risk preference behavior of banks. Chapter 3: The EU Directive and Impact on the UK The banking sector aims to use the information on how players in the sector use the medium of measurement to motivate employees to compare the performance of their departments with other similar departments across the industry. The sector uses the same to find areas of improvement is correct but with particular improvements. Banks should make their system more flexible and all-inclusive. The processors, customers and management duties are important in addition to the products. Banks have identified activities and the capital requirements. The information on how banks motivate their employees includes a brief description of each activity, time taken and the annual cost. The management responsibility was not included and neither were the costs to customers. Research by other scholars especially those who supported the ideology that bank traits have bigger influence the bank’s behavior was extensive. Funder’s work (Basle Committee on Banking Supervision)3 for instance was comprehensive and qualifies to use in explaining how the capital requirement-to- risk behavior debate ended. In the modern day analysis, it can be said that the earlier analysts who dwelt on this matter did not carry out their studies conclusively. Presently, it is possible to predict people’s behavior based on their traits. People show this during their daily chores and while in different situations. To realize that there was nothing that could bring controversy requires the assessment of people when they are in their natural setting. Observing a bank in such a situation, which is more practical because that would be real life research, proves that bank traits influences behavior. This is informs those who believe that the bank traits influence the bank’s behavior more than the situation. They assert that banks have unswerving behavior that influences their behavior when in varied situations. Analysis of data collected by this group of researchers shows that there is actually a recurrent way depicted by people in different situations. The capital requirements and trait theories developed during the studies conducted on this topic have helped a lot in ending the once controversial debate. The gaps left by the earliest analysts who studied on this topic have been filled courtesy of these theories. The differences among banks within the industry and the causes of the variations are reasons behind most theorists focusing on the stability of behaviors of banks as opposed to the degree of fluctuation (Barrios and Blanco)4. The successful end of the debate on the relations between capital requirements and risk behavior resulted in the shift in the focus from controversial to the important areas of study in banking industry. The focus now centers on the particular areas in the bank topic such as discussing the formal models used in the analysis the consistency of human behavior. The use of these models has been instrumental in emphasizing the correlations of the two factors of behavior .Banks are different in certain ways. Chapter 4: Response to Capital requirements and Regulation However, different people may appear to have particular similarities in other situations too. For instance, there are people who are more social than others are. The same people may seem similar in other situations. With these revelation and congruence, the researchers now focus on striking a balance between how the people could be complete opposites in character in one situation and come to one side in behavior in another arena. Conclusively, it can be summed that indeed behavior is a product of both situations and bank traits. Accepting the complicated way in which this relationship exists is what ended the once great debate several decades ago. Understanding these factors powerfully, influence behavior in their ways and at the same time dependent on each other eliminates controversy. Banking industry researchers have been helped a lot the end of the capital requirement-risk behavior debate. They have the freedom to choose their area of study without fears and contradictions and pursue their area of interest since the two factors have been approved. Traits are strong indicators of other social aspects in people that elicit much interest for study. They include distress, satisfaction in marriage, sadness and happiness among many more. Therefore, the controversy that pertained to whether the bank o has come been successfully concluded. Attempts to develop a particular way in which the capital requirements influence behavior do not seem to be productive. The consequence was supposed to follow a path in a way that suggested that a bank behaved in a particular manner because of a specific environment in which he or she was in during the event. Scholars call them bank signatures. This effort aimed at eliminating the error of measurement. Chapter 5: Case The fact that some of the researchers in this field of banking industry have come to recant some of the views that they held at the start of the debate that created the controversy proves that the discussion on the topic was amicable and successful. The fathers of situational line of thinking that resulted in analysts holding varied arguments that were similar in one way or the other. In this analysis, their views sum up to get the following ideas. By imploring the correlation coefficient, analysts hold an ideology that the relationship that exists between risk behavior and capital requirements averaged below fifty percentile in their studies leading them to hold that there is no link between capital needs and behavior (Angeloni)2. This formulation only brought controversy between the two varying factors of behavior in the discipline of bank banking industry. It is also evident that banking industry and especially the study of bank traits refer to human behavior. The case in point here is what analysts did. In their research, a lot of emphasis was put on understanding how situations affected the way people behaved with less consideration on the bank traits. By doing this, a deliberate acrimony created and as such, the other researchers would strive to counter the accusations. This clearly meant that the debate was not healthy to the topic of discussion and neither did some of the scholars involved mean well to the entire discipline of banking industry. Chapter 6: Conclusion In the end, the dissertation concludes that big banks prefer entering into loan deals with business enterprises while smaller financial institutions prefer developing a bank consortium with aim of pulling major projects. This discourse also follows through the conditions used by the heterology of banks in identifying loans internationally. In the process, the paper proofs those modifications on capital restrictions forces the banking institutions to adjust their credit framework to an extensive line that appears efficient. References 1Altunbas, Y. (2002), “Evidence on the Bank Lending Channel in Europe”, Journal of Banking and Finance, forthcoming, pp. 23. 2Allen F. and D. Gale (1997), “Financial Markets, Intermediaries, and Intertemporal Smoothing”, Journal of Political Economy, 3, 523-546. 3Basle Committee on Banking Supervision (1988), “International Convergence of Capital Measurements and Capital Standards”, July, pp. 63. 4Barrios, V.E. and J.M. Blanco (2001), “The Effectiveness of Bank Capital Adequacy Requirements: A Theoretical and Empirical Approach”, IRES, Discussion Paper, No.1, pp. 92. 5Angeloni, I. (1995), The Credit Channel of Monetary Policy across Università Cattolica Del Sacro Cuore, Milano, mimeo, pp. 86. Read More