7th Edition / July 2021

BrieFin #7: 

Macroprudential Challenges

Plus grand est l'obstacle, et plus grande est la gloire de le surmonter. 

(Jean-Baptiste Poquelin, “Molière”)

At the academic and policy-making levels, macroprudential policies refer to a panoply of regulatory tools aiming at maintaining the financial stability of the system in its entirety. By anticipating and detecting the actual and potential vulnerabilities -or weakest links-, supervisors and policy-makers aim at tackling any disruption affecting the stability of the system. Such measures have obviously an impact on the activity of the financial markets participants, for example by constraining them to retain additional regulatory capital (during expansive cycles) or preventing them from conducting certain activities (or limiting the exposure to them).

During the last year, under the long shadow shed by the COVID-19 outbreak, a number of macroprudential issues arose -and other existing ones exacerbated-. This seventh BrieFin, therefore, focuses on the macroprudential challenges ahead and their impact on financial and credit market participants.

Our first contribution by Seraina Grünewald, Professor of European and Comparative Financial Law (Radboud University Nijmegen, European Banking Institute and Sustainable Finance Lab), provides a comprehensive insight on the available macroprudential toolkit to tackle climate risks. The contribution explores how climate risks have become a source of financial instability lately, and also how the available methodologies for mitigitigating those risks may fall short -or are directly underdeveloped-. The contribution stresses the need to enhance coordination between macroprudential policy and monetary, financial, fiscal, and environmental ones.

The second contribution is the Industry´s view, provided by Dr. Nikos Maragopoulos, Associate Researcher at the European Banking Institute and Head of Resolution Planning & Banking Regulation at Eurobank. He offers an insightful perspective on how the Other Systemically Important Institutions (O-SIIs) buffers foreseen in CRD IV -or rather its inconsistent application- is capable of distorting competition within the Banking Union.

Finally, the young researchers’ view by Panagiotis N. Politsidis, Associate Researcher at the European Banking Institute and Assistant Professor of Finance at Audencia Business School, offers an insight into the interplay between the regulatory and market perceptions on credit institutions´ portfolio risk. In particular, this contribution focuses on how market participants measure bank´s portfolio risk -differently sometimes from supervisors´ approach- and its practical considerations from a macroeconomic perspective.

We hope that the short but enlightening pieces presented herein offer the reader an overview of the challenges -and potential opportunities- stemming from the macroprudential framework and its application. By presenting a variety of perspectives on the same topic, we aim to offer a multi-stakeholder analysis of this interesting and increasingly policy-relevant issue. Enjoy the reading and have a nice summer ahead!

Table of Contents

The Comprehensive View

Seraina Grünewald 

Climate risks – Is the macroprudential framework fit for purpose?

The Industry's View

Nikos Maragopoulos

How the application of the O-SII buffer distorts the level playing field in the Banking Union

Young Researchers' View

Panagiotis N. Politsidis

Regulatory vs. market perceptions about bank portfolio risk and implications for bank lending

EBI European Banking Institute e.V.

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CONTRIBUTIONS

1. The Comprehensive View

Seraina Grünewald

Professor of European and Comparative Financial Law (Radboud University Nijmegen, European Banking Institute and Sustainable Finance Lab)

Climate risks – Is the macroprudential framework fit for purpose?

Introduction

There is nowadays broad acknowledgement that the financial sector has a central role to play in enabling the transition to an environmentally sustainable economy. The Paris Agreement obliges its Signatories and their institutions to make finance flows consistent with a pathway towards low greenhouse gas emissions (GHG) and climate-resilient development (Article 2.1(c)). At the same time, banks and other financial institutions are themselves exposed to significant financial risks caused by rising temperatures – risks that may be systemic in nature and not be internalized by market players. This is where macroprudential policy comes into play. 

1. Climate change as a source of financial instability

What are climate risks? It has become customary to distinguish between two main sources of climate risks. The first involves physical risks, representing the economic costs and financial losses due to the increasing frequency and severity of climate-related weather events (e.g., storms, floods, and heat waves) and the effects of chronic changes in climate patterns (e.g., ocean acidification and rising sea levels). The second, transition risks, are associated with the uncertain financial impacts that could result from changes in climate policy, technological breakthroughs or limitations, and shifts in market preferences and social norms during the economic adjustment to net zero. In particular, a rapid and ambitious transition means that a large fraction of proven reserves of fossil fuel cannot be extracted and become ‘stranded assets’.

For financial institutions, physical and transition risks can materialize directly, through their exposures to sovereigns, corporations and households that experience physical or transition risks – or indirectly at the macro-level, through the effects of climate change on the wider economy and feedback effects within the financial system. Physical and transition risks are drivers of conventional financial risk types, including credit risks, market risks, liquidity risks, operational risks and – for insurance undertakings – underwriting losses. For example, changes in consumption behavior may lead to a sudden repricing of investments in emission-dependent sectors and potential fire sales of assets, hence market risk. Or real estate located in coastal areas may depreciate in value due to physical risk and thus lead to higher credit risk for banks.

2. Methodological challenges in the assessment of climate risks

Climate risks can become systemic, if they do not only affect individual financial institutions, but broader parts of the financial system, where risks are concentrated. The ECB’s latest Financial Stability Review indeed suggests that the banking sector is already exposed to climate risks and that these risks may be particularly concentrated in certain sectors, geographical regions, and individual banks. And yet, discussions on potential macroprudential policy measures to tackle climate risks are still in their infancy.

A key explanation for the inaction of macroprudential policymakers is that climate risks are hugely complex to forecast. First, they are inter-systemic in that they relate to interactions between two systems – the climate and economic/financial system – in addition to interactions within each of them. Second, climate, social and technological tipping points render climate risks non-linear and their dynamics thus inherently difficult to predict. And third, climate risks are subject to unusually long-term horizons, which significantly increase the uncertainty around economic and financial projections. The long horizons associated with the impacts of climate change reinforce existing inaction biases as hard (quantitative) indicators for action are lacking.

These specific features of climate risks have led some central bankers and economists to conclude that we find ourselves in a situation of radical uncertainty. In their Green Swan Paper, they argue that climate-economic models are inherently incapable of representing the complex natural, societal, economic, financial, and technological dynamics climate risks are subjected to. An epistemological break is needed instead, including through more qualitative and politically grounded approaches.

The Network for Greening the Financial System (NGFS) is less radical in its approach. It embraces climate scenario analysis and macro stress testing as vital tools to help prepare for a range of future pathways, but at the same time cautions against (remaining) significant uncertainties. The NGFS Climate Scenarios are groundbreaking, but should be taken for what they are: a range of hypothetical, yet plausible future outcomes.

3. Including climate risks in the macroprudential toolkit

Most of the instruments macroprudential policymakers in the Union have at hand could be used to (also) counteract the buildup of climate risks and their concentration in the financial system. For the time being, adapting the existing toolkit to the reality and specificities of climate risks seems to be the more promising approach than to implement a specific (new) macroprudential tool to address climate risks. [1] 

Macroprudential policymakers broadly distinguish between two sets of tools. The first set of tools addresses the procyclicality in the financial system, the so-called time dimension of systemic risks. The second set of tools aims to counteract common exposures and interconnectedness of financial institutions, the so-called cross-sectional dimension of systemic risk. Macroprudential policy addresses these sources of risk with different policy strategies. Countercyclical buffers are used to cope with procyclicality: buffers are built up as aggregate risk grows (upswing), so that they can be drawn on as risk materializes (downswing). Common exposures and interlinkages are dealt with by calibrating prudential tools to the (estimated) contribution of each institution to systemic risk.

How do climate risks fit into this analytical framework? Due to the irreversibility of climate change, physical risks are likely – and sadly – of a permanent nature and bound to go in only one direction. Macroprudential policy will thus primarily seek to limit concentration of exposures to firms (and potentially individuals) that are subject to certain physical risk indicators (e.g. geographic location). These indicators will aim to capture widespread climate risk drivers, including wildfires, heat waves or water stress, potentially amplified by chronic stresses, such as rising sea levels, in the second half of this century. As the ECB points out in its latest Financial Stability Review, a systemic amplifier could result from the fact that collateral used to secure banks’ exposures to physical climate hazards may itself be subject to damage or loss of value due to physical risk. Also, the role of insurance in mitigating physical risk is limited and may continue to shrink with more and more risks becoming uninsurable. To address exposure concentrations, macroprudential policymakers may either increase banks’ loss absorption capacity, e.g. by activating or increasing the systemic risk buffer (SyRB) or the own funds conservation buffer, or directly limit concentration risk through large exposures restrictions.

Transition risks, in contrast, exhibit arguably not only a cross-sectional dimension but also a time dimension. Even if technologies for carbon capture and storage were to improve significantly, reaching the climate targets of the Union will require substantial reductions in GHG emissions. Meanwhile, banks continue to lend to and invest in economic activities that directly or indirectly cause such emissions. It is thus not unfair to assume that there will be a correction of the now excessive credit growth in emission-intensive and dependent sectors. The difficulty with the assumed ‘carbon cycle’ is that its time horizon and pattern differs greatly from the financial cycle, which macroprudential policy normally targets. It has not become an actual cycle yet, as carbon emissions at the global level continue to rise. Conceptually, the carbon cycle may best be understood as a single, very long-term cycle. However, it cannot be ruled out that there will be short-term increases in demand for fossil fuels, and therefore ‘dips’ in the carbon cycle, during the transition to net zero, e.g. due to ineffective climate policy or unfulfilled expectations in alternative energy sources.

Classical instruments to address procyclicality in the financial system include the countercyclical capital buffer (CCyB), loan-to-value (LTV) and loan-to-income (LTI) or debt-service-to-income (DSTI) caps and sectoral capital requirements. The CCyB, applied on a sectoral basis, e.g. to banks’ credit exposures to economic activities with high scope 1-3 emissions, would provide an interesting broad-based instrument. It could be drawn on once transition risks materialize – e.g. in case of a sudden unanticipated rise of the carbon price – and would at the same time provide an incentive for banks to limit credit provision to emission-intensive or dependent firms. However, in light of the long horizon of transition risks, a carbon CCyB may stay activated for a long time, rendering its effects similar to those of a permanent brown penalizing factor under Pillar 1. A SyRB for banks overexposed to emission-intensive and dependent firms may offer a more targeted alternative to a carbon CCyB. Primarily aimed at increasing banks’ loss absorption capacity and reducing their exposures, such SyRB may have an indirect impact on the carbon cycle through higher funding costs.

Borrower-based measures, applied according to national law in some Member States, could be adjusted as well to consider climate risks. LTV ratios could require banks to include climate risk drivers, such as the geographical location or the energy efficiency of the underlying real estate, in the calculation of the property value. This may help reallocate credit from high-climate risk to low-climate risk housing markets. Moreover, macroprudential policymakers could include the emission intensity of the source of income as an indicator of creditworthiness under the DSTI/LTI ratios to prevent household overindebtedness due to climate risks. However, this latter option is not only politically sensitive, but also challenging and costly to implement and may bear a high risk of false negative and positive.

4. Conclusions: the role of macroprudential policy

Macroprudential policy is in many ways uniquely placed to tackle climate risks. First, climate risks are bound to affect every financial institution in one way or another. With its system-wide perspective, macroprudential policy can help identify and take precautions against concentrated vulnerabilities in the system. Second, while it is ideally evidence-based, macroprudential policy must naturally cope with significant uncertainties. It does so by striving for the best possible solution, partially by deploying heuristics. This could guide the way to deal with the many and partially deep uncertainties associated with the dynamics of climate risks and their impacts on the economic and financial systems. Third, climate risks fall squarely in the pre-emptive approach of macroprudential policy, which seeks to take precautions also against rare and hard-to-predict shocks. And forth, unlike monetary policy, macroprudential policy is by design not market neutral. While it may not be designed to counteract imbalances directly, it does so at least indirectly by increasing the system’s resilience and capacity to absorb shocks. Macroprudential policy may thus reduce the vulnerability of the financial system to climate shocks, while positively impacting the goal of emission reduction.

Nevertheless, macroprudential measures to address climate risks need careful calibration and strong political backing. Many carbon-intensive or dependent firms will need financing to reduce their carbon footprint and adapt to the net zero target. Disincentivizing or even prohibiting banks from lending to or investing in such firms for fear of transition risks would be counterproductive not only to the Commission’s Green Deal agenda, but also to financial stability. Assessments as to how firms are using the money they borrow will naturally increase the complexity for macroprudential policymakers and require them to more frequently deploy heuristics. Moreover, macroprudential measures to address physical risks will affect the economies of some Member States more than others and likely cause political controversies. Macroprudential policy therefore needs to be embedded in a much broader coordination effort between monetary, [2]  financial, fiscal, and environmental policies, ultimately aimed at limiting the physical risks of climate change altogether.

[1]  On the basis of Article 501c CRR II, the EBA shall submit a report on the need to implement a dedicated prudential treatment of exposures to assets or activities associated substantially with environmental and/or social objectives in the form of a green supporting factor or brown penalizing factor under Pillar 1 until 28 June 2025.

[2]  The ECB recently announced that climate change considerations will be included in its monetary policy framework as an outcome of its strategy review, reflected in particular in adjustments to the collateral framework and the asset purchase programme: https://www.ecb.europa.eu/ecb/climate/html/index.en.html.

2. The Industry's View

Nikos Maragopoulos

Head of Resolution Planning & Banking Regulation at Eurobank

How the application of the O-SII buffer distorts the level playing field in the Banking Union

I. Introduction

In response to the Global Financial Crisis (2007-2009), European policymakers adopted a series of reforms to improve the resilience of banks, particularly of the systemically important ones. Aiming to address the ‘too-big-to-fail’ problem, the Capital Requirements Directive 2013/36/EU (CRD IV) set rules for i) the identification of Global Systemically Important Institutions (G-SIIs) and Other Systemically Important Institutions (O-SIIs) and ii) the determination of additional capital buffers (G-SII and/or O-SII buffer) that these banks would have to meet to compensate for the higher risk posed to the financial system. If a bank is subject both to a G-SII and O-SII buffer at consolidated level the higher of the two applies.

The G-SII buffer applies to banks determined as systemically important at global level. National authorities determine G-SIIs and set the relevant buffer rate following strictly the relevant annual assessment carried out by the Financial Stability Board (FSB) for the G-SIIs across the world. The G-SII buffer is determined based on a methodology that considers specific criteria demonstrating the significance of a bank, namely: i) size, ii) interconnectedness with the financial system, iii) substitutability of the services or of the financial infrastructure provided by the bank, iv) complexity, and v) cross-border activities in non-participating Banking Union Member States and third countries. Each criterion consists of twelve quantifiable indicators that produce a score assigned to each bank. Based on this score, G-SIIs are allocated to at least four categories with different buffer rates ranging from 1% to 2.5% of Risk Weighted Assets (RWAs).

The O-SII buffer applies to banks of systemic importance for the economy of a Member State or the Union as a whole. National authorities identify the O-SIIs based on a methodology that considers the following criteria: i) size, ii) importance for the economy of the Union or relevant Member State, iii) cross-border activities, and iv) interconnectedness with the financial system. In order to achieve a partial harmonization of the national approaches for the identification of O-SIIs, the European Banking Authority (EBA) has issued Guidelines “on the criteria for the assessment of O-SIIs”. These Guidelines introduced a scoring methodology to specify the aforementioned dimensions of systemic relevance but did not establish a uniform approach for the calibration of the O-SII buffer. In accordance with Directive 2019/878 (CRD V), national authorities may set the upper bound of the O‐SII buffer up to 3% of RWAs.

II. The inconsistent application of the O-SII buffer in the Banking Union

If the Banking Union were treated as a single jurisdiction, banks would be subject to a consistent and totally harmonized regulatory framework, including macroprudential policies. Therefore, as a rule, two banks of similar systemic importance would be subject to the same O-SII buffer. However, the current regime relating to the application of the O-SII buffer is far from this point. In the Banking Union, the competence for setting macroprudential policies still lies primarily with national authorities. Where a national authority deems appropriate the introduction of a macroprudential tool, including capital buffers, it communicates its proposed decision to the ECB, which may object to that (as per Article 5(1) of the Regulation 1024/2013 (SSMR)) or apply higher requirements than those proposed by the national authority in accordance with Article 5(2) SSMR. Thus, the ECB may set higher capital buffers (“top-up”), where it considers it necessary for the purposes of financial stability. Nonetheless, the ECB can neither object to the set of banks identified by national authorities as O-SIIs nor scale down the proposed O-SII buffer rates.

Against this backdrop, the European rules for the O-SII buffer have been applied in an inconsistent way across the Banking Union contributing to the creation of an unlevel playing field. National authorities retain wide discretion as regards the range of the O-SII buffer, though the ECB has introduced a floor methodology to reduce heterogeneity of the O‐SII buffers applied across the Banking Union. In particular, the ECB has set a floor (1%) for the O-SII buffer that can be assigned to the O-SII with the highest score in each participating Member State. However, this minimum harmonization approach does not address the problem relating to the determination of the upper bound of the O-SII rate set in each Member State. National authorities make the relevant assessments for the identification of O-SIIs and the determination of O-SII buffer rates from a domestic -rather than a Banking Union- perspective. As shown in Figure 1, significant divergences are observed in the upper bound of the (fully-loaded) O-SII buffer. Some national authorities (France, Italy, Spain) have capped the O-SII buffer at the level of the G-SII buffer set for the (most systemically relevant) G-SII located in their jurisdiction. Other national authorities (Germany, Netherlands) have set the upper bound of the O-SII buffer at a level higher than the G-SII buffer applied to the G-SIIs headquartered in these countries. The remaining countries in which no G-SII is located are split into two (2) different groups. The majority of national authorities have set the upper bound of the O-SII buffer at 2%, which was the maximum threshold allowed under the former framework (CRD IV), while some other national authorities have capped the O-SII buffer at the lowest possible level (1%) in line with the aforementioned ECB’s floor methodology.

Figure 1: O-SII buffer range and upper G-SII buffer rate by country in the Banking Union

Sources: Data published by the EBA for the fully-loaded O-SIIs (list of O-SIIs notified to the EBA (2020) and the FSB for the G-SII rates (2020 list of global systemically important banks (G-SIBs))

Τhe rationale behind the decision of national authorities to cap the O-SII buffer at the level of the G-SII buffer should be attributed to their pursuit to not place the G-SIIs located in their jurisdiction on a disadvantageous position compared to the G-SIIs located in third countries. The preferential treatment of the aforementioned G-SIIs is extended also to other O-SIIs located in these countries, which are assigned with lower O-SII rates compared to the rates they would have received if a higher O-SII upper bound applied. On the other side, other national authorities have opted for a more conservative approach, mainly driven by their concerns for the risks that an O-SII failure could pose to domestic financial stability. This applies particularly to some small Member States, in which the relevant O-SIIs are mostly subsidiaries of banking groups headquartered in other EU Member States.

The inconsistent approaches applied by national authorities have resulted in an excessive heterogeneity as regards O-SII calibration. Banks with similar asset size and systemic relevance are treated in a different manner because they are located in different participating Member States. As shown in Figure 2, for some G-SIIs and other large banks with assets exceeding €200bn the O-SII buffer is capped at a lower level than deemed necessary, providing them with a competitive advantage over both their peers (i.e. other banks within the same asset cluster) and other smaller banks, which are penalized disproportionately to their size.

Figure 2: O-SII buffer rate (right axis) applied to G-SIIs and other ECB-supervised banks (per asset cluster) compared to their assets (in €m, left axis)

Sources: Own calculations based on data published by the EBA for the fully-loaded O-SIIs (list of O-SIIs notified to the EBA (2020)) and the assets (EBA Transparency Exercise, Autumn 2020 exercise (data as of 30 June 2020)).

As a result of the aforementioned discrepancies in the O-SII calibration, G-SIIs are subject to an average O-SII buffer of 1.4%, which is slightly higher than the respective rate for banks belonging to other asset clusters, including banks with assets less than €30bn (O-SII buffer of 1.1%). In addition, the inconsistent application of the O-SII buffer has led to the uneven distribution of banks into buffer rate buckets, as demonstrated by the fact that mainly small banks are assigned with an O-SII buffer above 1.5% (Figure 3). Based on this data, it can be assumed that the O-SII is not proportionate to the systemic relevance of each bank and the systemic risk posed to the financial stability of the Banking Union.

Figure 3: Allocation of ECB-supervised banks (per asset cluster) into O-SII buffer rate buckets

Sources: Based on data published by the EBA for the fully-loaded O-SIIs (List of O-SIIs notified to the EBA (2020))

III. The need for enhancing the ECB’s macroprudential powers

The Banking Union aims to foster financial stability and address the financial fragmentation observed in the euro area. This presupposes a uniform application of the regulatory framework, including a common approach for the determination of capital requirements. However, this is not the case under the existing regime. The discrepancies in the determination of the O-SII buffer, which is still determined at national level, contribute to the creation of an unlevel playing field. This inconsistency is a significant source of preferential treatment resulting in disproportionate capital requirements for O-SIIs.

For the purposes of ensuring a level playing field, the O-SII buffer should be proportionate to the systemic risks posed by banks to the financial stability of the Banking Union. This objective cannot be achieved as long as the responsibility for macroprudential policies, including capital buffers, lies with national authorities. Under the existing regulatory regime, the ECB may only apply higher requirements for capital buffers, which seems inadequate to fix the problem. The increase of the O-SII buffer for some banks, for which it is capped at lower levels than considered necessary, should be accompanied by the reduction of the buffer for less systemically important banks located in countries in which a more conservative approach as regards the upper bound of the O-SII has been adopted. Therefore, the SSMR should be amended to allow the ECB to scale down the proposed O-SII buffer rates and/or amend the list of O-SIIs identified by national authorities, where necessary. The proposed legislative amendment will address the existing regulatory loopholes and ensure that the Banking Union is treated as a single jurisdiction, where uniform conditions apply as regards the identification of O-SIIs and the determination of O-SII rates.

3. Young Researchers’ View

Panagiotis N. Politsidis[1] 

Research Associate at EBI & Assistant Professor of Finance at Audencia Business School

Regulatory vs. market perceptions about bank portfolio risk and implications for bank lending

Under Basel III, the risk-weighted framework has been overhauled to enhance risk capture and improve comparability in banks’ reported capital ratios (Basel Committee on Banking Supervision, 2021). However, notwithstanding these increased regulatory efforts on bank risk reporting, little attention is directed to what exactly constitutes a generally accepted measure of bank risk. In fact, regulators and market participants may often use different measures for assessing a bank’s portfolio risk.

1. Regulators' approach to bank portfolio risk vs. markets' perception

Regulators mainly focus on accounting-based measures and other operational reports obtained directly from the banks under their supervision to establish bank supervisory ratings. One of the principal measures is the risk-based capital ratio; bank regulators most often examine this measure since it reflects a bank’s portfolio risk vis-à-vis the capital available to support the bank’s risk-related choices. The ratio is jointly determined by the bank and its supervisors and is subject to supervisory approval even in cases where the bank’s economic capital exceeds regulatory capital requirements (Basel Committee on Banking Supervision, 2017).[2]  However, a loss of equity market value is not necessarily reflected in book equity measures, which impedes the supervisors’ ability to require a bank to augment its capital due to a significant loss. Although they frequently complement this with auditing and market-based measures, they mostly rely on the output of their supervisory capacities.

Markets on the other hand, use all available information (including that disclosed by bank regulators) to form perceptions of overall bank risk; the outcome of this information yields bank asset volatility as the key market-based measure of risk.[3]

2. Differences between the two approaches

Hence, any differences between the two measures captures a general form of information asymmetry. Specifically, if bank portfolio risk is harder to observe and measure, markets and regulators (supervising the accounting-based measure) should disagree more often about the true level of bank portfolio risk. Such disagreement can ultimately affect the way a bank organizes its lending arrangements (i.e., the supply-side lending decisions of banks). An increase in asymmetric information regarding the true level of banks’ portfolio risk creates a reputational disadvantage, thereby increasing pressure on the banks to make sound lending choices.

In the presence of low information asymmetry, both players should, ceteris paribus, agree in their evaluations of bank portfolio risk, especially if these refer to solvent and transparent banks. Nevertheless, if high information asymmetry prevails (for reasons either endogenous or exogenous to bank operations), this may give rise to strong disagreement between the two players. This disagreement in turn implies a higher degree of uncertainty with regard to bank financial health and prospects.

In fact, perceptions about bank portfolio risk often differ between markets and regulators. These differences in turn, constitute a significant source of asymmetric information that carry implications for bank lending policies and ultimately bank profitability (see Vallascas and Hagendorff, 2013; Delis, Kim, Politsidis and Wu, 2021). These differences partly emerge due to the fact that risk-weighted assets (the regulatory measure of portfolio risk, which determines minimum capital requirements) are ill-calibrated to bank asset market measure of bank portfolio risk, namely bank asset volatility (see Vallascas and Hagendorff, 2013).

3. Practical consequences and effects arising from differences in regulatory and market risk assessment

Evidence from large corporate loan deals in the global syndicated loan market suggests that an increase in the market-regulatory difference regarding a bank’s portfolio risk lowers the price (measured as a spread over LIBOR) of the syndicated loan facilities granted from the given bank (see Delis, Kim, Politsidis and Wu, 2021). In specific, loan spreads decrease by an economically significant 4.3%, or 11.6 basis points, in response to a one standard deviation increase in the employed market-regulatory difference measure.[4] This in turn represents a real cost for banks, as it amounts to approximately USD 0.41 million less in annual interest income for a loan of average size; it further increases to USD 2.03 million over the loan’s duration for a loan of average size and maturity. Importantly, the effect of these risk differences is mainly concentrated in banks perceived by the markets to be riskier (i.e., market risk is above regulatory risk), while banks perceived to be riskier by the regulators do not experience a significant effect on their loan prices.

European banks (including their UK counterparts) pose no exception, as market-based measures of their bank portfolio risk are generally lower than regulatory-based measures. As a result, once markets start perceiving these banks as relatively riskier, the latter respond by granting discounted loans in an attempt to convince about their solvency and entice prospective borrowers. The implications extend beyond loan pricing, as they further affect the sustainability of bank-firm relationships. In this regard, higher relevant informational asymmetries increase the probability of ending a lending relationship. This infers a real cost not only to the banks but also to borrowing firms, who must then initiate a new lending relationship with another bank.

Furthermore, these effects are susceptible to supply-side rather than demand-side considerations. Along these lines, they are mainly attributed to the sharper increases in market assessment (compared to regulatory assessment), the inattention of lending participants to regulatory risk assessment when bad news hits the markets and the unenforceability of market risk assessment (as opposed to the enforceability of regulatory assessment that must yield a decrease in risk-weighted assets/increase in capital). The negative effect of these regulatory-market differences is more potent for less profitable banks, with worse credit ratings and with higher levels of non-performing loans. They are further magnified in the absence of established bank-firm relationships, as the latter theoretically reduce information asymmetry between the loan counterparties.

4. Systemic/macroeconomic consequences: some considerations and further recommendations

It is therefore clear that the existence of this asymmetric information – and the resulting differences in risk perceptions – cause uncertainty for market participants that engage in bank lending. If we consider that the global syndicated loan market is dominated by large systemic banks (where the size of loans may be substantial), any disagreement about those banks’ true level of portfolio risk can have destabilizing effects on the financial market framework. The importance lies in acknowledging that although, these differences operate as a correcting mechanism that deters banks from assuming more risk (at least as perceived by the markets), they also operate as a penalizing mechanism that ultimately affects bank profitability.

As a general recommendation, regulatory and relevant policy-making authorities should pay attention to these regulatory-market differences and incorporate them into their overall assessment of a bank’s portfolio risk. This is even more relevant, considering their supply-side effects on loan pricing and the real implications for loan contracting. Given these implications, the regulatory framework should be adjusted toward providing a definition of bank portfolio risk, particularly in the presence of contrasting views, and how this risk can be accustomed to better reflect market assessments.

Among the solutions considered, more resources should be diverted to address the delay in regulatory supervision and assessment. These should further target the related difficulty in onsite supervision of banks, as well as the lengthy supervision process when excessive risks are identified.

Further, regulators should reconsider their tendency to be conservative in their risk assessment (asking banks to hold an increasing volume of lower risk-weighted assets in the balance sheets). Due to this tendency, a negative value on the difference between market and regulatory risk might be the norm, making the lending participants (borrowers and banks) inattentive. Although, conservatism appears to be efficient in the global banking system (due to its ability to ameliorate the negative effects of financial crises), this should be on ad hoc basis, after incorporating all relevant information from market participants and analyzing the prevailing credit conditions.

Finally, regulators should monitor more closely institutions with levels of market-based risk relatively higher than the equivalent regulatory-based. This entails regulators processing the timely bank accounting information to which they have access (along with relevant financial data) in order to calculate dynamic bank-specific market-based measures. That way, they can determine the extent of deviation – if any – between their assessments and those of the market. Despite highlighting potentially notable regulatory-market differences, this is further necessitated by the fact that markets exert only a disciplining effect on riskier banks, without (as opposed to regulators) enforcing this effect. Given that banks are not obliged to lower asset risk in order to ease market concerns, they can further increase the true risk evidenced in their portfolios and can be more severely affected during unexpected shocks (see Vallascas and Hagendorff, 2013; Acharya, Engle, and Pierret, 2014).

5. Conclusions

Overall, regulators should acknowledge the operative and disciplinary role of market forces in banking supervision, which materialize when there are conflicting bank risk estimates between investors and supervisors. What appears to be important for bank lending behavior is not necessarily the risk perceptions of different players, but potential differences between these risk perceptions.

[1] Panagiotis N. Politsidis is an Associate Researcher at the European Banking Institute e.V., Tech Quartier (POLLUX), Platz der Einheit, 260327 Frankfurt am Main, Germany, and an Assistant Professor of Finance at Audencia Business School, 8 Route de la Jonelière, 44312 Nantes, Pays de la Loire, France. Email: panagiotis.politsidis@ebi-europa.eu.

[2] Regulators supervise banks concerning this risk and ultimately adopt the book values or ask for revisions via informal and formal enforcement actions; they nevertheless remain bound to these measures (see, e.g., Acharya, Engle and Pierret, 2014; Flannery, 2014).

[3] The volatility of bank asset returns is derived from option pricing theory (see, e.g., Ronn and Verma, 1986; Flannery and Rangan, 2008; Vallascas and Hagendorff, 2013).

[4] The measure is calculated as the residuals of the bivariate regression of the bank’s asset volatility on the bank’s risk-based capital ratio (for a detailed description of this methodology see Delis, Kim, Politsidis and Wu, 2021).