The Impact of Basel III and the Predictive Power of the Leverage Ratio on the Amount of Risk Banks Take

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The Impact of Basel III and the Predictive Power of the Leverage

Ratio on the Amount of Risk Banks Take

An Empirical Investigation on European Banks

22 September 2013 Michiel Nab

Abstract

Legislators responded to the recent financial crisis by enforcing higher capital requirements on banks. Not only will banks be required to hold more risk-based capital, a non risk-based leverage ratio will be also part of the new requirements. This thesis studies both the impact of Basel III, the new capital requirements for banks, on the amount of risk banks take as well as the

relationship between the leverage ratio and the amount of risk banks take. Data is gathered from the annual reports and pillar 3 disclosures of 59 large European banks. The results show that banks are actively decreasing the amount of risk they take and that banks with a higher leverage ratio take on more risk. This has implications for the banking industry as the safest banks will be hit hardest by the leverage ratio requirement.

Keywords: Basel II, Basel III, risk-weighted assets, leverage ratio, banks, capital requirements

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Master Thesis Accountancy

University of Groningen, Faculty of Economics and Business 30 August 2013 Michiel Nab S1789449 Ooievaarhof 24 3582 DC Utrecht Tel: 0654985394 E-mail: m.nab@student.rug.nl Supervisor University: K. L. Leijendekker Second Supervisor University:

-TBA- Supervisor KPMG: J.G. Huttenhuis

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Introduction

The financial crisis of 2007-2008, also referred to as the global financial crisis, is considered by many economists (for e.g. Nouriel Roubini; Kenneth Rogoff; Nariman Behravesh) to be the worst financial crisis since the Great Depression of the 1930s. The global financial crisis brought the world’s financial system to the brink of collapse. Its continuing operation became possible only after the extensive and costly public rescues of some very big financial institutions (e.g. ING; BNP Paribas) (Avgouleas 2009). These costly public rescues were necessary because without a viable financial system, lending to businesses and consumers would have frozen. Given the massive losses suffered by banks, and the extraordinary governmental assistance they have received, banks were clearly the epicenter of the global financial crisis (Wilmarth 2009). Banks are also considered to be the primary cause for the credit boom that precipitated the global financial crisis (Wilmarth 2009).

Unfortunately these public rescues were still not enough to contain the global financial crisis: it still triggered the Great Recession and contributed to the European sovereign-debt crisis. This led to declines in consumer wealth, the failure of key businesses, an increase in unemployment and a downturn in economic activity. Although there are many different reasons given for the cause of the global financial crisis, a recurring theme is excessive risk-taking (Dowd 2009). Two

important incentives for banks to take on excessive risk are limited liability and deposit

insurance (Stolz 2002). Capital requirements can alleviate this problem as banks are obliged to hold more capital which forces them to have more of their own funds at risk (Stolz 2002). The downside of higher capital requirements is that it negatively influences bank profits and

economic growth (Angelini et al. 2011; Santos and Elliot 2012). Although by how much remains unclear. If holding more capital successfully reduces the likelihood of bank failures, the higher requirements could overall still have a positive effect on output (Jackson et al. 1999). The capital requirement framework in effect in Europe in 2007, the year the global financial crisis

commenced, was Basel II. Basel II is based on the concept of risk weighting, the idea that some assets are riskier than others, and that banks should hold more capital against riskier assets than they do against safer assets. Evidently these risk-based capital requirements were not sufficient to curb excessive risk-taking and cope with the encountered financial distress caused by it

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(Larson 2011). It showed that after the first two Basel Accords, there is still room for

improvement in the regulation of bank capital (Larson 2011). The Basel Committee on Banking Supervision (BCBS), the standard setting body for capital requirements, responded by: (i) increasing the level of capital banks are required to hold, (ii) raising the quality, consistency and transparency of this capital, and (iii) strengthening the risk coverage of the capital framework (Ojo 2011; Miu et al. 2010).

Figure 1. Graphical depiction of the impact of Basel III on the capital ratio and its components.

A new accord on capital regulation for banks, Basel III, was reached on 12 September 2010 but was planned to be phased in gradually between the 1st of January 2013 and the 1st of January 2019. Banks have begun monitoring capital ratios well before the mandatory date of compliance though. Also, more than a few banks have indicated a desire to meet the requirements even sooner as a way to reassure markets and rating agencies and give themselves business flexibility (Härle et al. 2010). Banks can increase the level of their capital ratio(s) in two ways: (i) by increasing the amount of eligible regulatory capital held, which boosts the numerator of the ratio, or (ii) by decreasing risk-weighted assets, which is the denominator of the regulatory ratio. This raises the question how banks are increasing their capital ratio. In this thesis I will focus solely on the denominator of the capital ratio, risk-weighted assets, which when divided by total assets is a measure of risk (Shrieves and Dahl 1992). Taking this into account I will try to answer the following question:

“What has the impact of the Basel III accord been on the amount of risk banks take?”

There has been previous research done on the effect of risk-based capital requirements on the risks that banks take. Examples include, but are not limited to, Blum (1999), who finds that risk-based capital requirements may increase a bank’s riskiness. His reasoning is that when raising equity is excessively costly, the only possibility to increase equity tomorrow is to increase risk today. And VanHoose (2007), who did a literature review on theories of bank behavior under

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capital regulation, came to the conclusion that the literature produces highly mixed predictions regarding the effects of capital regulation on asset risk. In conclusion, previous research done on the effect of risk-based capital on the risks that banks take is far from univocal. The impact of Basel III has also been the subject of research. Examples include, but are not limited to, Cosimano and Hakura (2011) who did a cross-country analysis on the impact of the new capital requirements in Basel III on bank lending rates and loan growth and found that lending rates will increase and loan growth will decline. They also found that the impact of Basel III will vary from one country to another. And Angelini et al. (2011) who investigated the long term-impact of Basel III on economic performance and found that every percentage point of increase in the capital ratio causes an average of 0.09 percent decline in steady state output. To the best of my knowledge no research has been conducted on the impact of the Basel III accord on the amount of risks that banks take. This research contributes to the existing research on both risk-based capital requirements and the impact of Basel III. It is important to conduct this research, because as Arroya et al. (2012) state, crises almost always start on the side of the capital ratio denominator (RWA). Furthermore Larson (2011) argues that due to higher capital requirements banks will have a reduced lending ability which will in turn make the banks lose out on income. To compensate for this loss in income banks will take on assets with a higher return, assets that often carry more risk. Therefore, with the higher capital requirements, not only will there be less lending, but the lending that does take place will be more expensive and riskier. When banks do not decrease the amount of risk-weighted assets they hold to fulfill the capital requirements of Basel III, but instead only hold more capital, Basel III might not have the desired effect of stabilizing the financial system. After all higher capital requirements do not eliminate externalities such as financial crises, taking less risk on the other hand will to an extent (Kashyap et al. 2008). Moreover at the end of 2012 the European Union has delayed the introduction of the new capital requirements for banks by a year to the 1st of January 2014 (Reuters 2012). The original deadline for the gradual implementation of the global Basel III accords, as mentioned before, was set to begin at the 1st of January 2013. This message came shortly after the U.S. had delayed the introduction of the new capital requirements for banks by up to a year (Bloomberg 2013a). And even more recently news came out that some states in the European Union were looking to delay the implementation of Basel III even beyond the 1st of January 2014 (Bloomberg 2013b). These delays makes one wonder if the regulatory authorities have forgotten

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about the severity of the global financial crisis already or that banks simply couldn’t comply with the new standards in time. They also point out the actuality of this research.

In this thesis I will also, in addition to the above, add to the discussion surrounding the leverage ratio that resurfaced after Commissie Wijffels issued their report “Naar een Dienstbaar en Sociaal Bankwezen” (2013). Basel II required that capital requirements should be maintained solely on the basis of RWAs. Basel III rejects this notion. Prior to the crisis, a number of banks and other financial institutions built up leverage that was seen as excessive, while still showing strong capital ratios as measured against RWAs (King and Tarbert 2010). That’s why Basel III is introducing a minimum required leverage ratio. The leverage ratio acts as a non risk sensitive backstop measure to reduce the risk of a build-up of excessive leverage in the institution and in the financial system as a whole (KPMG 2011). There are both proponents and opponents of this rather crude measure of determining capital requirements. Proponents state that the leverage would be a good reinforcement to the existing risk-based capital measure (e.g. BCBS 2009; Hildebrand 2008), while opponents state that the leverage ratio requirement would make the effective capital requirement on low-risk assets too high and will therefore lead to risk-shifting

from low-risk to higher-risk assets (e.g. Kiema and Jokivuolle 2011).I will add to this discussion by trying to answer the following question:

“Is there a relationship between a bank’s leverage ratio and the amount of risk the bank is taking?”

The research is conducted on 59 of the largest Europeans banks ranked by assets in the Global Top 2000 list from Forbes. The required data is gathered from the annual reports and pillar 3 disclosures of these banks. The results show that banks have significantly reduced the amount of risk they take and that banks with a higher leverage ratio take on more risk.

The remaining of this research is organized as follows. First I will develop a theoretical

framework with consistent hypotheses. Second I will discuss the research method and research sample with the different variables. Third I will present and discuss the results of my research. And last I will end this research with a brief conclusion.

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Theoretical Framework

Financial Stability

Financial stability is of central importance to the effective functioning of market economies such as those in Europe. The absence of financial stability creates damaging uncertainties that can lead to resource misallocation and reduces the willingness to enter into intertemporal contracts. In extreme cases, disruptions in the financial sector can have severe adverse effects on economic activity (Crockett 1996). As the IMF states: “financial stability is paramount for economic growth, as most transactions in the real economy are made through the financial system”. Therefore, the health of a nation’s economy is closely related to the soundness of its banking system. Financial crises have relevant costs in terms of output reduction and, once they occur, the period to recover from them is quite long (Quagliariello 2008). Crockett (1996) states that financial stability is “the stable functioning of the intermediaries and markets that make up the financial system”. A bank is an intermediary, a third party that offers intermediation services between two trading parties. In the case of banks it connects suppliers of funds and users of funds. Banks do not create new wealth but, when they successfully connect suppliers and users of funds, they lower the cost of capital to firms, boost capital formation and stimulate

productivity growth (Levine 2004). In a world with complete markets and in the absence of any frictions there would not be a need for banks. Information theories suggest that a primary rationale for the existence of banks is that they have an information advantage in monitoring firms (Stolz 2002). Depositors do not have this information and therefore cannot fully assess the riskiness of bank portfolios. They cannot efficiently monitor or sanction banks either. This information advantage of banks gives rise to moral hazard (Stolz 2002). Jensen and Meckling (1976) show that, if information is not equally distributed, shareholders have an incentive to pretend to invest in a low-risk asset, but after having sold bonds at a high price, to increase the portfolio risk or to issue additional debt. In a banking context, this means that if depositors cannot interfere into the bank’s activity and/or cannot observe the bank’s actions, interest rates fail to fully reflect the risk of bankruptcy. Moral hazard arises, i.e., banks will have an incentive to increase leverage and risk. Because of the dispersion of small investors (i.e. depositors) their ability to monitor the activities of the bank is also limited (Matutes and Vives 2000). Limited

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liability and deposit insurance further reinforce incentives for excessive risk-taking in banks. Shareholders in a limited liability company, like a bank, are not personally liable for any of the debts of the company, other than for the value of their own investment. This makes them have a limited downside risk while they have an unbounded upside potential. Thus shareholders have an incentive to encourage management to take a lot of risk. The situation is similar for under deposit insurance where a government provides protection to depositors against risk of loss arising from bank failure so that depositors do not incur any risk by depositing their funds with a bank. Jensen and Meckling (1976) state that this makes their pay-off deterministic and independent of the riskiness of the banks’ assets and makes them lose any incentive to monitor banks’ behavior. Furthermore the great depression of the 1930s proved that in banking excessive competition can lead to bank failures, runs, and panics. In order to preserve the stability of the banking and financial industry, competition had to be restrained (Boyd and De Nicolo 2005). Lastly, in the recent global financial crisis a major reason for the excessive risk-taking of banks was played by the pressure to attain high returns (Arroyo et al. 2012). All these factors lead banks to take on more risk than is socially desirable (Berger et al. 1995). Excess risk-taking at financial

institutions affects more than just creditors; it affects depositors, taxpayers, and potentially the financial system as a whole (Bolton, Mehran and Shapiro 2010). There is a wide body of

evidence that the most severe economic crises are associated with banking sector distress (Walter 2011). The social cost of bank failures are high, the fact that governments are prepared to pay large amounts to bail out banks as opposed to simply liquidating them may be interpreted as evidence (Matutes and Vives 2000). Governments respond to crises with bailouts that allow new expansions to begin. As a result, financial markets have become ever larger and financial crises have become more threatening to society, which forces governments to enact ever larger bailouts (Crotty 2009). In summary, in banking there is an important probability of failure, with a

potentially severe moral hazard problem, and failure is associated with a large social cost, typically of a systemic nature (Matutes and Vives 2000). Authorities try to lower the probability of bank failure and maintain stability through regulation of the financial markets.

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Financial Regulation

The global financial crisis did bring into sharp focus the inadequacies of financial regulation, both at the national and the global level, in maintaining financial stability (Avgouleas 2009). Regulation finds its origin in Pigou (1924)’s public interest theory. According to this theory markets are very fragile and have a tendency to operate inefficiently and in favor of individuals while ignoring the importance of society as a whole. Therefore government intervention in markets is required. The government makes the banks work in the interest of society through financial regulation. Society’s reaction to the global financial crisis made stricter financial regulation for banks necessary. Capital requirements for banks seem to be today’s most accepted financial regulatory instrument (Jackson et al. 1999). Capital requirements play three separate roles in promoting financial stability: It is a buffer against losses (for taxpayers, among others); it promotes proper incentives, reducing management’s incentive to take excessive risk; and it serves as a basis for supervisory intervention (Haubrich and Thomson 2012). Berger and Bouwman (2013) did research on bank capital during the global financial crisis for different sized banks. Their findings are as follows. First, capital helps banks of all sizes during banking crises. Higher capital helps these banks increase their probability of survival, market share, and profitability during such crises. Second, higher capital improves the performance of small banks in all three dimensions during market crises and normal times as well, but the effect on medium and large banks during these periods is less pronounced. Overall their results suggest that capital is important for small banks at all times and is important for medium and large banks primarily during banking crises. Bankers, however, have typically argued that being forced to hold more capital would jeopardize their performance, especially profitability (Berger and Bouwman 2013). The argument that higher capital need not be beneficial has found some support in the academic literature as well (e.g., Calomiris and Kahn 1991).

Capital requirements are issued by the Basel Committee on Banking Supervision (BCBS). The BCBS consists of representatives from central banks and regulatory authorities from all the G-20 major economies as well as some other major banking hubs such as Hong Kong and Singapore. The BCBS is the only organization in the world that provides prudential standards for banking. The BCBS does not possess any formal supranational authority. Its decisions do not have legal

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force, that’s why the BCBC relies on its members’ to implement and apply standards in their domestic jurisdictions. In Europe Basel standards are implemented and enforced using the Capital Requirements Directive (CRD) issued by the European Commission. This obliges banks in different European countries to comply with the standards set by the BCBS. Banks can’t opt out of it so they will have to comply with the new capital requirements by 2019.

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The Basel Accords

The standards on capital requirements issued by the BCBS are called the Basel Accords. The accords are called the Basel Accords because the BCBS maintains its secretariat at the Bank for International Settlements (BIS) in Basel, Switzerland. The first Basel Accord was issued in 1988, now better known as Basel I. It primarily focused on credit risk, which is defined by the BCBS as “the risk of counterparty failure”. Assets were classified into five categories with risk weights from zero up to one hundred percent. Banks with international presence were required to hold capital equal to 8% of risk weighted assets.

Basel I served the banking industry well since its introduction in 1988 but it lagged behind the financial market developments and innovation. It increasingly became outdated and flawed as it relies on a relatively crude method of assigning risk weights to assets, emphasizing mostly balance sheet risks relative to multiple risks facing financial firms today. Furthermore, it offered a regulatory approach to capital determination and standard setting which did not capture fully the range of large and complex banking operations and the accompanying range of diverse set of economic risks (Akhtar 2006). That’s why in 1999 the BCBS published the first round of

proposals for revising the capital requirement framework. This set an extensive consultative process into motion in all member countries. The proposals were also circulated to supervisory authorities worldwide. Ultimately this lead to the issuance of Basel II in 2004, a framework with a more risk-sensitive approach. The framework is applied to internationally active banks on a consolidated basis. Applying capital standards on a consolidated basis as opposed to on an entity-level basis addresses the problems of excessive holding company leverage, unregulated affiliates and double gearing (Jackson 2005). The Basel II framework is based on three pillars.

Pillar 1, minimum capital requirements, specifies the minimum amount of capital required to cover credit, market and operational risk. This has to be at least 8% of risk weighted assets. Risk-weighted assets (RWA) are used to classify the risk associated with an asset. The BCBS allows banks to choose between a standardized approach to measure credit risks and an internal rating based (IRB) approach allowing banks to use their own internal models for risk assessment. Under the standardized approach external ratings from recognized credit rating agencies serve to

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measure the risk sensitivity of sovereign, interbank and corporate exposures. The IRB approach has to be approved by the banks’ supervisor.

In both methods RWA is calculated as follows:

Total RWA = sum (Asset total per category * Risk Weight)

Pillar 2, supervisory review, requires an assessment to be made of whether additional capital is required over and above that required in Pillar 1, and is specific to each firm. To comply with Pillar 2, banks are required to undertake an Internal Capital Adequacy Assessment Process (ICAAP). The ICAAP consists of designing and implementing a risk-adjusted management framework. This framework must ensure the bank constantly meets its regulatory capital

requirements and manages risks beyond those captured in Pillar 1 (e.g. concentration risk, fraud or rogue trading, liquidity risk). This process is documented into the ICAAP report which needs to be approved by the board before being submitted to the regulator for review. Outcomes of supervisory reviews can include, for instance, a requirement to hold capital above regulatory capital levels calculated by the bank or to enhance risk management systems and controls. The supervisory review is an ongoing process as is the case for the ICAAP. The review needs to evolve constantly according to the bank’s evolving risk profile, enhancements to regulations (i.e. stress testing), product innovation and changing market conditions (Moody’s 2011).

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Pillar 3, market discipline, introduces public disclosure designed to promote market discipline by providing market participants with key information on a firm's capital, risk exposures and risk assessment process. Nier (2005) concluded that the regulator can improve the safety of the banking system by tightening the disclosure requirements. The stricter the disclosure

requirements are the bigger is a positive impact of an increase in capital requirements on bank safety. Regarding capital requirements the capital section of pillar 3 is especially relevant. This section consists of requirements for capital structure and capital adequacy. Capital structure deals with the composition of capital and the terms and conditions related to the instruments included. Capital adequacy includes the banks’ assessment of capital adequacy to support current and future activities. This is subdivided into requirements for credit, market and operational risk, requirements on equity exposures, total- and Tier 1 capital adequacy.

In comparison the Basel I framework only dealt with parts of each of these pillars. In this thesis I will solely focus on Pillar 1, although I will be using banks’ pillar 3 disclosures to gather my data.

The goal of Basel II was to draw regulatory capital closer to economic capital.Economic capital is the amount of risk-based capital a bank requires, based on its own analysis, in order to remain solvent at a given confidence level and time horizon. Regulatory capital on the other hand reflects the amount of capital that a bank needs given regulatory and guidance rules. Basel II tried to accomplish the goal of drawing these amounts of capital closer together by allowing banks to use more risk-sensitive capital requirements calculation systems, including the use of internal models (Arroyo et al. 2012). Evidently these risk-based capital requirements were not sufficient to curb excessive risk-taking and cope with the encountered financial distress caused by it (Larson 2011). The global financial crisis and society’s reaction to it made stricter

regulation for banks necessary. That’s why the BCBS issued an enhanced framework under the name Basel III. This framework is built on the risk-based capital approach of Basel II, but has more stringent requirements and also includes a non risk-based leverage ratio. The BIS states that the objective of the reforms is “to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy”.

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The implementation of the higher capital requirements was planned to start on 1 January 2013. From 1 January 2013 onwards, banks will have to meet the following minimum capital

requirements expressed in risk-weighted assets: 3.5% share capital, 4.5% Tier-1 capital and 8% total capital. During the transitional period from 1 January 2013 up to and including 2019, these ratios will gradually be stepped up to 4.5% share capital, 6% Tier-1 capital and 8% total capital. The conservation buffer will be build up along gradual lines to a percentage of 2.5% from 1 January 2016 through 1 January 2019. Thus, banks will ultimately have to hold 10.5% of their total capital expressed in risk-weighted assets. National supervisors will gradually introduce additional allowable deductions from bank capital such as deferred tax assets and investments in financial institutions from 1 January 2014 through 1 January 2018.

Basel III also introduces a leverage ratio which is currently proposed to be set at 3 percent. Critics argue that this ratio has been set too low. The leverage ratio is calculated as follows: Leverage Ratio = Tier 1 Capital / Exposure Measure

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The Exposure Measure includes both on-balance sheet and off-balance sheet exposures (BCBS 2013a). The exposure measure does not take risk-weighting of assets into account.

Furthermore the BCBS has implemented an extra capital requirement for the so called global systemically important banks (SIBs). The rationale for adopting additional standards for G-SIBs is based on the cross-border negative externalities created by systemically important banks which current regulation does not take into account (BIS 2012). These are the negative

externalities associated with institutions that are perceived as not being allowed to fail due to their size, interconnectedness, complexity, lack of substitutability or global scope.

Total risk-weighted assets have also been increased in Basel III. This increase is driven largely by extra charges against credit valuation adjustment risk, trading book exposures, and

securitization exposures. Banks that have significant exposures in these areas will see a significant rise in their amount of risk-weighted assets (BCBS 2013b).

Lastly liquidity requirements are also part of the new Basel III accord (BIS 2013c), these are however not a subject of this Thesis.

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The impact of the Basel III higher risk-based capital requirements on the risk a bank takes

Previous research done on the impact of risk-based capital standards on the amount of risk banks take is vast but not univocal. The research consists of two views, the view that risk-based capital standards leads banks to take on less risk and the view that risk-based capital standards leads banks to remain in the status quo or even take on more risk. Here I will present research on both views, starting with the former. In their research Jacques and Nigro (1997) conclude that risk-based capital standards were effective in increasing capital ratios and reducing portfolio risk in commercial banks. Kashyap et al. (2008) state that capital-raising tends to be sluggish during crises. Not only is capital a relatively costly mode of funding at all times, it is particularly costly for a bank to raise new capital during times of great uncertainty. Moreover, at such times many of the benefits of building a stronger balance sheet accrue to other banks and to the broader economy and thus are not properly internalized by the capital-raising bank. They also state that banks perceive equity to be an expensive form of financing and take steps to use as little of it as possible; indeed, a primary challenge for regulation is that it amounts to forcing banks to hold more equity than they would like. Therefore banks would prefer to comply with the new capital requirements, such as Basel III, by decreasing their risk so that they have to raise less capital. Maurin and Toivanan (2012) found empirical evidence that undercapitalized banks tend to restrict the provision of loans to the economy, as the relatively higher cost of bank equity leads banks to deleverage in order to reach target capital ratios and to close the existing capital gap. Arroyo et al. (2012) state that the greater the pressure to increase the numerator of the capital ratio, the greater will be the pressure to reduce the denominator. This previous research shows that, especially in time of crises, there are various factors pressuring banks to decrease the amount of risks they take. However, there is also previous research which argues the status quo or even the opposite. Rime (2001), indicates that regulatory pressure in the form of more stringent risk-based capital requirements induces banks to increase their capital, but does not affect the level of risk they take. Calem and Rob (1999) found that an increased capital requirement, whether flat or risk-based, tends to induce more risk-taking by ex-ante well-capitalized banks that comply with the new standard. According to Benmelech and Dlugosz (2010) downgrading of credit ratings on assets is still continuing. Regardless of bank’s willingness in changing their risk-weighted assets, less risky assets might be downgraded and

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moved into a riskier category. This means that banks might not be able to lower risk-weighted assets even if they have the intention of doing so. In conclusion, banks are definitely pressured to decrease the amount of risk they take by higher risk-based capital requirements. But if they are able to, or actually want to for that matter, and not search for another way to comply with higher risk-based capital requirements remains the question. This conclusion is in line with VanHoose (2007)’s extensive literature review.

Given this conclusion I propose the following hypothesis:

H1: The higher risk-based capital requirements of Basel III will decrease the amount of risk banks take.

The relationship between a bank’s leverage ratio and the risk a bank takes

The high levels of leverage which occurred prior to the financial crisis were not accounted for in the risk-based capital requirements. Because these high levels of leverage are widely believed to have contributed to the financial crisis Basel III is introducing a leverage ratio (e.g. Crotty 2009). The introduction of the leverage ratio has caused much discussion about whether it is a good addition to the existing risk-based capital requirements. The Basel Committee on Banking Supervision (2009) argues that the leverage ratio requirement would “help contain the buildup of excessive leverage in the banking system, introduce additional safeguards against attempts to game the risk-based requirements, and help address model risk”. Dalmaz et al. (2011) are of the opinion that the leverage ratio could help identify banks that are outliers compared with their peers. Estrella et al. (2002) concluded that the simple leverage ratio is as good a predictor of banking failure as the more complex risk-weighted capital requirements. Carney (2008) concluded that even though the leverage ratio does not encourage more prudent behavior, the leverage ratio ensures a minimal buffer to absorb the negative consequences of imprudent behavior. Larson (2011) argues that the addition of a leverage ratio will lead to banks taking on more risk because banks will compensate for the lost income from their reduced lending ability due to the higher capital requirements by increasing the interest rates they will charge on loans,

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thus making credit more expensive to borrowers. To accomplish this, banks will take on riskier assets regardless of the concomitant higher capital requirements. Therefore, with the higher capital requirements, not only will there be less lending, but the lending that does take place will be riskier and more expensive. Kiema and Jokivuolle (2011) present a similar argument. They state that a leverage ratio interferes with the basic idea of risk-sensitive capital requirements, which is to align minimum capital requirements with banks’ true asset risks and hence promote efficient client credit allocation. According to this argument, an additional leverage ratio

requirement would make the effective capital requirement on low-risk assets too high. This could lead to risk-shifting from low-risk to higher-risk assets. In conclusion, previous research leads us to believe that there is a relationship between the leverage ratio of a bank and the amount of risk a bank takes.

Given this conclusion I propose the following hypothesis:

H2: There is a relationship between the leverage ratio of a bank and the risk a bank takes and thus the leverage ratio is a predictor of the risk profile of a bank.

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Methods and Sample

For this research I gathered data from the annual reports and pillar 3 disclosures of all the

European banks in the Forbes Global 2000 of 2010. First I compiled the list of banks, after which I proceeded to gather the required data for the years 2010 to 2012. After excluding the banks that were sold or liquidated (e.g. CAM Group; Atebank) and several banks that were not disclosing the required data (e.g. Volksbank; PPR) this resulted in a dataset of 177 observations on 59 European banks. To test the hypotheses several statistical tests were used. For the first hypothesis a paired samples t-test was performed to examine if there is a significant change in the amount of risk banks take in the years 2010 to 2012. For the second hypothesis a multiple linear regression analysis was performed to examine if the leverage ratio is a predictor of the amount of risk a bank takes. In this analysis the dependent variable is risk and the independent variable is the leverage ratio. Below you will find an explanation of these variables and the various control variables that were included in the multiple linear regression analysis. The dependent variable risk is also used in the paired samples t-test.

Dependent Variable

Risk. Risk-Weighted Assets / Total Assets is a measure of risk. Shrieves and Dahl (1992) state that “a bank's portfolio risk is primarily determined by its allocation of assets across risk categories and the quality of its loans, two features captured by the risk-weighted asset to total asset ratio”. This argument is reinforced by Avery and Berger (1991) and Berger (1995) who concluded that the risk-weighted asset to total asset ratio is positively correlated with risk. All the banks I have collected data on reported according to IFRS and were subject to the most recent regulation of the BCBS. This made comparison of risk-weighted assets and total assets across different countries possible.

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Independent Variable

Leverage ratio. In Basel III the leverage ratio is measured as Leverage Ratio = Tier 1 Capital / Exposure Measure. The Exposure Measure is calculated by adding-up on balance sheet

exposures, derivative exposures, securities financing transactions exposures and other off-balance sheet exposures. Almost all European banks report their Tier 1 Capital, but public

disclosure by banks of their Basel III Exposure Measure is not due to the 1st of January 2015 as it was only in June 2013 when the BCBS issued a consultative document on how to calculate the Exposure Measure. Manually adding up the four components of the exposure measure is next to impossible as not all banks report on these components separately, if they even report on them at all (Kalemli-Ozcan et al. 2012). Therefore I have calculated the leverage ratio as Tier 1 Capital / (Total Assets – Intangible Assets). Needless to say this is a greatly simplified way of calculating the leverage ratio compared to the Basel III way. In their research Kalemli-Ozcan et al. (2012) calculated the leverage ratio of banks in various ways (e.g. the ratio of total liabilities to total assets; the ratio of total debt to total assets; the ratio of total debt to equity) and found that all the different ways of calculating the leverage ratio showed the same pattern. Therefore I can

reasonably safely assume that my simplified way of calculating the leverage ratio still show the same pattern as the more complicated way in Basel III.

Control Variables

Risk can be influenced by several other variables; in this research I controlled the following factors.

Size. Size may have an impact on risk due to its relationship to bank diversification, the nature of a bank’s investment opportunity set, or to bank ownership characteristics and access to equity capital (Shrieves and Dahl 1992). Jacques and Nigro (1997) also included size as a control variable in their research on risk-based capital and portfolio risk. I used the natural logarithm of the total assets of a bank to measure size as the sizes of banks in my database differ significantly.

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Global Systemic Importance. As previously stated banks that are labeled as systemically important are subject to an additional regulatory capital surcharge. This in combination with the fact that systemically important banks are closely watched by the Financial Stability Board gives them a clear incentive to decrease the amount of risk they take. That’s why I included global systemic importance as a dummy variable in my research. If a bank is labeled systemically important in a year I gave it a value of 1 and a value of 0 if it was not.

Profitability. If a bank is making losses, or is not profitable enough, management will look for ways to increase profitability. This could be done by taking on assets with a higher return, often riskier assets. This is in line with Larson’s (2011) findings. Losses could however also be the result of having too risky assets in the first place. In conclusion profitability most likely has an impact on the risk strategy a bank will pursue and therefore I included it as a control variable. Profitability will be calculated as Earnings Before Tax / Total Assets.

Year. Since I gathered data on multiple years, namely from 2010 to 2012, it is likely that events, which have an impact on the amount of risk a bank takes, have taken place outside the scope of this research. Especially fluctuations in the state of the economy could play an important role. Therefore I included year as a dummy variable in my research. In the database each year was given its own column, the value 1 was given if the observation was equal to the year in the column and the value 0 if the observation was not equal to the year in the column. The year 2010 was used as the reference group.

In their research Härle et al. (2010) concluded that the impact of Basel III regulations on RWA is greater for investment- or corporate banks than for a pure savings and loan bank. Since this research consists of the largest European banks it is hard to differentiate between types of banks as bigger banks almost always fit into multiple categories. Therefore I decided that this would not be part of the scope of this research.

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Analysis

Before I carried out the several different statistical analyses I standardized the variable total assets using the natural logarithm (LN) of its values. I then proceeded to winsorize the variables risk, leverage ratio, ROA and total assets. By limiting extreme values in the statistical data I reduced the effect of possible spurious outliers. From there on a correlation matrix was created to see if multicollinearity existed between my independent and control variables. After that I carried out the paired samples t-test and the multiple linear regression analyses. In the latter the effect on the dependent variable, risk, got tested in 2 different models. Model 1 with just the control variables and model 2 with the control variables and the independent variable leverage ratio.

Results

Table 1: Descriptive Statistics

_{Mean Minimum}_Maximum_Std._Deviation

Dependent Variable Risk 0.4496 0.1513 0.8326 0.17108 Independent Variable Leverage Ratio 0.0522 0.0153 0.1218 0.0174 Control Variables Total Assets 12.028 8.557 14.588 1.54283 ROA 0.0012 -0.0885 0.0251 0.01299 Global Systemic Importance 0.2655 0 1 0.44287 2011 0.333 0 1 0.47274 2012 0.333 0 1 0.47274

Table 1 presents the descriptive statistics for my variables. The average risk is 44.96% with a standard deviation of 17.11%, where the minimum and maximum differ significantly. The average leverage ratio is 5.22% with a standard deviation of 1.74% and the minimum and maximum differ significantly. 1.53% being the lowest leverage ratio among the biggest

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European banks at the moment. Caution should be taken when drawing a conclusion from these numbers, as like previously stated the way leverage ratio is calculated in this Thesis is greatly simplified. The average natural logged total assets is 12.03 with a standard deviation of 1.54, the difference in assets between the biggest banks in Europe and the smaller banks is enormous. The average ROA is 0.12% with a standard deviation of 1.3%. Again the maximum and minimum differ significantly in this case. 26,55% of the banks in the database are considered to be of global systemic importance on average across the 3 years.

As can be seen from table 2 the average risk in 2010 was 47.31% and 45.29% in 2011. This constitutes a -2.02% change which equals a -4.27% change expressed in percentage. So banks decreased their risk in 2011 compared to 2010. To test if this decrease in risk is significant I did a Paired Samples T-Test. The results are in table 3.

Table 3: Paired-Samples T-test

t Sig. (2-tailed)

Risk 5.235 0.000

As can be seen from table 3 the decrease in risk from 2010 to 2011 is highly significant.

Table 4: Risk comparison between 2011 and 2012

2011 2012 Change Percentage Change

Weighted Average 45.29% 42.23% -3.06% -7.25%

Exactly the same was done for 2012 compared to 2011. In 2011 the average risk was 45.29% and 42.23% in 2012. This constitutes a -3.06% change which equals a -7.25% change expressed in percentage. So after 2011 banks continued to take less risk. To test if this decrease in risk is significant I did a Paired Samples T-Test again. The results are in table 5.

Table 2: Risk comparison between 2010 and 2011

2010 2011 Change Percentage Change

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Table 5: Paired-Samples T-test

t Sig. (2-tailed)

Risk 5.378 0.000

As can be seen from table 5 the decrease in risk from 2011 to 2012 is highly significant.

On basis of these results we can accept H1: The higher risk-based capital requirements of Basel III will decrease the amount of risk banks take.

Furthermore there were only a handful of banks who increased their risk in 2012 compared to 2010. And these banks only increased their risk a little, with the maximum being 1,47% for SpareBank 1 Gruppen, a Norwegian bank.

Table 6: Correlationmatrix

Variable Leverage

Ratio ROA Global Systemic

Importance Total Assets

Leverage Ratio Pearson Correlation

Sig. (2-tailed) 1

ROA Pearson Correlation

Sig. (2-tailed) 0.167* 1 Global Systemic Importance Pearson Correlation Sig. (2-tailed) -0.441** 0.65 1

Total Assets Pearson Correlation

Sig. (2-tailed) -0.527** -0.03 0.76** 1

*. Correlation is significant at the 0.05 level (2-tailed). **. Correlation is significant at the 0.01 level (2-tailed).

Table 6 presents the correlation matrix for all the independent and control variables. We can derive that ROA has a significant positive correlation with the leverage ratio. Furthermore both Global Systemic Importance and Total Assets have a significant negative correlation with the leverage ratio. This means that bigger European banks have a lower leverage ratio on average compared to the smaller ones. Total Assets and Global Systemic Importance are also

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classified as globally systemically important. This latter correlation is quite high and suggests possible multicollinearity. I further examined the possible existence of multicollinearity and found that the variables all had VIF values smaller than 3. Therefore I can reasonably safely assume multicollinearity won’t be an issue for all the mentioned significant correlations.

Table 7: Regression Analysis

Model 1 Model 2 B Sig. B Sig. Constant (Risk) 0.884 *** 0.18 Total Assets -0.032 *** -0.001 ROA 0.153 -1.328 * Global Systemic Importance -0.086 ** -0.054 * 2011 -0.019 * -0.032 2012 -0.05 -0.077 *** Leverage Ratio (H2) 6.441 *** Adjusted R Square 0.226 *** 0.525 *** F value 11.285 *** 33.416 *** F change 11.285 *** 108.57 *** Largest VIF 2.415 2.675

*. Correlation is significant at the 0.1 level (2-tailed). **. Correlation is significant at the 0.05 level (2-tailed). ***. Correlation is significant at the 0.01 level (2-tailed).

Table 7 presents the results of the multiple regression analyses. Hereby, as previously emerged, 2 models are presented. The coefficients, which can be found in the table, show the influence of the independent- and control variables on the dependent variable when all the other variables are kept the same. I will now evaluate the second formulated hypothesis, using the results of the multiple regression analyses.

H2: There is a relationship between the leverage ratio of a bank and the risk a bank takes and thus the leverage ratio is a predictor of the risk profile of a bank.

The results show that the leverage ratio is significantly positively correlated with risk, (b = 6.441; p < 0.01). Therefore hypothesis 2 can be accepted.

Furthermore below model 1 we can see that 22.6% of the risk a bank takes can be explained by the control variables (Adjusted R² = 0.226; p < 0.01). All control variables have a significant

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effect on the risk a bank takes in either model 1 or 2 or both models. Model 2 gives the best explanation of the risk a bank takes with 52.5% (Adjusted R² = 0.525; p <0.01). This means that a significant amount of the explanation is given by the leverage ratio of a bank.

Discussion

The results showed that the amount of risk a bank takes is partially explained by its size, profitability, if the bank is seen as globally systemically important or not and the year. Both assets and global systemic importance are significantly negatively correlated with risk. An explanation for this relationship can be given by multiple factors. Firstly, the large European banks have a lot of government bonds on their balance sheet. As can be seen from Figure 2 these generally carry the least risk. Especially considering, in an effort to stimulate the economy, banks are allowed to carry bonds of European governments with a risk weight of 0% (Nouy 2012). Secondly, the large European banks often have vast business in the savings and loan sector, which is considered less risky than the investment and corporate sector (Härle et al. 2010). Thirdly, the systemically important banks are closely watched by the Financial Stability Board and also receive a lot more media attention than smaller banks. It is only logical to assume that they do not want to get involved in too risky activities or they will get a backlash from the public, much like what happened after the global financial crisis. The years 2011 and 2012 are both negatively correlated with risk. Since Basel III got announced in 2010 banks have had a clear incentive to decrease the amount of risk they take. Public backlashes against the risky activities of banks after the global financial crisis also lead them to take on less risk. The

profitability of a bank is significantly negatively correlated with risk. In bad economic times safe assets give the best return. Using literature on impact of risk-based capital studies and financial regulation I formulated two hypotheses. Looking at the results we can conclude that hypothesis 1 can be accepted, banks have significantly decreased the amount of risk they take since Basel III was announced in 2010. Furthermore Tier 1 capital increased from an average of 18,018 million in 2010 to 18,625 million in 2011 and 19,451 million in 2012. Total assets first increased from an average of 442,245 million in 2010 to 461,379 in 2011 and then decreased to 453,983 in

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2012. The pattern seen here seems to be most in line with research from Jacques and Nigro (1997). They concluded that risk-based capital standards were effective in increasing capital ratios and reducing portfolio risk in commercial banks. This conclusion seems to be in line with the findings of my research. Research by Arroyo et al. (2012) and Kashyap ey al. (2008) also support my findings. Both researches concluded that banks will reduce the amount of risk-weighted assets they hold and thus the amount of risk they take in order to comply with the new, more stringent, risk-based capital requirements. My findings are not in line with research by Rime (2001) who found that more stringent risk-based capital requirements would make banks increase their capital but would not have an effect on the level of risk they take. It is possible that our findings differ because his research is over 10 years old and was conducted when Basel I was still in place. The last years have brought a lot of financial innovation and this could change the outcome of the study. Also banks have multiple years of experience with risk-based capital requirements now while his research was done before risk-based capital requirements even existed. Further looking at the results we can also conclude that hypothesis 2 can be accepted, the leverage ratio of a bank is related to the amount of risk a bank takes and thus is a predictor of the risk portfolio of a bank. My results show that when a bank has a higher leverage ratio the bank is likely to take more risk. This might seem counterintuitive at first, but makes a lot of sense when you think about it. Banks that take a lot of risk need a lot of capital to fulfill the Basel II risk-based capital requirements, meaning they have a lot of Tier 1 capital. The numerator of the leverage ratio in Basel III is Tier 1 capital, so banks that take a lot of risk automatically have a high numerator (assuming they are complying with the capital

requirements). The Exposure Measure is non risk-based which is also an advantage for banks that take a lot of risk. These two factors combined ensure that banks who take a lot of risk automatically have a good leverage ratio. This also means that the leverage ratio in Basel III will hit savings and loan banks the hardest since those banks are not required to hold a lot of capital under the risk-based requirements of Basel III (Härle et al. 2010). Holding too many risk-free assets is therefore not beneficial as a bank needs to oblige to the leverage ratio anyways. This could lead to banks, which are currently not taking a lot of risk, taking on riskier assets. In conclusion Basel III seems to fulfill its goal of “improving the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy”. Virtually every bank will be required to

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hold more capital and the overall riskiness of the banking sector has decreased over the last few years. What should be closely monitored is if banks that are currently not fulfilling the leverage ratio requirement, which are banks that are not taking a lot of risk such as savings and loan banks, will take on riskier assets. Since they have to fulfill the leverage ratio requirement there is no incentive for those banks to not obtain risky assets as holding too many riskless assets is discouraged by the leverage ratio. The BCBS should question if they want such banks to take on riskier assets like derivatives and other financial vehicles. This conclusion is in line with Larson (2011). Like Kiema and Jokivuolle (2011) stated the leverage ratio will make effective capital requirements on low-risk assets too high, this perfectly resembles my own conclusion.

Conclusion

This research focused on both the impact of Basel III, the new capital requirements for banks, on the amount of risk banks take as well as the relationship between the leverage ratio and the amount of risk banks take. The results show that banks have significantly decreased the amount of risk they take in the last few years and that the leverage ratio of a bank is significantly positively correlated with the amount of risk a bank takes. This latter result points out the

importance of having capital requirements that include both risk-based as well as non risk-based measures. When capital requirements only include risk-based measures banks that do not take a lot of risk will carry almost no capital to protect them against external shocks like, for example, a downturn in economic activity. On the other hand if capital requirements only include on non risk-based measures banks are motivated to take a lot of risk since they are required to hold a certain amount of capital regardless of the risk of their assets. To stay competitive banks that do not take a lot of risk would need to take more risk. Therefore this Thesis dismisses the arguments from opponents of capital requirements that solely include either a risk-based measure or a non risk-based measure. This research is subject to several limitations. First of all it should be taken into account that risk is multi-faceted and far from straightforward to measure (BCBS 2013d). The risk-weighted asset to total asset ratio is as Avery and Berger (1991) and Berger (1995) state positively correlated to risk and the ratio captures both a bank’s portfolio risk and the quality of its loans (Shrieves and Dahl 1992). The risk-weighted asset to total asset ratio should not be seen

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as an exact measure of risk, but more as an indication. Measuring the exact amount of risk a bank takes is impossible. Another limitation lies in the comparability of the data across banks due to various measures put in place by governments and the European Union to manage the global financial crisis. To prevent banks’ internal risk weights from reducing risk-weighted assets and thus bank’s capital needs too much and too quickly, temporary, lower limits were set for how much capital could be reduced. These limits were set relative to the previous framework for capital requirements, Basel I, and are referred to as the Basel II transitional arrangements. The floor was originally intended to expire at the end of 2009, but due to the global financial crisis it was kept in place as part of a European crisis-management package. Under the current floor limit, the floor is binding on a bank if its own risk-weighted assets are lower than 80 percent of risk-weighted assets measured in accordance with Basel I (Borchgrevink 2012). These

transitional arrangements have the most impact on banks that carry a lot of safe assets. Especially Nordic banks are hit hard by these transitional arrangements. In some cases their RWA’s are almost double of what they would have been without the transitional arrangements. Because these transitional arrangements won’t be part of Basel III the current risk these banks are taking is greatly inflated. The same goes for the comparability of the leverage ratio across banks. Various governments have recapitalized their banks. For example Greece introduced The Hellenic Financial Stability Fund which is “aimed at maintaining the stability of the Greek financial system through the support of the capital adequacy of banks and the capital support of Transitory Credit Institutions”. Since there are banks who did not receive support and the level of support across banks also differs the comparability of the leverage ratio gets disrupted by this government support. Possibly the most important limitation is the use of capital arbitrage by banks in order to artificially lower their risk-weighted assets. A recent study done by the European Banking Authority (2013) confirmed the existence of a variation in RWA calculation which hinders the comparability of risk across banks. This is in line with Ledo (2011) who finds inconsistencies in RWAs between the US and the Europe, but also within Europe. Das and Sy (2012) discuss the tactics used by banks to lower their risk-weighted assets. Banks move assets around in assets of the same risk category. This won’t be captured by measuring risk-weighted assets. Lastly, the sample of this research only consists of large European banks and therefore the scope of this research is limited. With this research I have contributed to both research on risk-based capital requirements and the impact of Basel III. Since there are a lot more questions

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surrounding Basel III I hereby provide some, although not limitative, options for future research. Capital arbitrage is an interesting, be it difficult, topic for future research. If banks are freely able to manipulate their risk-weighted assets the question raises of how much use risk-based capital requirements are. Research has to be done on how severe these manipulations are and how an even-level playing field can be created. This research is based on big European banks, the same research could be conducted on smaller banks. These smaller banks often do not participate in risky financial vehicles and it is therefore interesting to see in what way these banks will be affected by the new requirements of Basel III, especially the leverage ratio. Furthermore when banks are required to disclose their leverage ratio according to Basel III starting in 2015 more research can be done on the leverage ratio and its different components. This research can also be done in the USA where banks hold significantly more risk-weighted assets (European Banking Authority 2013).

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The Impact of Basel III and the Predictive Power of the Leverage Ratio on the Amount of Risk Banks Take