Capital Regulation, Bailout and Banking Asset Correlation

• Author: Peng Sui,Dandan Zhou
• Published date: 01 March 2019
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/irfi.12178

Capital Regulation, Bailout and

Banking Asset Correlation*

PENG SUI AND DANDAN ZHOU

The Center for Economic Research, Shandong University, Jinan, P. R. China

ABSTRACT

We study the effect of capital regulation on banking asset correlation. Banks

are more efficient users of banking assets. This implies that it may be ex post

optimal to bail out a failed bank. We show, under Basel 1 capital regulation,

that the financial regulator is committed to a mixed bailout strategy in the

state of systemic failure, which reduces banks’incentive to choose highly

correlated assets. The mixed strategy is not creditable under mark-to-market

capital regulation. In the subgame perfect equilibrium, banking asset correla-

tion increases, resulting in a high probability of systemic failure. We then

discuss social losses under different capital regulations.

JEL Codes: G21; G28

Accepted: 20 December 2017

I. INTRODUCTION

This paper studies the effect of capital regulation on banking asset correlation.

Two banks choose their investment correlation before the financial regulator

decides whether to implement bailout. Banks are more efficient users of bank-

ing assets than other market participants, called outside investors, because they

are endowed with special management expertise and skills as shown in Dia-

mond and Rajan (2001). These specialties imply that the financial regulator

may find it ex post optimal to bail out a bank that faces bankruptcy, because liq-

uidating the banking assets to outside investors can lead to misallocation cost.

Having anticipated the bailout, banks strategically choose their level of invest-

ment correlation, which determines the probability of banks failing together in

what we call systemic failure, to maximize their expected payoffs.

We show that under Basel 1 capital regulation,

1

the financial regulator can

commit to a mixed bailout strategy: randomly bailing out only one bank in the

* Peng Sui would like to thank the financial support from NSSFC, grant no. 15CJL007.

1 Basel 1, which is also called the Basel Accord of 1988, stipulated minimum capital requirements

for banks, charging the capital amounted to 8% of risky loans. Basel 1 received several criticisms in

the early 1990s. The most important one was that the coarse risk buckets in which assets are classi-

fied is not a market-based risk measurement, which was said to mark a step back from the quality

of risk management. From the mid-1990s, there was a tendency toward more market-based capital

regulation up to the recent crisis, see Hellwig (2010) for a history review of capital regulation.

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 19:1, 2019: pp. 83–103

DOI: 10.1111/irfi.12178

state of systemic failure. This mixed strategy is ex post optimal for both the

bailed-out bank and the financial regulator. The bailed-out bank finds it profit-

able to purchase the liquidated banking assets at the price set by the outside

investors because it has special expertise to generate higher return.

2

The finan-

cial regulator finds it optimal for the bailed-out bank to purchase the banking

assets because it minimizes both the misallocation costs and the costs of deposit

insurance. This mixed strategy is also ex ante optimal. In the subgame perfect

equilibrium, the randomization of the bailout policy can reduce banks’incen-

tive to invest in highly correlated assets and hence decreases the probability of

systemic failure.

We then study banks’correlation strategy under the capital regulation that is

marked to market. Under mark-to-market, the level of the banking capital

required depends on the market value of the assets.

3

In this case, the financial

regulator may not be committed to the mixed strategy. This is because the mar-

ket value of the liquidated banking assets is now determined by the outside

investors, who are inefficient users of the assets. The price drop of liquidated

banking assets reflects outside investors’valuation. The mark-to-market regula-

tion implies that the bailed-out bank has to hold more banking capital to

acquire the assets. As banking capitals are costly, it may not be profitable for

the bailed-out bank to do so.

4

The mark-to-market capital regulation thus gives

rise to a debt overhang problem, refraining banks from purchasing assets with

positive net present value because of the high cost of banking capital. If the

misallocation costs are large, it is then ex post optimal for the financial regulator

to bail out every failed bank. Having anticipated the bailout, in the subgame

perfect equilibrium, banks tend to invest in highly correlated assets to increase

the probability of systemic failure. A “too many to fail”rescue arises.

5

We then

compare the social losses under two capital regulations and show that the

mark-to-market regulation can be socially inefficient from the systemic point

of view.

2 We use the name “outside investors”to represent the financial market participants that are

outside the banking sector. The banking sector is small relative to the whole financial system,

so that any individual bank cannot affect the market price of the liquidated assets.

3 Brunnermeier et al. (2009) note that under mark-to-market, the level of the capital ratio banks

are required to hold depends on the market value of the assets. As asset prices drop, risk mea-

sures increase, leading to higher capital ratio costs for the banks purchasing these assets. The

capital ratio is obtained from risk measures such as Value at Risk (VaR), which are estimated

naively using past data. Hence, a sharp price drop leads to a sharp increase in the estimates of

these risk measures. The direct result of this risk calibration of regulatory capital is that banks’

ability to sell or buy the assets is very susceptible to the market condition.

4 Costly banking capital can be explained in Dewatripont and Tirole (1994) under manager–

shareholder conflicts, information asymmetry of the equity holders in Froot, Scharfstein and

Stein (1993), and informed trading in capital markets in Froot and Stein (1998).

5 We borrow this term from Acharya and Yorulmazer (2007). They show that, to reduce the

social losses, the financial regulator finds it ex post optimal to bail out every troubled bank. We

can also use the name of “too correlated to fail”because the rationale for this bailout is that

many banks fail because of high correlation of their assets.

© 2018 International Review of Finance Ltd. 201884

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