Risk-based capital regulation revisited: evidence from the early 2000s

Author:Thomas L. Hogan, Neil R. Meredith, Xuhao (Harry) Pan
Position:Johnson Center for Political Economy, Troy University, Troy, Alabama, USA; Department of Accounting, Economics, and Finance, West Texas A&M University, Canyon, Texas, USA; George Mason University, Fairfax, Virginia, USA
Pages:115-134
SUMMARY

Purpose - The purpose of this study is to replicate Avery and Berger’s (1991) analysis using data from 2001 through 2011. Although risk-based capital (RBC) regulation is a key component of US banking regulation, empirical evidence of the effectiveness of these regulations has been mixed. Among the first studies of RBC regulation, Avery and Berger (1991) provide evidence... (see full summary)

 
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Risk-based capital regulation
revisited: evidence from the
early 2000s
Thomas L. Hogan
Johnson Center for Political Economy, Troy University, Troy,
Alabama, USA
Neil R. Meredith
Department of Accounting, Economics, and Finance,
West Texas A&M University, Canyon, Texas, USA, and
Xuhao (Harry) Pan
George Mason University, Fairfax, Virginia, USA
Abstract
Purpose – The purpose of this study is to replicate Avery and Berger’s (1991) analysis using data from
2001 through 2011. Although risk-based capital (RBC) regulation is a key component of US banking
regulation, empirical evidence of the effectiveness of these regulations has been mixed. Among the rst
studies of RBC regulation, Avery and Berger (1991) provide evidence from data on US banks that new
RBC regulations outperformed old capital regulations from 1982 through 1989.
Design/methodology/approach – Using data from the Federal Reserve’s Call Reports, the authors
compare banks’ capital ratios and RBC ratios to ve measures of bank performance: income, standard
deviation of income, non-performing loans, loan charge-offs and probability of failure.
Findings – Consistent with Avery and Berger (1991), the authors nd banks’ risk-weighted assets to
be signicant predictors of their future performance and that RBC ratios outperform regular capital
ratios as predictors of risk.
Originality/value – The study improves on Avery and Berger (1991) by using an updated data set
from 2001 through 2011. The authors also discuss some potential limitations of this method of analysis.
Keywords Banking, Bank performance, Capital, Bank failure, Bank regulation, Risk-based capital
Paper type Research paper
1. Introduction
The 2008 nancial crisis has created great turmoil regarding the stability of the banking
sector and the effectiveness of nancial regulation. Economists have differing opinions
about the causes of the crisis (Crotty, 2009;Acharya and Richardson, 2009;Obstfeld and
Rogoff, 2009) and propose different solutions including increasing bank capital (Admati
et al., 2011), better corporate governance (Peni and Vähämaa 2012) and increasing
transparency in the banking system (Lo, 2009). One institution blamed as a potential
source of the nancial crisis is the system of risk-based capital (RBC) regulations based
on the Basel Accords[1]. RBC regulations have been linked to the build-up of risk in the
The authors would like to thank the Mercatus Center at George Mason University for generously
supporting this research.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
Risk-based
capital
regulation
revisited
115
Journalof Financial Regulation
andCompliance
Vol.23 No. 2, 2015
pp.115-134
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-02-2014-0006
banking sectors in the USA (Jablecki, 2009) and Europe (Dowd et al., 2011). However,
defenders of RBC regulation argue that such regulations are necessary for limiting bank
risk. The Federal Reserve has revised its system of RBC regulations in accordance with
the Basel II agreement and is moving toward the adoption of Basel III. Federal Reserve
Chairman Ben Bernanke believes that these regulations will “make the nancial system
more stable and reduce the likelihood of future nancial crises by requiring these banks
to hold more and better-quality capital and more-robust liquidity buffers” (Bernanke,
2011).
One aspect of this debate is whether RBC metrics are better predictors of bank risk
than regular capital ratios. Starting in 1991, the Federal Reserve began evaluating banks
using the RBC ratio based on the Basel system of risk-weighting. The RBC ratio became
the Federal Reserve’s primary measure of bank risk, replacing the regular capital ratio
of equity over assets. Avery and Berger (1991) was one of the rst empirical studies to
compare the new RBC regulations to the old regulations based on the regular capital
ratio, and it is still widely cited as evidence of the effectiveness of RBC regulation. Using
data on US commercial banks from 1982 through 1989, the study found that a bank’s
risk-weighted assets (RWAs) were signicant predictors of several measures of the
bank’s future performance and that new capital regulations were a better indicator of
performance than old regulations.
The goal of this paper is to replicate the analysis of Avery and Berger (1991) using
data from 2001 through 2011 to see whether their results still hold. In Section 2, we
discuss our data set and compare it to the data set in Avery and Berger (1991). Section 3
discusses our empirical approach and results concerning RWA and bank performance.
Section 4 explains our empirical approach and results for the evaluation of new and old
capital standards. Section 5 concludes with a discussion of our limitations and ideas for
future research.
2. Data
Following Avery and Berger (1991), we gather data from the Consolidated Reports of
Condition and Income (Call Reports). We adopt the same variables of Avery and Berger
(1991), as shown in the summary of the RBC standards as follows:
1. Risk categories:
Category A1 (0 per cent weight):
Cash, Federal Reserve Bank balance; and
Securities of US Treasury. OECD governments and some US agencies.
Category A2 (20 per cent weight):
Cash items in the process of collection;
US and OECD interbank deposits and guaranteed claims;
Some non-OECD bank and government deposits and securities;
General obligation municipal bonds;
Some mortgage-backed securities; and
Claims collateralized by the US Treasury and some other government
securities.
JFRC
23,2
116

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