The impacts of financial regulations: solvency and liquidity in the post-crisis period

Author:Colleen Baker, Christine Cummings, Julapa Jagtiani
Position:Independent Consultant, Austin, Texas
Pages:253-270
SUMMARY

Purpose Basel III and the capital stress testing introduced new requirements and new definitions while retaining the structure of the pre-2010 requirements. The total number of requirements increased, making it difficult to determine which and how many constraints are binding. The purpose of this paper is to discuss the new financial regulations in the post-financial crisis period, focusing on the capital and liquidity regulations. Design/methodology/approach The authors explore the impact of financial regulations using various data sources - financial and accounting data from Y-9C Reports. Market data such as daily bond... (see full summary)

 
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The impacts of nancial
regulations: solvency and
liquidity in the post-crisis period
Colleen Baker
Independent Consultant, Austin, Texas
Christine Cummings
Federal Reserve Bank of New York, New York, New York, USA, and
Julapa Jagtiani
Department of Supervision, Regulation and Credit,
Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylvania, USA
Abstract
Purpose Basel III and the capital stress testing introduced new requirements and new denitions while
retaining the structure of the pre-2010 requirements. The total number of requirements increased, making it
difcult to determine which and how many constraints are binding. The purpose of this paper is to discuss the
new nancial regulations in the post-nancial crisis period, focusing on the capital and liquidity regulations.
Design/methodology/approach The authors explore the impact of nancial regulations using various
data sources – nancial and accounting data from Y-9C Reports. Market data such as daily bond trading from
TRACE through the Wharton Data Research Services and Treasury yield from the Bloomberg. The authors
use regression analysis to examine the roles of capital adequacy and liquidity regulations.
Findings The authors’ analysis in this paper suggest that Basel III, CET1 and Level 1 HQLAs
requirements post-nancial crisis have reshaped the balance sheets of large nancial institutions, with some
differential impacts on traditional versus capital markets banks. These changes appear to respond to the
binding constraints (CET1 being a preponderance of required regulatory capital, Level 1 HQLAs a majority of
required HQLAs and the expense of both) created by these new requirements, which also appear to have
constrained asset growth at such institutions. Consistent with the authors’ view, their results suggest that the
new requirements are less constraining for large traditional banks (such institutions show a rapid increase in
CET1 capital to steady-state levels by 2012 and strong retail deposit rebuilding resulting in a relatively low
required HQLA) and much more so, particularly the liquidity requirement, for the capital markets banks (such
institutions show continuous building of CET1 capital over the post-crisis observation period, declines in the
share of trading assets and increases in the share of HQLAs combined with efforts to increase retail deposits).
Credit risk spreads rose dramatically during the nancial crisis of 2008-2009. Although decreased, they
remain higher and with greater dispersion (for both groups of banks) than pre-crisis. Preliminary regression
analysis suggests that the market responds to changes in measured liquidity, rather than the regulatory
capital ratios, when pricing bank risk (as reected on bond spreads).
Research limitations/implications The estimation is based on historical relationship in the data. We
must be cautious in extrapolating the results in a different environment.
Practical implications There appears to be an arbitrage between HQLA and retail deposits. Capital
markets banks and traditional banks follow different business models as evident in the analysis in this paper.
Social implications Market pricing suggests that the liquidity measures are more transparent and
easier to understand. Capital ratios are not as easy to interpret.
JEL classication – G12, G18, G21, G28
The authors thank Leigh-Ann Wilkins and Raman Quinn Maingi for their dedicated research assistance.
Theviews in this paper are those of the authors and do not necessarily reect the views of the Federal Reserve
Bank of Philadelphia or the Federal Reserve System Christine. Cummings is retired.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
Solvency and
liquidity
253
Journalof Financial Regulation
andCompliance
Vol.25 No. 3, 2017
pp.253-270
©Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-02-2017-0027
Originality/value Original research. To the authors’ knowledge, there is no paper that examines impacts
of capital and liquidity regulations after the crisis at capital markets banks vs traditional banks – using both
accounting data and market data.
Keywords Basel III, Banking reform, CET1, HQLA, Liquidity regulation, Regulatory capital
Paper type Research paper
1. Introduction
For many large nancial institutions, the nancial crisis of 2007-2009 led to a severe
depletion of common equity and an inability to fund in short-term, wholesale funding
markets. Out of necessity, governments and central banks around the world intervened to
support distressed nancial institutions and dysfunctional markets. Consequently, the G20
nations’ regulatory reform agenda prioritized the revision of international capital and
liquidity regulation.
The Basel III capital and liquidity framework reects this agenda and key lessons learned
from the nancial crisis. These lessons include a much stronger emphasis on the common
equity component in bank capital, additional capital requirements (i.e. buffers) for
systemically important banks and new liquidity requirements for larger institutions.
This paper examines the Basel III requirements for large US nancial institutions and
discusses three key effects of their implementation at such institutions. First, we explore the
creation of capital and liquidity binding constraints. We posit that the new capital
requirements form new binding constraints, such as the Common Equity Tier 1 (CET1)
requirement, and that the liquidity constraints are more binding for banks with large capital
markets activities. Second, we explore how these requirements may be affecting banks’
balance sheet choices (e.g. reductions in trading assets and increases in less “runnable”
liabilities) and how the impacts differ with the banks’ business models. Third, we relate our
empirical results to existing theoretical and empirical work and ll a gap in the nancial
stability literature.
Our ndings are consistent with the argument that the enhanced capital and liquidity
rules would likely improve many measures of nancial stability. Related to this, we also nd
that debt spreads incorporate bank liquidity and have had greater volatility and dispersion
since the crisis, which is consistent with some theories of the life cycle of nancial crises, and
perhaps reects an erosion of the belief that large institutions are too-big-to-fail (TBTF).
2. Literature review
The nancial crisis of 2007-2009, the most serious such crisis since the Great Depression,
began with bank-like runs outside of the traditional banking system in the shadow banking
system (Gorton and Metrick, 2013). Repurchase agreements, off-balance-sheet entities,
derivatives and securitized products compose this parallel banking system (Gorton, 2008),
estimated to have approximated the size of the traditional banking system as the crisis began
(Gorton and Metrick, 2013). During the lead up to the nancial crisis, markets initially
understood little about the complex production chain creating securitized, subprime
mortgage assets (Gorton, 2008).
During the recent crisis, the liquidity shortages created enormous demands for cash that
the shadow banking system could not meet and endangered the solvency of Global
Systemically Important Financial Institutions (G-SIFIs)[1]. Consequently, policymakers
around the world took massive actions such as “interest rate cuts, liquidity support,
recapitalization, asset purchases, and liability guarantees” to rescue their nancial
systems[2]. Post-crisis reforms focus on increased capital and liquidity requirements,
especially for G-SIFIs – entities regarded as TBTF.
JFRC
25,3
254

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