Rethinking Bank Regulatory Capital

Since the crisis, the debate over appropriate capital levels for large banks has intensified. Policymakers, guided by accords like Basel III, have emphasized the importance of banks holding higher quantities and better quality of capital to withstand financial shocks. This approach, rooted in the Capital-Buffer Rationale (CBR), views capital primarily as a safety net—a means to absorb losses when crises occur. However, determining whether regulatory capital is sufficient is challenging without accurately estimating the potential magnitude of the next financial crisis. If unexpected losses are not precisely forecasted—which is often the case—mandating a specific percentage for regulatory capital may seem arbitrary or insufficient. In his Ph.D. dissertation, Jalal Mrabti argues that this perspective addresses only the aftermath of risk events, not their prevention. While the loss-absorbing capacity of capital is crucial, it's inherently reactive. It doesn't actively reduce the likelihood or severity of financial crises; it merely mitigates the damage once they've occurred.

This critique gives rise to the Risk-Disincentivizing Rationale (RDR), wherein Mrabti proposes a fundamental shift in how regulatory capital should be perceived. Instead of serving solely as a buffer, capital should act as a deterrent against excessive risk-taking by banks. By calibrating capital buffers to the incremental risks that banks assume beyond a certain threshold, regulators can directly influence banks' behavior before crises occur, thereby smoothing and slowing the accumulation of risk in the financial system. The RDR approach transforms regulatory capital into an ex-ante safety measure, proactively reducing the probability and potential impact of risky events by making excessive risk-taking less attractive to banks beyond a certain threshold.

Mrabti's findings consistently show a positive and significant relationship between minimum capital requirements and bank riskiness (measured by risk-weighted assets, or RWAs). This suggests that requiring banks to hold higher minimum capital requirements may inadvertently lead to increased risk-taking—as they seek to offset the cost of raising additional capital—and vice versa. The impact appears more pronounced with Tier 1 capital, indicating that both the type and quality of capital influence banks' risk-taking behavior. The study found it takes two quarters for changes in bank riskiness to significantly Granger-cause changes in regulatory capital. Conversely, regulatory capital Granger-causes changes in bank riskiness, but this causality becomes significant only after four quarters. These findings support the role of capital as a buffer mechanism against negative shocks.

In stark contrast, the study uncovered a negative association between capital buffers and bank riskiness. Although the effect size is relatively small, it is statistically significant and suggests that capital buffers are more effective in discouraging excessive risk-taking compared to minimum capital requirements. This conclusion is one of the central findings of Mrabti's research, bearing substantial implications for policy considerations. The negative association might be attributed to the discretionary nature of capital buffers. Granger causality tests revealed that changes in capital buffers Granger-cause bank riskiness, but not vice versa. Furthermore, the results show that requiring a unit increase in capital buffers during an expansionary business cycle results in a larger decrease in a bank’s RWAs compared to an equivalent increase during a contractionary cycle. In other words, capital buffers are more effective and have a greater disincentivizing effect on banks' risk-taking behavior when the economy is booming.

Consequently, capital buffers and minimum capital requirements are complements, not substitutes. Capital buffers emerge as potent instruments in discouraging excessive risk-taking among European systemic banks (Risk-Disincentivizing Rationale), while minimum capital requirements provide a cushion against potential losses (Capital-Buffer Rationale).

Introducing Risk Parity Principles to Macroprudential Policy

Building on this, Mrabti introduces risk parity principles to macroprudential policy, offering a novel approach to balancing regulatory capital and bank risk contributions. In the absence of an accepted theoretical framework to determine optimal capital levels in banking, he employs the principles of risk parity—for the first time in macroprudential policy literature—to explore the relationship between regulatory capital and banks' risk contributions. By integrating regulatory risk and capital contributions, Mrabti constructs a sophisticated "capital parity" model that provides unprecedented insights into the dynamics of this relationship. He successfully applies this approach in macroprudential policy, identifying excessive risk-takers and undercapitalized banks.

The essence of capital prudential regulation in Basel III revolves around the interplay of capital and risk. The fundamental principles of the risk parity approach are deeply rooted in these concepts. Consequently, applying the risk parity framework to capital prudential policy is a logical extension of these shared foundational elements. This integration not only is relevant but also holds practical significance, harnessing the synergy between these perspectives to enhance the effectiveness and precision of capital prudential regulations. According to Mrabti, this is the first application of this approach in the capital prudential policy field. Risk parity is a strategy that seeks to balance the risk contribution of each asset to the total risk of a diversified portfolio, thereby reducing overall portfolio risk by avoiding risk concentration. Typically, this involves allocating more capital to lower-risk assets to achieve equal risk contributions from each asset. The main difference between risk parity and capital parity lies in capital allocation. While risk parity allocates more capital to less risky assets, capital parity allocates more capital to riskier banks. Consequently, the total risk in the system becomes less skewed toward any single bank, helping to curb the contagion effect of systemic risk and the failure of large institutions.

By adjusting the risk parity approach, Mrabti converts it into a capital parity model suitable for macroprudential analysis. Adopting this framework enables regulators to better identify undercapitalized banks and excessive risk-takers, ultimately enhancing the resilience of the financial system.

This article is based on the Ph.D. dissertation by Jalal Mrabti and reflects his research findings and theoretical contributions to the field of banking regulation.