PrefBlog

Assiduous Readers will remember that I have long complained about the dearth of research on the ill-effects of Canada’s bank capitalization requirements. Various OSFI puff-pieces (e.g., a speech by Mark White; an essay by Carol Ann Northcott & Graydon Paulin of the Bank of Canada and Mark White; a speech by Jule Dickson later clarified for the sub-moronic) have given unreserved praise to the high capitalization required by OSFI. I have long wondered what the through-the-cycle costs of having all this excess (by world standards) capital tied up in banks might be – ain’t NUTHIN’ free! The high levels of bank capitalization certainly helped through the crisis (although not, probably, as much as secure retail funding) but what did that cost us and is it worth that cost?

I don’t know the answer – I’m just annoyed that Canadians are not asking the question.

Into the breach steps the UK Financial Stability Authority, which has just published a paper by their staff members William Francis and Matthew Osborne titled Bank regulation, capital and credit supply: Measuring the impact of Prudential Standards:

The existence of a “bank capital channel”, where shocks to a bank’s capital affect the level and composition of its assets, implies that changes in bank capital regulation have implications for macroeconomic outcomes, since profit-maximising banks may respond by altering credit supply or making other changes to their asset mix. The existence of such a channel requires (i) that banks do not have excess capital with which to insulate credit supply from regulatory changes, (ii) raising capital is costly for banks, and (iii) firms and consumers in the economy are to some extent dependent on banks for credit. This study investigates evidence on the existence of a bank capital channel in the UK lending market. We estimate a long-run internal target risk-weighted capital ratio for each bank in the UK which is found to be a function of the capital requirements set for individual banks by the FSA and the Bank of England as the previous supervisor (Although within the FSA’s regulatory capital framework the FSA’s view of the capital that an individual bank should hold is given to the firm through individual capital guidance, for reasons of simplicity/consistency this paper refers throughout to “capital requirements”). We further find that in the period 1996-2007, banks with surpluses (deficits) of capital relative to this target tend to have higher (lower) growth in credit and other on- and off-balance sheet asset measures, and lower (higher) growth in regulatory capital and tier 1 capital. These findings have important implications for the assessment of changes to the design and calibration of capital requirements, since while tighter standards may produce significant benefits such as greater financial stability and a lower probability of crisis events, our results suggest that they may also have costs in terms of reduced loan supply. We find that a single percentage point increase in 2002 would have reduced lending by 1.2% and total risk weighted assets by 2.4% after four years. We also simulate the impact of a countercyclical capital requirement imposing three one-point rises in capital requirements in 1997, 2001 and 2003. By the end of 2007, these might have reduced the stock of lending by 5.2% and total risk-weighted assets by 10.2%.

Unfortunately for the direct translation of this paper’s conclusions to the Canadian experience, the paper focusses on shocks to bank capital requirements, which may be different from the steady-state effects of a constantly high requirement. For all that, however, the reasoning seems applicable in general terms:

Moreover, a large body of theoretical and empirical literature suggests that, contrary to the predictions of the Modigliani-Miller theorems (Modigliani and Miller (1958)), maintaining a higher capital ratio is costly for a bank and, consequently, a shortfall relative to the desired capital ratio may result in a downward shift in loan supply (Van den Heuvel (2004); Gambacorta and Mistrulli (2004)).
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A secondary aim of our paper is to use evidence of systematic association between changes in banks’ balance sheets and banks’ surplus or deficit relative to desired capital levels during economic upturns to develop measures that may assist policymakers in calibrating capital requirements, including proposals for counter-cyclical capital requirements, which are explicitly designed to address the build-up of risk during a credit boom.

Not surprisingly, there is an effect:

Our results show that regulatory capital requirements are positively associated with banks’ targeted capital ratios. We further show that the gap between actual and targeted capital ratios is positively associated with banks’ loan supply (suggesting that loan supply falls as actual capital falls below targeted levels), suggesting that banks amend their supply schedule (for example by raising the cost of borrowing or rationing credit supply at a given price) or take action to raise capital levels (for example, restricting dividends in order to retain profits or raising new equity or debt capital). Taken together, these results indicate that capital requirements affect credit supply, confirming the linkage found by previous researchers and demonstrating a ‘credit view’ channel through which prudential regulation affects economic output. We also find significant and positive relationships with growth in the size of banks’ balance sheets and total risk-weighted assets, and significant and negative relationships with growth in capital.

The effect of increasing regulatory requirements on Italian banks has been examined:

One notable study that addresses the problem of a lack of heterogeneity of capital requirements and assesses the impact on bank lending is Gambacorta and Mistrulli (2004). The authors explicitly examine the effects of the introduction of capital requirements higher than the Basel 8% solvency standard on lending volumes of Italian banks. They find that the imposition of higher requirements reduced lending by around 20% after two years. The results are consistent with the idea that, in the face of rising capital requirements, banks may find it less costly to adjust loans than capital as the risk-based capital requirement becomes increasingly more binding. Frictions in the market for bank capital make adjusting (raising) capital in response to higher regulatory requirements, in this case, expensive, so the result of the trade-off may be a reduction in lending. This result is consistent with the idea of a ‘bank capital channel’.

As noted, the paper’s emphasis is on the effect of shocks, not upon the constant effects of higher capital requirements, and the author’s conclusions reflect this bias:

Our simple theoretical model clarifies the link between capital requirements and lending and shows how, in the presence of capital adjustment costs, the “bank capital channel” implies that higher capital requirements lower a bank’s optimal loan growth. That effect, however, depends on the level of excess capitalization, with better capitalized banks (i.e., those with more capital above regulatory thresholds) experiencing less pronounced impacts on their lending. These predictions depend on departures from the Modigliani-Miller propositions and, in particular, increasing marginal costs of capital adjustment.

A full examination of the Canadian experience would include an accounting for the effects on loans of steady-state capital ratios and – perhaps equally importantly – some accounting of the crowding-out effects on risk-capital of other firms of requiring so much equity in banks. Don’t look for any pearls of wisdom from OSFI, though; perhaps the Bank of Canada might do it.

The Bank of England has announced the release of the 2009 Q3 issue of the Bank of England Quarterly Bulletin with the usual top-notch research. This quarter’s articles are:

• Foreword
• Markets and operations
• Global imbalances and the financial crisis
• Household saving
• Interpreting recent movements in sterling
• What can be said about the rise and fall in oil prices?
• Bank of England Systemic Risk Survey
• Monetary Policy Roundtable

The article on Global imbalances seeks to challenge Taylor’s assertion that there was no global saving glut by focussing on gross, not net numbers:

An important factor was the adoption of managed exchange rate policies by some EAEs [East Asian Economies],(2) whereby a particular level of their currency was targeted, usually against the US dollar. This policy was prompted, in part, by the aim of spurring economic development through exports, thereby addressing extensive rural underemployment.(3)(4) The desire to accumulate foreign exchange reserves as insurance against a repeat of the 1997–98 Asian currency crises was an additional motivation.(5) Another factor may have been the slow pace of financial development in many EAEs which meant that there was a dearth of domestic investment opportunities (see Caballero et al (2008)). This may have necessitated savings being channelled to the deeper and more liquid financial markets in western economies.
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Bernanke (2005) has argued that the low and falling savings rates in deficit countries which accompanied the credit boom, were principally the outcome of an endogenous process by which the excess savings of the surplus countries — the ‘global
savings glut’ — were recycled.

Meanwhile, banks were exposing themselves to liquidity risk:

An associated innovation was that banks changed their funding models. In particular, banks sold the new types of securities to
end-investors via the so-called ‘shadow banking system’, encompassing structured investment vehicles (SIVs) and conduits, which provided a framework for lending and borrowing without accepting deposits. This was termed the ‘originate to distribute’ model: aiming to spread the risks associated with securitised assets off their balance sheets, banks sold them to SIVs, which then aimed to sell them on to end-investors.(1) At the same time, banks increasingly relied on wholesale funding markets, including in selling the securitised assets, see the October 2008 Financial Stability Report. The magenta bars in Chart 8 show that the share of funding by UK banks derived from securitisations increased between 2000 and 2008.(2)

The authors repeatedly emphasize this point:

The funding structure of financial institutions, with its reliance on wholesale markets and the use of securitised assets (Chart 8), was a related vulnerability. In particular, this funding model relied on the continued functioning of those markets. This funding often came from foreign investors and this, together with banks’ increased lending overseas and the growth of the shadow banking system, generated the further vulnerability of increased and complex cross-border linkages between both financial institutions and between countries more generally. Such complex international linkages potentially give rise to unappreciated, but potent, interconnections between firms in the global financial system.

The article on oil prices makes a claim of regulatory significance:

The price of oil rose steadily between the middle of 2003 and the end of 2007, rose further and more rapidly until mid-2008 and fell sharply until the end of that year. Commentators agree that a significant part of the increase in the oil price over that period was due to rapid demand growth from emerging markets, but there are substantial differences of view about the relative importance of other factors, and limited work thus far in explaining the large fall in oil prices in the second half of 2008. The purpose of this article is to analyse the main explanations for the rise and fall in oil prices in the five years until the end of 2008. It argues that shocks to oil demand and supply, coupled with the institutional factors of the oil market, are qualitatively consistent with the direction of price movements, although the magnitude of the rise and subsequent fall during 2008 is more difficult to justify. The available empirical evidence suggests that financial flows into oil markets have not been an important factor over the period as a whole. Nonetheless, one cannot rule out the possibility that some part of the sharp rise and fall in the oil price in 2008 might have had some of the characteristics of an asset price bubble.

I recently highlighted a paper by Alistair Murdoch of the University of Manitoba in which he showed that, in terms of the effect on the CAPM Beta of the common stock, preferred shares that were not convertible at a fixed rate into common were perceived by the market as being debt-like.

This paper was used as evidence to support the accounting reclassification of retractible preferred shares as debt for audited balance sheet purposes.

He then wrote a follow-up paper examining the effects of this change, titled Management Reaction to Mandatory Accounting Changes: The Canadian Preferred Shares Case:

The new Canadian accounting standards for financial instruments require that retractable preferred shares be classified as debt, thus negatively affecting the debt/equity ratio. Previous research, most of which has examined the impact of a change in American accounting standards affecting the determination of earnings, indicates that firms with such shares will act to mitigate the negative impact of the accounting change on their financial statements. Specifically, firms are likely to: a) reduce the amount of retractable preferred shares outstanding, and/or b) reduce the amount of other liabilities, and/or c) increase the amount of equity outstanding.

I test these predictions using data on firms required to file information on their preferred shares with Canadian securities commissions. Evidence based on a sample of 34 such firms indicates that they did indeed reduce the amounts of both retractable preferred shares and the amounts of other liabilities and issued additional common shares. Surprisingly, smaller firms did not make greater reductions (as a proportion of total assets) than larger firms.

He makes one statement about market efficiency that I consider worthy of comment:

The economic consequences of the replacement of retractable preferred shares by other sources of financing, primarily common shares, is not clear. If retractable preferred shares became a popular financial instrument during the 1970s and 1980s because they allowed firms to issue debt in the guise of equity, then their disappearance due to the standard change having stripped this disguise from them is desirable because it promotes informational efficiency.

This is of interest because it may be flipped upside down and used as an attack on the Efficient Market Hypothesis. The mandated change in classification is cosmetic only; no information is supplied to the marketplace by an auditor’s opinion as to whether a particular instrument is best placed in the shareholders’ equity section of the balance sheet or not. The prospectus contains all the necessary information for investors to judge the nature of the instrument for themselves and is not changed by this opinion.

Thus, any change in management or market behaviour due to such a change is evidence that the market’s efficiency has changed; and if the market’s efficiency can change, then the EMH does not hold.

In this particular case, I take the view that the change increased the efficiency of the market, by allowing bozos (who equate the term “research” with “looking stuff up in Compustat”) to more closely match the judgement of those who have actually examined the data and thus reduces the rewards for market professionals to think about what they are doing.

This supports the hypothesis that informtion has a value – it ain’t free!

Of interest in the paper was Table 1 “Number of publicly listed Canadian companies with outstanding retractable preferred shares”, which documents a nearly monotonic decline from 1988 (114 companies) to 1997 (32 companies). With the benefit of over a decade’s worth of additional data, we can now see that retractibles from Operating Companies (the HIMIPref™ subindex “OpRet”) has dwindled to virtual insignificance.

This is an old paper (1997) but interesting none-the-less.

Alistair Murdoch of the Deparment of Accounting and Finance, University of Manitoba wrote a paper Are Preferred Shares Debt or Equity?: Some Canadian Evidence with the abstract:

I test the appropriateness of new accounting standards that would treat some types of preferred shares as debt rather than equity. I develop a new model to examine whether capital markets view the (systematic) risk of preferred shares to be more like the risk of debt or more like the risk of common equity. The proposed model is compared to a traditional model tested on 1986 to 1994 data of thirty-nine companies that trade on the Toronto Stock Exchange and issued preferred shares during that period. Debt, retractable preferred shares and p lain vanilla preferred shares appear to be substantially less risky than common shares. Other types of preferred shares are more risky than debt; some appear to be more risky than common shares. These results support the view that some types of preferred shares should be classified as liabilities.

He reasons that:

A firm that increases its debt/(common) equity ratio increases the risk of the (common) equity and may increase the risk of the debt. If preferred shares are viewed as debt, then issuing preferred shares should have the same effect as increasing the debt/(common) equity ratio. If they are viewed as equity, then their issue should have the same effect as decreasing the debt/(common) equity ratio. Finally, if they are some intermediate form of financing, they may have no effect on the risk of the (common) equity.
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… I confirm that debt is less risky than common equity. I find that retractable preferred shares and plain vanilla shares are also less risky than common equity and that in most of my tests their level of risk is not statistically significantly different from that of debt. Other kinds of preferred shares are more risky than debt. Convertible preferred shares are as risky as common shares, while preferred shares that are convertible at market or that are both retractible and convertible appear more risky than common shares

Risk is defined as Beta in the Capital Asset Pricing Model. The “Asset Beta” of each company is decomposed into the equity beta and terms representing the contributions of debt and the various flavours of preferred share, where:

A firm’s asset beta is a measure of the relation between the firm’s return on assets and the market return. Beta is usually estimated by regressing the firm’s return on the market return over some period during which beta is assumed to be constant.

After performing the regressions, the author concludes:

This paper has attempted to determine empirically whether during the past decade the Canadian market has viewed preferred shares as being more like debt or more like equity. It reports that retractable preferred shares have been viewed much like debt which supports the recent change in the accounting classification of these securities

An interesting paper in that it attempts to classify preferred shares according to the effect of their issuance on the Beta of the common, rather than considering the market price of the preferred shares themselves.