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Calibrating the Level of Capital: The Way We See It

Author

Listed:
  • Ryo Kato

    (Bank of Japan)

  • Shun Kobayashi
  • Yumi Saita

Abstract

This paper aims primarily to propose the framework for estimating the optimal levels of capital at banks with broad perspectives, elaborating factors such as liquidity and macroeconomic conditions. First, we attempt to reorganize the variety of policy proposals for enhancing financial sector regulation. In light of the broad perspective of the prudential policy framework, we discuss the role of bank capital in enhancing banking-sector resilience. Second, with our perspective in mind, we lay out an early warning system (EWS) to predict a financial crisis where the role of capital and liquidity are explicitly captured. In the EWS, the estimation results confirm two-fold evidence: (i) capital and liquidity are imperfect substitutes for each other against the probability of crisis. And, on top of the liquidity on the asset side of the banks' balance sheet, (ii) liability-side liquidity has a statistically significant predictive power for a potential financial crisis a few years ahead. Then, we apply the EWS as a component of a cost-benefit analysis (CBA) to gauge the benefit from raising capital and liquidity requirements, as more stringent regulations are expected to reduce the probability of financial crisis. On the other hand, financial-sector regulations should come along with certain costs. To quantify the cost, we employ some existing macroeconomic models to estimate the cost of raising capital and liquidity requirements. Combining the EWS (for benefit calculation) with the macroeconomic models (for cost calculation), we provide a full-fledged CBA framework that can determine the optimal levels of capital that strike the right balance between the costs and benefits of the financial-sector regulation. The main results indicate that the optimal level of bank capital would considerably vary depending on the level of liquidity indicators both on the asset and liability sides of banks' balance sheets as well as macroeconomic conditions, typically represented by housing market inflation. Finally, the CBA framework suggests that banks could stand in a better shape with a counter-cyclical capital buffer to be well-prepared for a prospective distress.

Suggested Citation

  • Ryo Kato & Shun Kobayashi & Yumi Saita, 2010. "Calibrating the Level of Capital: The Way We See It," Bank of Japan Working Paper Series 10-E-6, Bank of Japan.
  • Handle: RePEc:boj:bojwps:10-e-6
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    References listed on IDEAS

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    1. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises; A New Database," IMF Working Papers 2008/224, International Monetary Fund.
    2. Ray Barrell & E Philip Davis & Tatiana Fic & Dawn Holland & Simon Kirby & Iana Liadze, 2009. "Optimal Regulation of Bank Capital and Liquidity: How to Calibrate New International Standards," Occasional Papers 38, Financial Services Authority.
    3. Rocco Huang & Lev Ratnovski, 2009. "Why Are Canadian Banks More Resilient?," IMF Working Papers 2009/152, International Monetary Fund.
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    Citations

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    Cited by:

    1. Jochen Schanz & David Aikman & Paul Collazos & Marc Farag & David Gregory & Sujit Kapadia, 2011. "The long-term economic impact of higher capital levels," BIS Papers chapters, in: Bank for International Settlements (ed.), Macroprudential regulation and policy, volume 60, pages 73-81, Bank for International Settlements.
    2. Yan, Meilan & Hall, Maximilian J.B. & Turner, Paul, 2012. "A cost–benefit analysis of Basel III: Some evidence from the UK," International Review of Financial Analysis, Elsevier, vol. 25(C), pages 73-82.
    3. Oliver Röhn & Aida Caldera Sánchez & Mikkel Hermansen & Morten Rasmussen, 2015. "Economic resilience: A new set of vulnerability indicators for OECD countries," OECD Economics Department Working Papers 1249, OECD Publishing.
    4. Jost H. Heckemeyer & Ruud A. de Mooij, 2017. "Taxation and Corporate Debt: Are Banks Any Different?," National Tax Journal, National Tax Association;National Tax Journal, vol. 70(1), pages 53-76, March.
    5. Mikkel Hermansen & Oliver Röhn, 2017. "Economic resilience: The usefulness of early warning indicators in OECD countries," OECD Journal: Economic Studies, OECD Publishing, vol. 2016(1), pages 9-35.
    6. William R. Cline, 2016. "Benefits and Costs of Higher Capital Requirements for Banks," Working Paper Series WP16-6, Peterson Institute for International Economics.
    7. Chalermchatvichien, Pichaphop & Jumreornvong, Seksak & Jiraporn, Pornsit, 2014. "Basel III, capital stability, risk-taking, ownership: Evidence from Asia," Journal of Multinational Financial Management, Elsevier, vol. 28(C), pages 28-46.
    8. Douglas Elliott & Andre O Santos, 2012. "Assessing the Cost of Financial Regulation," IMF Working Papers 2012/233, International Monetary Fund.
    9. Ruud A. de Mooij & Michael Keen & Masanori Orihara, 2013. "Taxation, Bank Leverage, and Financial Crises," IMF Working Papers 2013/048, International Monetary Fund.
    10. Lallour, Antoine & Mio, Hitoshi, 2016. "Do we need a stable funding ratio? Banks’ funding in the global financial crisis," Bank of England working papers 602, Bank of England.
    11. Brunella Bruno & Giacomo Nocera & Andrea Resti, 2015. "The credibility of European banks’ risk-weighted capital: structural differences or national segmentations?," BAFFI CAREFIN Working Papers 1509, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.
    12. Naohisa Hirakata & Nao Sudo & Kozo Ueda, 2013. "Is the net worth of financial intermediaries more important than that of non-financial firms?," Globalization Institute Working Papers 161, Federal Reserve Bank of Dallas.
    13. de Haan, Leo & van den End, Jan Willem, 2013. "Bank liquidity, the maturity ladder, and regulation," Journal of Banking & Finance, Elsevier, vol. 37(10), pages 3930-3950.
    14. Sebastian Krug & Matthias Lengnick & Hans-Werner Wohltmann, 2014. "The impact of Basel III on financial (in)stability: an agent-based credit network approach," Quantitative Finance, Taylor & Francis Journals, vol. 15(12), pages 1917-1932, December.
    15. Sumera Anis & Abdul Rashid, 2017. "Optimal Bank Capital And Impact Of The Mm Theorem: A Study Of The Pakistani Financial Sector," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 12(02), pages 1-21, June.
    16. de-Ramon, Sebastián & Iscenko, Zanna & Osborne, Matthew & Straughan, Michael & Andrews, Peter, 2012. "Measuring the impact of prudential policy on the macroeconomy: A practical application to Basel III and other responses to the financial crisis," MPRA Paper 69423, University Library of Munich, Germany.
    17. Tom Gole & Tao Sun, 2013. "Financial Structures and Economic Outcomes; An Empirical Analysis," IMF Working Papers 2013/121, International Monetary Fund.

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    More about this item

    Keywords

    Capital ratio; Liquidity; Financial crisis; Probit model; Bank regulation;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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