The regulatory requirement for banks to hold capital is related to the safety net afforded by (often implicit) government guarantees. Regulators are also concerned about the possibility of systemic risk arising from bank default, especially any impact on the real economy. Imposing severe capital requirements may, however, impact the extent of financial intermediation as regulatory costs are passed on to customers. Bank management, using innovative capital instruments and strategic risk modelling, contribute to the complexity of the nexus between capital and risk. At the core of banking regulation is the concept of minimum capital requirements, but capital regulation has often struggled to keep pace with the evolution of bank financial and operational sophistication.
Successive Basel frameworks have required banks to hold capital as a buffer in the event of losses and as a means to reduce the potential for risk shifting by shareholders. Under prudential capital regulation, a large menu of securities are permitted to contribute to regulatory capital. Tier 1 capital consists primarily of paid-up share capital and disclosed reserves and may include perpetual non-cumulative shares. Such capital can be split into high quality tangible equity and a lower quality residual component, termed non-core tier 1 capital (NCT1). Tier 2 capital is often thought of as ‘gone-concern’ capital, absorbing losses in the event of failure and consists of securities such as subordinated debt and hybrid capital.
While previous research has predominantly concentrated on the relationship between bank risk and narrow capital measures (such as tier 1 capital or equity capital), in our recent article, Beyond Common Equity: the Influence of Secondary Capital on Bank Insolvency Risk, we expand upon this by looking at a broader menu of capital components. We examine bank insolvency risk (distance to default) for listed North American and European banks over the period 2002-2014, focusing on sensitivity to capital other than common equity. Considered collectively, tier 1 capital is not reliably associated with a reduction in bank risk. This finding does not carry over to the components comprising tier 1 capital. Unweighted tangible equity is most consistently found to be linked with a reduction in insolvency risk. NCT1, in contrast, is inconsistently associated with insolvency risk and linked with increased risk under certain circumstances. The limited risk moderation properties of NCT1 impairs the risk reduction capacity of aggregate tier 1 capital. Tier 2 capital is not linked with insolvency risk, although a conflicting relationship is isolated, conditional on the level of total regulatory capital held. Finally, the association between risk and capital is weakened when the latter is defined relative to risk-weighted assets.
Ostensibly, many of the findings outlined in this research are congruent with the renewed focus on high quality capital under the Basel III framework, to be fully introduced by 2019. This framework distinguishes between non-core tier 1 capital and high-quality common equity, requiring regulated financial entities to hold more of the latter. In this light, one potential concern relates to our finding that links between insolvency risk and tangible equity wane for banks holding greater than median tangible equity. This highlights a potential limitation to the focus on greater quantities of core equity capital under the Basel III framework.
Thomas Conlon is Associate Professor at University College Dublin
John Cotter is Professor at University College Dublin
Philip Molyneux is Professor at the University of Sharjah – College of Business Administration