Photographer: Peter Frommenwiler/Bloomberg

When Bank Capital Standards Aren't Actually That Standard

A Federal Reserve working paper shows a wide variation in the way banking rules are implemented across jurisdictions.

Fifty shades of banking regulation might not sound very titillating. Perhaps it should be.

A new Federal Reserve working paper lays bare the degree to which ostensibly black-and-white rules set by the Basel Committee on Banking Supervision differ in their implementation.

At issue is the way in which countries can enforce requirements under Basel bank capital adequacy standards first introduced in 1988 and subsequently updated in 2004 (Basel II) and then overhauled in the aftermath of the financial crisis in 2010 (Basel III). While such rules set a minimum required capital level for banks, countries retain leeway in calculating the ratio by which that level is achieved — allowing for tinkering in the numerator (definition of capital) and the denominator (risk-weighted assets).

"The adoption of Basel principles by the majority of countries around the globe is an important fact; however, what is more important is how countries are actually implementing those principles in practice," writes Fed Economist Gazi Ishak Kara. "The Basel principles for bank regulation are rich and complex in nature, which gives countries a substantial amount of leeway in their implementation."

To demonstrate the variation, Kara looks at four specific years in time — 1999, 2002, 2006, and 2011 — and then creates "capital stringency indexes" displayed in the below two figures.

The first shows the distribution of the stringency indexes across countries. The standard deviations of the capital indexes are 1.66, 1.56, 1.75 and 1.40 for each selected year, respectively. Meanwhile, the percentage of countries with an index value that is below the mean comes in at 50 percent in 1999, 42 percent in 2002, 57 percent in 2006, and a mere 28 percent in 2011. 

Source: Federal Reserve

"The average capital stringency index rises by a significant amount after the global financial crisis, and its standard deviation shrinks; however, the cross-country variation does not disappear," writes Kara. The figure "shows that after the global financial crisis, the distribution becomes significantly skewed to the right, indicating that there is an overall increase in the stringency of capital regulations around the world."

The second chart shows changes in capital stringency over time, or from one survey year to the next. Between 2002 and 2006, for instance, 15 of the 49 countries surveyed relaxed their regulatory standards. Between 2006 and 2011, the trend is completely reversed with only six of the 51 countries surveyed relaxing their standards and the vast majority firming them up.

Capital stringency is adversely affected by three factors, according to the author. They are  returns on investment, government-owned banks, and concentration ratios. In other words, when bank returns are on the rise, capital toughness is on the decline, while financial systems with significant government control or concentration of lenders also show a lighter touch.

Source: Federal Reserve

"Countries with high average returns to investment or a higher ratio of government ownership of banks choose less stringent capital regulation standards," concludes Kara. "Government ownership of banks is used as a proxy for regulatory capture: the degree to which regulators are captured by the financial institutions under their control. Therefore, this result implies that the stringency of capital regulations decreases with regulatory capture."

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