Capital management in European Banks. Critical issues

by  Fabiano Colombini

 Abstract: This paper aims to analyse critical issues in the capital management in the light of recent financial crises, focusing on capital constraints by regulation and supervision in the composition of bank capital. Capital constraints by regulation and by supervision plays an important task in the level and composition of bank capital considering intensity and range of all risks. Instruments and business areas need to be considered.

Bank discretional margins are very restricted and the influence of public authorities is substantial: it exerts an adverse effect on the quality banks that are capable of rational screening and monitoring and, at the same time, of sound risk management, efficiency, thereby achieving a good performance. Changes, incentives and recreating structural conditions postulate new and innovative measures build up by regulatory and also supervisory authorities.

The raising of capital is the main tool used by regulation on a prudential application and by supervision on a discretional application in order to maintain the viability of the banking system. Capital requirements are calculated through Basel III and  the forthcoming Basel IV and are also imposed as an additional tool through discretional decisions by supervisory authorities. Considering only the capital level is misleading as it is unable to create the premises for a sound and stable bank in the future time.

The improvement of risk management through the identification, measurement and management of all risks linked with bank instruments and bank business areas is the best strategy to achieve structural reinforcement and, therefore, to ensure the soundness of individual banks and the banking system in the medium and long term.

The improvement of efficiency in the various forms of cost, revenue and profit, would be in line with the structural premises for sound and viable conditions leading to better frameworks for the economic account from one period of time to another.

 The solvency risk concerns the different ability of banks to settle their debts at any cost. Solvency is achieved by means of systematically higher asset values as compared to liabilities, thereby indicating positive levels of the bank’s capital. This highlights the problem of growth of profit and of a bank’s recourse to market instruments in order to develop its capital and its monetary resources and production volumes. The expansion path starts from the  raising of capital and positive performance, which in turn increases sound business and generation of profit.

  Capital raising creates premises for solvency, stability, business evolution, business growth in individual banks in Europe and world-wide. Capital raising is inspired by regulation and, at the same time, by supervision. Bank management is conducted through choices concerning the actual current situation and the future situation.

Capital represents a key variable in business, but the improvement of risk management and efficiency constitutes the best reply as a means of reinforcing structural conditions for survival. This report aims to investigate these elements in order to express critical issues and critical points for the evolution of individual banks and their business.

Basel I, Basel II and Basel III and forthcoming Basel IV rules  increase the compliance costs of individual banks while disregarding the fact that banks differ greatly between small and medium banks in comparison with the largest  banking institutions. The issue for banks is the use of rational and rigorous methods for the management of business areas and correlated risks, from the viewpoint of producing profits in the short, medium and long term. The establishment of more and more rules introduces greater complexity in bank regulation and, at the same time, increases compliance costs. Therefore a comparison of costs and benefits arising from the introduction of regulation should be performed.

The habitual focus on increasing capital is not the correct approach, because it makes use of a unitary attitude, i.e. the “one size fits all” approach to banks which are profoundly different in their business areas and risk range. Rules essentially consider a loss coverage issue through an adequate capital level, and this is a very different matter from the actual ability to manage the entire risk range.

Increasing the number and complexity of rules tends to introduce further complications in the task of supervision, but the main aim of supervision is still that of checking and ensuring control over the application of the rules in European banks. A banking crisis requires supervision initiatives which usually involve the raising of capital as a standard approach to build up a “wall” against the worsening or failure of the situation of a bank.

   Capital raising for satisfying regulatory and supervisory capital requirements contribute to increasing the capital level and therefore the absorption capacity in the event of unexpected losses. A higher level of capital will be able to handle negative economic results, and bank survival: solvency can be measured at given times.

  Improving  risk management and efficiency allows banks to achieve  structural conditions to recreate positive premises towards positive trends in costs and revenue and, at the same time, in the evolution of assets, liabilities and capital. This is the key point to pursue in the evolution of management conditions within European banks and within world banks.

Summary 1. Financial crises – 2 Banking business – 3. Capital composition, capital constraints and solvency  – 4. Capital management and financial stability – 5. Capital, regulation and supervision – 6. Final remarks.

1.Financial crises can be examined in the framework of crises involving financial markets, crises affecting financial intermediaries, sovereign debt crises and currency crises. Careful examination of the issues involved shows that financial crises are the result of interrelations among a number of circumstances: adverse trends on the financial markets, adverse situations affecting financial  intermediaries, tensions focusing on the public debt and turmoil in the exchange markets.

Financial crises have effects that ripple through financial markets, financial intermediaries, financial instruments, states and central banks, thus highlighting correlations and interdependencies as well as financial instability (Colombini, Calabrò, 2011). In short, financial crises have repercussions of marked intensity that are projected in the short, medium and long term over financial systems and, at the same time, over economic systems. For example, the subprime mortgage financial crisis calls for state aid measures in support of crisis-ridden financial intermediaries; the sovereign debt crisis implies the need for action to restore balance in the public finances; the economic crisis necessitates economic stimulus initiatives which diverge from the measures suggested in the previous two cases and may indeed be in conflict with them.

One aspect that clearly emerges is the importance of a scale of priorities concerning the volume of public resources required. Decisions on priorities must take into account the margins for public expenditure without causing excessive imbalance in the public budgets.

It likewise becomes clear that the irrational strategies based on innovative finance must be downsized or abandoned, in favour of restoring the concept of cultural and regulatory financial responsibility. Profits should be achieved by rational risk management, rather than arising from practices inspired by a separation between risk and return which ends up offloading the negative impact of risk onto the state budgets, while the positive impact of returns is inserted into the balance sheets of individual banks.

These improper practices tend to exacerbate the risks weighing on the entire financial system, thereby undermining savers’ confidence in financial intermediaries. The latter thus tend to be regarded as incapable of reducing the information asymmetries present on the financial markets. The move towards excessive risk-taking has been allowed to creep in partly on account of failure by the supervisory authorities to exert proper control over the individual financial intermediaries and over the placement of financial market instruments; however, it is partly also ascribable to systematic attribution of decidedly positive ratings that are totally mistaken in their quantification.

The subprime mortgage financial crisis can be identified as originating above all from the practice of selecting and transferring the credit risk associated with poor quality mortgage loans, thereby intensifying and transferring the overall credit risk. The collapse of the real estate market has led to markedly negative and widespread repercussions on the assets of banks and financial intermediaries that are characterised by significant levels of very bad mortgage loans and which, additionally, have made use of financial instruments of equally poor quality.

The sudden drop in house prices has induced adverse effects on the economy, triggering a recessive process of notable extension. A very worrying aspect is the situation of many families who are facing rising levels of unemployment and thus experience difficulty in meeting their mortgage instalment payments.

Thus on the one hand, the subprime mortgage financial crisis has made it necessary for governments to intervene in support of financial systems threatened by an unprecedented crisis, while on the other it has focused attention on the fragility of public budgets. Admittedly, massive resources have been made available to crisis-ridden banks in the different countries, but it is equally true that the shaky conditions of the public finances cannot exclusively be attributed to the subprime mortgage financial crisis.

Bailout plans to address the subprime mortgage financial crisis and expansionary policies designed to tackle the economic crisis have led to a marked deterioration in the public finances. However, the dramatic condition of the public finances should be ascribed not merely to the above described exceptional measures, but also to unbridled public expenditure that has risen to unsustainable levels. The most critical elements affecting the public finances involve the following aspects: rising pension and health care expenditure due to an aging population; fairly high expenditure on the national, regional and local level in matters pertaining to political affairs; intensity of tax evasion; amount of the public debt and its composition in terms of maturities and apportionment between residents and non residents; private debt levels and degree of solidity of the banking systems.

The elevated levels of public indebtedness create the premises for the sovereign debt crisis, leading to an increase in the returns that the markets demand on bonds issued by states perceived as being at risk and thereby bringing about an increase in spreads between the bonds of an individual state and those of the German state. This, in turn, exacerbates the fragility of the budgets of crisis-ridden states and makes it difficult, if not impossible, to intervene with measures aimed at economic recovery (Acharya, Philippon, Richardson, Roubini, 2009; Adrian, Shin, 2010; Allen, Carletti, 2010; Bernanke, 2015; Blanchard, Dell’Ariccia, Mauro, 2010; Boccuzzi, 2011; Bolton, Jeanne 2011; Calabria 2009; Capriglione, Semeraro, 2012; Cassidy, 2009; Claessens, Dell’Ariccia, Igan, Laeven, 2010; Colombini, 2011; Colombini, Calabrò, 2011; Crescenzi, 2010; Davies, 2010; Dowd, Hutchinson, 2010; Duffie, 2010; Eichengreen, 2008; Elson, 2017;Estrella, Schich, 2011; FCIC, 2011; Franke, Krahnen, 2008; Fratianni, 2008; Fornasari, 2009; Geithner, 2014; Goodhart, 2008; Haldane, 2009; Hubbard, 2009; King, 2016; Marconi, 2010; Masera, 2009; Mishkin, 2011; Reinhart, Rogoff, 2011; Shiller, 2008; Sorkin, 2009; Spaventa, 2010; Stiglitz, 2010; Wolf, 2014).

The trend of the spreads is thus linked to the situation within the various countries and to the perceived credit risk inherent in the sovereign debts as interpreted by the financial markets. Moreover, the trend is also influenced by the overall situation of the euro zone. Progress or worsening of the financial and economic situation within individual countries or involving the euro zone mechanisms leads to positive (reduction) or negative (increase) repercussions on the spreads.

It hardly need be added that speculation undoubtedly influences the fluctuation of the spreads. This makes itself felt not only in definition of the costs of individual public refinancing operations but also in the costs incurred by banks in raising funds, as well as in the costs dictated by the financial markets regarding bank loans to firms. Furthermore, the issue of contagion cannot be ignored, given that the interrelations among states transform the problems of individual states into global problems. This postulate is particularly evident in the context of the euro zone countries, triggering potential contagion among countries viewed as weaker on the financial level and therefore more fragile in the context of speculation.

It is imperative to examine the main causes, highlighting above all the role played by securitisation and credit derivatives in influencing the extent of credit risk transfer onto loan portfolios and sovereign bond portfolios. This issue is crucial because the repercussions can lead to fluctuations in value, weighing heavily on the losses suffered by financial intermediaries and by operators who invest in mortgages or in financial instruments linked to subprime mortgages, or in bonds and financial instruments linked to sovereign states.

One major aspect common to the financial crises discussed here resides in the contraction of liquidity due to the negative fluctuations and losses of value associated with subprime mortgages and the related financial instruments. This phenomenon also impacts on sovereign bond portfolios and the related financial instruments. The repercussions adversely affect the trends concerning the value of bank assets and the assets of financial intermediaries and operators, leading to the need for adjustments and deleveraging processes on various levels.

Such observations underline the importance of correct analysis and evaluation of the credit risk inherent in loan portfolios, asset-backed securities (ABS), credit derivatives, financial instrument portfolios and sovereign bonds. In short, the manner in which the credit risk is manifested, transferred and multiplied on the level of individual financial systems constitutes the basic thread allowing analysis and interpretation of the financial crises that form part of the broader context of the subprime mortgage financial crisis and the sovereign debt crisis.

In the process of credit risk transfer that has characterised international finance essentially since the beginning of the third millennium, it is not easy to identify precisely which repercussions have an impact on the direct circuit as opposed to those that impact on the indirect circuit. Only by exploring the integration between the two processes does it become possible to delineate more clearly the effects of the subprime mortgage financial crisis and the sovereign debt crisis.

Irrational criteria that turn a blind eye to the creation and intensification of credit risk have induced financial intermediaries to engage in unreasonable practices of experimenting with the transfer of credit risk to the financial markets, by means of securitisation and credit derivatives. This has triggered multiplicative impulses, raising problems concerning medium and long term sustainability. Moreover, such practices are suggestive of an original flaw which is of fundamental importance in the evolutionary path of financial systems.

On closer examination, credit risk transfer onto financial markets, where the main figure both in the field of sales and also of purchasing is represented by financial intermediaries, assumes the extended meaning of an increase in the burden of risk weighing upon the financial system, due to the numerous inter-relations among financial intermediaries (Shin, 2010). Basically, the problem can be traced partly to unorthodox practices in granting loans to a very poor quality customer base, and partly also to the subsequent experimental practices of risk transfer taken to excessive levels, as well as to failure of the supervisory authorities to exercise proper control.

In the context of financial crises of the period 2007-2017 at least in Europe, the ECB provides liquidity to the economy using conventional and unconventional instruments of monetary policy for support to issue and placing of public debt and, at the same time, contributing to  prices stabilisation  and yield reduction. It is worth to point out the quantitative easing (Qe)  instrument that ECB is still using in the European context.

It is important to consider the increasing in balance sheet volumes and, at the same time,  the risk growth of the ECB following the trend of Qe as buying public securities tend to increase assets.

Among the motivations at the basis of financial crises and, especially, of the subprime mortgage financial crisis the excessive borrowing has been indicated as the major factor (Admati, Hellwig, 2014). This is a wrong point of view as the main reason of the financial crisis of 2007-2009 lies in the irrationality of screening and monitoring and, at the same time, in the recurrent application of securitisation  and derivatives, contributing to creation, transfer and multiplication of credit risk of financial intermediaries (Colombini, Calabrò, 2011).

 

2.Banks pursue the objective of expansion of on- and off-balance sheet instruments and volumes over time in order to create the premises for profits and positive performance. Banking balance sheets have grown rapidly in a low interest-rate environment and in the presence of a surge in innovative instruments (Richardson, Smith, Walter, 2010).

Traditionally, banks take deposits and make loans to individuals and firms (commercial banking). Some banks engage in underwriting, dealing, market making of securities and derivatives, management of personal and real estate property, consultancy, mergers and acquisitions, financial planning, custody and administration of securities, intermediation and selling of securities, derivatives, investment trusts and real estate investment trusts, pension funds and insurance policies (investment banking).

The growth of the banking business has underlined the shift from commercial banking to investment banking, and therefore an increase in the range of risks and in total risk. The process of identification, measurement and management of risks is of crucial importance in creating and maintaining conditions for profit and solvency. The above mentioned shift is evident when looking at the assets side, the liabilities side and income sources as the share of net interest income falls and non-interest income rises (Liikanen, 2012).

The universal model in the banking sector combines commercial banking with investment banking and can be regarded as a critical issue for managing risks at a sustainable level for the individual institution and for the whole financial system.

Large banks tend to apply the universal banking model in the European Union (EU) for production diversification and also for risk diversification, adopting jointly the instruments of commercial banking and investment banking. Moreover, the expansion of business areas leads to a corresponding increase in the range of risks, with the result that risk management assumes a progressively more significant role. As a consequence of the links among different business areas, a bank may encounter difficulty in estimating its total risk exposure; accordingly, many banks engage in risk transfer as a practice for management of asset classes that involve a higher credit risk.

The systematic use of this practice has negative repercussions on the two classical banking activities: screening and monitoring. Screening and monitoring reduce or – in a very optimistic assumption – completely eliminate the problems, respectively, of information asymmetry ex-ante and, therefore, of adverse selection, and the problem of information asymmetry ex-post and, therefore, of moral hazard.

Screening and monitoring activities, together with the information content of bank loans, the uncertainty of return and of the value of their assets, and the “certainty” of remuneration and of the value of their liabilities, as well as the specific nature and depth of financial transformation, underline the importance of banks and, at the same time, highlight their differences in comparison with other financial intermediaries (Colombini, 2008).

A considerable number of banks have undertaken the development of business areas which are parallel to the classical areas of raising and lending funds. Many of these developments frequently involve high leverage areas, as in the case of derivatives (Colombini, 1999; Colombini, 2004; Colombini, Calabrò, 2011). Restoring rational choices in the context of commercial banks constitutes a requirement for medium and long period financial stability, with less importance awarded to growth of their  capital.

Over time, the dealing and market making of securities and derivatives and proprietary trading have become increasingly important. There has also been a remarkable growth in derivatives, especially in the over the counter (OTC) market (Colombini, Calabrò, 2011; King, 2016; Oldani, 2008; Savona, 2010). Since the beginning of the third millennium, securitisation markets have grown rapidly and created the phenomenon of the shadow banking system, built up essentially by special purpose vehicles (SPVs) and structured investment vehicles (SIVs).

Extensive recourse to leverage and, at the same time, the development of the shadow banking system (Claessens, Pozsar, Ratnovsky, Singh, 2012; Gorton, Metrick, 2010; Lemma, 2016; Stein, 2010) imply avoidance of capital requirements in a banking context, through the constitution of off-balance sheet vehicles. The latter, in particular, run up debts on the market of commercial papers such as short-term securities, and use the resources thereby achieved to purchase long-term securities, such as asset-backed securities (ABS). The difference between return on purchased securities and the cost of financing through commercial papers makes it possible to obtain  profits by means of special purpose vehicles.

Changes and innovations in rules should be accompanied by adequate levels of controls on bank practices of regulatory avoidance through off-balance sheet items (OBSIs). For banks, the shadow banking system represents one of the main ways in which a vast quantity of risk that is generated and transferred is rendered opaque (Pozsar, Adrian, Ashcraft, Boesky, 2012). It is important to bring greater transparency into financial intermediaries’ balance sheets, above all as regards OBSIs, which, in the light of financial crises on a global scale, highlight  irrationalities in the management of banks.

In this framework, the subprime mortgage financial crisis causes negative repercussions, because the liquidity crisis affecting banks does not allow special purpose vehicles to satisfy their continuous demand for re-financing through commercial papers.

It is worth pointing out that the paralysis of asset-backed securities markets, due to the collapse of the real-estate market and of the underlying assets characterising these securities, does not allow special purpose vehicles to raise funds to cope with their short-term commitments.

In their desire to reassure the markets of the commercial papers, banks are forced to  re-enter the special purpose vehicles assets and the enormous losses recorded in the balance sheet perimeter. The repercussions are devastating and banks experience heavy write-downs both on the lending portfolio and the financial instruments portfolio, recording losses and bank failures.

National responses to financial and economic crises, together with years of waste in public resource management, cause a rise in public expenditure and imbalance in the major Western countries’ public accounts, leading the way to a sovereign debt crisis. Essentially this means a credit risk for the country due to the non-payment of its debt maturity (debt default), or the intervention of an international financial authority, such as International Monetary Fund (IMF), to adjust deadlines and amounts of those payments as defined in the debt contract (debt restructuring) .

Considerable diversity in business areas, financial instruments and the associated range of risks can be observed among banking intermediaries. Typical financial risks include: liquidity, solvency, credit, the interest rate and exchange rate. A typical pure risk consists of operational risk. Such risks affect banks and are similar to those that affect other financial intermediaries. However, they do not exhaust the range of bank risks, as it is necessary to analyse and make comparisons among different instruments and the respective business areas, in order to assess the complete range of risks affecting the various areas. Additionally, this circumstance presupposes appropriate management capacity in the process of risk identification.

3.Bank capital is composed of three elements: capital constraints by regulation, capital constraints by supervision and free capital by bank choices. Bank discretional margins are very restricted and the influence of public authorities is substantial: it exerts an adverse effect on the quality banks that are capable of rational screening and monitoring and, at the same time, of sound risk management, efficiency, thereby achieving a good performance. Changes, incentives and recreating structural conditions postulate new and innovative measures build up by regulatory and also supervisory authorities (Colombini, 2018).

The raising of capital is the main tool used by regulation on a prudential application and by supervision on a discretional application in order to maintain the viability of the banking system. Capital requirements are calculated through Basel III and  the forthcoming Basel IV and are also imposed as an additional tool through discretional decisions by supervisory authorities.

  This is a sort of “recurrent  stressing” for implementation by banks in  order to pursue the stability objective. It is important to point out that raising of capital is useful only to hedge the solvency risk at the specific time date involved, and only if the solvency risk is correctly estimated at that time.

Looking at only the capital level is misleading as it is unable to create the premises for a sound and stable bank at a future time. Improving risk management through the identification, measurement and management of all risks linked with bank instruments and bank business areas is the best strategy to achieve structural reinforcement and, therefore, to ensure the soundness of individual banks and the banking system in the medium and long term.

This strategy can be completed by an improvement of efficiency in the various forms of cost, revenue and profit, as this would be in line with the structural premises for sound and viable conditions leading to better frameworks for the economic account from one period of time to another.

Solvency concerns the bank’s  ability to honour its debts at any costs. This, in turn, presupposes the availability of monetary resources during crisis periods. Solvency is measured by the ratio between capital and total deposits or total assets, or better, of assets exposed to risk. The latter concept basically reproposes that of capital adequacy.

The solvency risk concerns the different ability of banks to settle their debts at any cost. Solvency is achieved by means of systematically higher asset values as compared to liabilities, thereby indicating positive levels of the bank’s capital. This highlights the problem of growth of profit and of a bank’s recourse to market instruments in order to develop its capital and its monetary resources and production volumes. The expansion path starts from the  raising of capital and positive performance, which in turn increases sound business and generation of profit.

Capital raising creates premises for solvency, stability, business evolution, business growth in individual banks in Europe and world-wide. Capital raising is inspired by regulation and, at the same time, by supervision. Bank management is conducted through choices concerning the actual current situation and the future situation. Capital represents a key variable in business, but the improvement of risk management and efficiency constitutes the best reply as a means of reinforcing structural conditions for survival. This report aims to investigate these elements in order to express critical issues and critical points for the evolution of individual banks and their business.

On closer inspection, insolvency arises from an excessive risk level, which brings about reductions in value of financial asset portfolios (Johnson, 1993; Kohn, 2004; Saunders, Cornett, 2008). This testifies to a problem of appropriate choices for risk identification, measurement and control, as well as the need to minimise the impact on a bank’s  capital and to ensure its survival on the market.

Maintenance of solvency presupposes management choices based on appropriate principles of rigour and, above all, on accuracy in credit risk assessment. It is also necessary to ensure the creation of a loan portfolio which, over time, will prove capable of restoring and renewing cash flow, together with the ordinary cash flow arising from interest collection.

Solvency has close links to liquidity because the sources of liquidity arise from assets, liabilities and  off balance sheet items (OBSIs)  and from the costs and revenue trend, because the sources of solvency are directly affected by asset and liability values and by achievement of profit.

Solvency is also linked to management of the other risks, as their impact influences the economic outcome and leads to fluctuations in the value of assets and liabilities. Raising capital will be able to offset  the solvency at a given time and not in the medium and long term. Therefore regulatory and supervisory authorities require capital  to protect the bank from insolvency, which is measured at a given time period.  Evolution of competition, inputs, output, costs and revenue allow banks to create conditions in which the level of capital may not be inadequate for the evolution of economy.

Increasing capital constraints by regulation and supervision stresses the use of capital in order to solve bank problems: is this a rational approach or should it be investigated more deeply? Capital constraints should be able to mitigate the insolvency risk, but this is only a quantitative solution in order to absorb  losses which have been generated by bank management.

Raising capital usually implies a deterioration in asset values and costs and revenue, attributable to poor quality in corporate governance as well as in risk management and efficiency.

 It is important to stress that improvement in risk management and efficiency represents the structural conditions that are necessary to recreate the premises for a shift towards positive trends in costs and revenue and, at the same time, in the evolution of assets, liabilities and capital. This is the key point to pursue in the evolution of management conditions through European banks.

Raising capital is the most widespread regulatory and supervisory measure concerning banking intermediaries in the evolution of banking systems in Europe. In what direction will banks evolve  after the raising of capital? The future of a well capitalised and well managed bank will be less unstable and less unpredictable than that of a poorly capitalised and badly managed bank. Competition can create growth problems for production volumes, reducing the basis for the bank’s profit. Raising capital will change the dividend distribution and, at the same time, the distinction between the pay-out ratio and the retention ratio: profit will thus be split into the part  for distribution  and the part for retention.

In this context, supervisory authorities should create an organisation unit for monitoring the level and evolution of capital absorbed by individual banks in Europe and the number of capital procedures to reinforce the bank capital. The greater the number of procedures for raising capital and the more frequent the recapitalisation, the more serious the problems of individual banks are likely to be. This is a sign of intrinsic weakness of the individual bank, and the raising of capital imposed by regulation and by supervision in different time periods can be considered the clear signal. The problem, however, is the wasting of capital which can be measured only in the case of problems, crises or failures incurred with bank  exits from the market.

Raising the level of capital and improving risk management and efficiency allow individual banks  to achieve structural and solid reinforcement overtime: the bank will be more solid and thus better able to offset adverse events and stay on the market. This is a purely statistical observation, which is important but at the same time is not sufficient to grant insight into the genuine current status and  future evolution, as capital plays a crucial role for  banking business strategies.

Turnover of loans can be high or slow: in the former of these two cases it has a good impact on liquidity, in the latter case it has a bad impact on liquidity, underlying the relative strategies to set up. It is important to pursue an adequate level of turnover in order to obtain a genuine impact on liquidity and management of the individual bank.

4.In this framework, capital management is designed to encourage the growth of available resources, reinforce the bank’s business wealth and ensure respect for adequacy criteria. Its development and management constitute a premise for solvency and profitability.

   Bank financial structure rests to a large extent on indebtedness, rather than capital. The following types of indebtedness can be distinguished: short-term, medium-term or long-term maturities, fixed or indexed interest rate and the consequent financial charges that reduce the level of profits; the bank’s capital, on the other hand, is characterised by indeterminate maturity, an oscillating rate of return and dividends that affect the distribution of profits.

The peculiarity of bank financial structure is associated with the trust and reputation acquired on the market. The acquisition of trust and reputation facilitates the issue and placement of banks’ liabilities: accordingly, indebtedness may rise considerably to high levels. Changes in the financial structure and, therefore, the utilisation of instruments involving debt and capital respond to different needs on the part of the public: essentially, these divergent needs involve insufficient – or, alternatively, a vast quantity – of information concerning business areas.

The strategic role of capital arises from the protection awarded to depositors and purchasers of liabilities in the hypothesis of failed repayment of credits, which would reduce the value of a bank’s assets and could lead to its insolvency and bankruptcy, since there exist well-known problems of adverse selection and moral hazard that can generate negative outcomes and ensuing chain reactions.

Capital is regarded as the bulwark of the stability and solidity of commercial banks for three fundamental reasons: absorption of fluctuations in value of the assets; stabilisation in the sources of financing; absence of contractually established remuneration constraints (Berger, Herring, Szegö, 1995; Pecchioli, 1987; Pringle, 1974; Taggart, Greenbaum, 1978).

Differences among risks, when the latter are related to different business areas, lead to unequal requirements as regards capital and processes aimed at increasing capital within banks (Lindquist, 2004). Information asymmetries, the extent of available instruments, the danger of massive and rapid requests to convert deposits into money must be taken into account when a bank seeks to identify the suitable level of capital.

A capital increase creates the premises for development of intermediated and productive volumes, providing positive influence on the formative process of the profit and loss account. Furthermore, the increased incidence of capital versus liabilities reinforces the degree of solidity of the bank’s financial situation and, therefore, the solvency of  individual banks.

The increase in capital and available resources is reflected in the effects on investments, regarding especially  investment in new technologies.

With regard to commercial banks, for a medium and long time period horizon there exists a direct relation, as can easily be noted, between the expansion of capital and that of loans.  This progressively enhances available resources, and also ensures protection of buyers of liabilities (Gunther, Moore, 1993; Moore, 1992).

The increase in capital is linked to the following aspects: retention of profits for reserve formation, placement of shares on the market, and creation of subordinate liabilities.

In screening and monitoring concerning the range of loans, the bank aims to encourage the size development of companies and, at the same time, to create the premises for economic growth. By granting loans to reliable clients, the bank pursues its own interests but also pursues the general interest consisting in the reinforcement of enterprises which, more than others, contribute to economic growth while maintaining solid bases for the future.

In European banks, capital is a tool used very frequently by regulatory and supervisory authorities essentially with the aim of creating a protection against bad events and negative impacts on the economic account. Raising capital is useful but at the same time creates remuneration problems and investment problems.

Therefore the “walls”  against bad events should be able to provide safety  and soundness for just a period of time.  Changing production and distribution processes, rationalising   costs and revenue and profits  leading to best practices of risk management  and  efficiency constitute the true and real tools to activate for restoring  and improving the internal conditions of individual banks and, as a consequence, of the  banking system.

Banks in Europe have a loan portfolio distinguished by good loans and bad loans. The good loans create turnover and, at the same time, return rates; in contrast, bad loans create problems for repayment in capital and interest. Increasing deterioration worsens the economic conditions and liquidity conditions of the bank.

 

5.An adequate level of capital is necessary according to the regulations (Basel I,  II, III and forthcoming IV) and in the supervisory framework: the former represents the prudential line while the latter (i.e.the supervisory framework)  is in the discretional line. Prudence versus discretion: two different and  opposite views create capital constraints and therefore contribute to the level of  bank’s  capital.

Regulation imposes capital constraints by establishing capital coefficients for their achievement and respect through time periods (prudential view). Supervision intervenes generally when critical adjustments are necessary (discretional view). Whereas regulation is operational, reflecting changes through time, supervision is operational from time to time, checking the asset and liability values and costs and revenue  trend of the given bank and, if necessary, making the decision to intervene. There is a remarkable point that should be emphasised: the time lag between the origin of the critical situations and the supervisory decision to impose the raising of capital is usually too long for several reasons, and this interval of time leads to deterioration in bank values.

Therefore, the level of bank capital is the final result of free choices, regulatory constraints and supervisory constraints. The free component involves a very restricted area as an individual decision: is this bureaucratic procedure underlining a rational approach? This is not clear and it appears to be based on a plurality of bodies and on a plurality of calculations with reference to the composition of the risk-weighted assets (RWA) and the off  balance sheet items (OBSIs).

Available details seem to testify to the complexity and bureaucratic approach to distinguishing between banks with low or adequate level of capital. Credit risk and  solvency risk are important in order to estimate capital needs for the present and future time. Therefore, the level of capital is a crucial variable for the business areas, as well as for the lending and investment process and development of the bank in question. Strategic and operational choices contribute to achieving good or bad results according to the professional skills and capacity of the management and the reactions of competition and  markets.

The application of Basel III and the forthcoming Basel IV are inspired, as in the past, by prudential logic stressing progressive corrections and inadequacies in regulatory measures in the EU. Basel III has introduced higher and better levels of capital, in the framework of risk-weighted assets, and, at the same time, the liquidity risk and the leverage to be implemented progressively over time. It can thus be regarded as based on a prudential approach.

It does not exclude additional capital corrections for the banks which are subject to AQR, stress tests, on-site inspections and  the SREP evaluation carried out by the supervisory unit at the ECB Accordingly, this can be regarded as adopting a discretionary approach which highlights overlapping and excessive regulations, and uncertainties for banks in the EU.

The transition to Basle III and recent additional steps show that the previous Basle I and Basle II regulations proved to be inadequate and unable of preventing the birth and the effects of subprime mortgage financial crisis and sovereign debt crisis in Europe, which produced serious repercussions on financial stability and economic growth.

The application of Basel III implies compliance with capital requirements indicated as equal for all banks and checked and reformulated in several cases by the supervisory authorities through additional corrections, thus increasing the impact on capital.

Balance sheet assets and off-balance sheet items, even when classified, are considered for subsequent evaluation and inclusion in the denominator for the capital requirement calculation.

Ratings are used to assess the credit-worthiness of borrowers who approach a bank and become customers. The application of ratings leads to the creation of different classes and different weighting coefficients, ranging from low values for not particularly risky loans to increasingly high values for risky loans, raising capital requirement differences.

The risk-based approach postulates the subdivision of the loan portfolio into different classes. For each class or class set, rating intervals are identified, which imply the application of increasingly high weighting coefficients upon the worsening of the associated rating interval.

Thus the loan portfolio is split into different classes and class sets for the internal application of percentage weighting coefficients on the basis of rating assignments.

The bank’s choices should be set according to rigorous principles, selecting the best customers for their positive effects on the credit risk, the lightest impacts on capital absorption and, therefore, the best stimulations for intermediated and production volumes.

Therefore, with equal rating interval, the uniform coefficient approach does not take into account this non-homogeneity in loan diversification which is often important for the resulting credit loss effects and the consequent impact on the economic account and on capital.

The types of capital ratios, and adherence thereto, sometimes necessitates a forcing in management choices. Their imposition has spread in various countries, mainly aiming at stability through internal reinforcement in crisis situations.

Taking a closer look, capital ratios neither eliminate nor lower corporate risks, which may even suffer increases; they merely create the premises for the reduction or elimination of losses occurring in negative events. This is a crucial point: regulatory and supervisory capital requirements do not contribute to shifts or reductions in the level and range of bank risks but create the resources for more greater absorption of losses in negative events. Therefore, bank survival relies on the financial operators’ skills and professional capacity for rationality and sound risk management over time.

Capital ratios meet the need for prediction and allocation of an adequate level of capital, essentially with regard to negative impacts and losses caused by credit, market and operational risks. Capital is considered the main aid to commercial banking stability and solidity for three reasons: absorption of asset value fluctuation, stabilisation of financing sources and absence of contractual remuneration constraints (Berger, Herring, Szegö, 1995; Pecchioli, 1987; Taggart and Greenbaum, 1978; Pringle, 1974).

The main target for supervisory authorities, distinguishing between the significant banks, as examined by the supervisory unit at the ECB, and the less significant banks, as examined by the national competent authorities, is the setting of higher capital levels in relation to higher risk levels of financial instrument types, thus reducing the incentive for moral hazard. However, the effects of capital ratios on moral hazard are not entirely uniform, diverging according to the theoretical model followed.

Real guarantees, personal guarantees, credit derivatives and balance sheet compensations stress credit risk mitigation and, thus, benefits  for the estimation of capital requirements.

Capital coefficients imply the calculation of ratios between the regulatory capital and balance sheet asset and off-balance sheet item types, appropriately risk-weighted. The total capital used is greater than the strict capital account, including not only the real capital but also any subordinated debts, as the latter are bound to periodical remuneration, and subject to repayment obligation.

The standardised model on credit risk postulates the partition of balance sheet assets and off-balance sheet instruments into classes for the application of the weights established by the regulatory authorities, in the same way for all banks.

The reactions and behaviour of individual banks differ widely. These distinctions are weakly justified by the uniform and generalised capital ratio application for issues, due to the lack of assessment for each instrument on the portfolio risk, and also to the identical weight assigned to different loans within the same class.

It also follows that the results achieved are the outcome of initial starting situations which postulate different levels of capital and different levels of composition of business areas and related instruments.

Each class incorporates diversity in its instruments and in the composition of customers, but this also gives rise to risk differences. In addition, the degree of correlation between different asset instruments is not taken into account, ignoring the postulates of diversification (Grenadier, Hall, 1996; Santomero, 1991; Shaefer, 1987).

The different capacity of individual banks to create a diversified lending portfolio is not taken into account (Colombini, 2008). An ideal system should consider the increase in risk to the portfolio arising from the introduction of assets instead of limiting itself to a mere capital addition. Thus  the risk associated with different financial instruments should be correctly appreciated.

Even individual banks’ capacity to select and monitor loans to customers is neglected, despite the existence of differences in methods and choices which influence the concrete risk of each individual loan and of the portfolio as a whole. A uniform coefficient application does not take into account these differences in risk screening and risk monitoring, which often prove to be fundamental in the subsequent credit loss and consequent impact on the economic account.

In the framework of the theory of information asymmetries, the position of individual bank intermediaries for news and data collection and in the production of information is necessarily very different. Accordingly, higher or lower costs will be involved. The creation and archiving of data on customer relations, as well as bank capacity to produce information and the related costs,  reflect the  strengths and weaknesses in comparison and  competition with other similar intermediaries.

Therefore classes are rather broad; they do not take into account the existence of diversification, nor the benefits of methods of screening and monitoring; furthermore, they present substantial static elements and are essentially set up for the creation of conditions of control performed by supervisory authorities.

At the base of the internal models there is the value at risk (VaR), which constitutes the maximum potential loss affecting a portfolio of financial instruments in a precise time interval, calculated assuming a determined probability. VaR considers the impact of the variations in market factors on the value of each single financial instrument, such as interest rates and exchange rates.

The internal model on credit risk introduces internal ratings for the appreciation of balance sheet assets and off-balance sheet items. This model reflects evaluations and calculations from individual banks and makes it necessary to obtain the approval of supervisory authorities.

The internal model presupposes individual banks’ best capacity for risk appreciation and management, in comparison with the standardised model, drawn up and imposed by the supervisory authorities. The problem lies in the trade-off evaluation, between setting and realisation expenses, together with consequent capital constraints on one side and benefits inherent in the best risk management on the other.

The various Basel I, Basel II and Basel III and forthcoming Basel IV rules aim to increase the compliance costs of individual banks while disregarding the fact that banks differ greatly between small and medium banks in comparison with the largest  banking institutions. The issue for banks is the use of rational and rigorous methods for the management of business areas and correlated risks, from the viewpoint of producing profits in the short, medium and long term. The establishment of more and more rules introduces greater complexity in bank regulation and, at the same time, increases compliance costs. Therefore a comparison of costs and benefits arising from the introduction of regulation should be performed.

The habitual focus on increasing capital is not the correct approach, because it makes use of a unitary attitude, i.e. the “one size fits all” approach (Bliss, 1995) to banks which are profoundly different in their business areas and risk range. Rules essentially consider a loss coverage issue through an adequate capital level, and this is a very different matter from the actual ability to manage the entire risk range.

Increasing the number and complexity of rules tends to introduce further complications in the task of supervision, but the main aim of supervision is still that of checking and ensuring control over the application of the rules in European banks. A banking crisis requires supervision initiatives which usually involve the raising of capital as a standard approach to build up a “wall” against the worsening or failure of the situation of a bank.

Therefore supervisory capital constraints, together with regulatory capital constraints, imply a reduction of the capacity to lend to the economy, and do not introduce improvements in risk management.

Quantitative data should be gathered and updated over time on banks that are experiencing a period of difficulties, or which are undergoing supervisory imposition of capital. Records should also be kept with regard to the time periods involved, in order to trace recurrent events and, potentially, to predict which banks are likely need new capital again in the future and which banks will improve and achieve stability. The repetition of supervisory capital raising from time to time for the same banks is an adverse phenomenon, as it points to survival by capital raising and  unstable internal conditions. Such a situation is a signal of poor quality  management.

Therefore, the supervisory measures are unsatisfactory  and do not represent definitive solutions for banks in trouble; furthermore, in no way the issue of the lack of internal capacity for adding new resources to improve the quality of management is taken into consideration.

In a medium and long time perspective, a correspondence between capital erosion and bad management will become evident. Thus macro supervision will highlight the problem of “wasting capital” and the absence of ultimate solutions. Moreover, building up and checking quantitative data at the central level of the ECB for significant banks and the national level of NCAs for less significant banks will provide insight into the evolution of the European banking system.

For instance, during the period from 2010 to 2017, Deutsche Bank achieved four capital increases, raising around €30 billion (Sole 24 Ore – Finanza e Mercati, 7^th April 2017). It is very clear the massive and repeated recourse to the capital market with the aim to resolve situations of loss, and therefore, the fundamental data constituted by the need to restore physiological conditions with significant increases of capital, indicating a problem of wasting capital and, at the same time, highlighting that the problem lies in the need for an internal restructuring process that reduces costs and increases revenue for a short- and long-term rebalancing. Otherwise the structural problem remains, and capital increases will temporarily restore oxygen to a bank which has critical issues, raising risks of financial instability and systemic risks of considerable proportions, even if the geographical location is in Germany.

It is worth pointing out that this example is certainly not an isolated case. Often, there are problems linked to the revision of business models, production, distribution, costs, revenue and profits in the context of European banks, assuming complementarity and interaction between the bank and the management in the direction of improvement and strengthening of risk management and increasing efficiency at different levels.

Supervision is characterised by gathering and analysing information, checking bank evolution, drawing up an assessment on the bank. The result can be expressed in the overall SREP which reflects the supervisors’ overall assessment on the bank’s viability. The SREP is built up on quantitative and non-quantitative requirements: the principle applied is that an increase in risk should be matched by the raising of capital in banks involved.

The most important issue for a bank is the accurate and rational ability to identify, measure and manage the entire risk range, in a manner closely related to the bank’s business areas. Attention  should focus on instruments for a positive impact on profit production and on simple and risk-adjusted performance indicators.

The creation of the banking union and the experimental ECB asset quality review (AQR) concerning significant European banks lay the foundations for uniform analysis and modes of risk assessment ways for banks in Europe.

The Single Supervision rule postulates control over bank capital ratios on the basis of Basel III and the forthcoming Basel IV application, and control over economic, financial and capital trends. Problematic situations are monitored as soon as difficulties become evident, from their initial phase onwards, the development of an asset quality review also plays an important role, together with stress tests and the SREP as an overall indicator for identifying weaknesses, poor initiatives and bad practices.

However, the ECB alone cannot create strong premises for economic development in Europe. Political choices are necessary in order to move towards structural economic reforms in the short term, to be followed by much more solid integration, removing all sources of uncertainty affecting finance and economics (Andenas and Supino, 2015; Capriglione, Sacco Ginevri, 2015; McCormick, 2015).

In this framework, the performance considers the results achieved in different business areas. It examines the construction and analysis of a series of financial, capital and economic indicators, and in particular, the focus on profits.

The contraction in net interest income drives bank intermediaries to reinforce their non-interest income through a larger range of products. This causes an extension in instruments and business areas, and the consequent increase in risk range and mutual interrelations.

Responsibility for bad or good results is attributed to administrators of the bank. Therefore, in a crisis or bank-failure event, the responsibility falls primarily on the administrators, especially at the high bank levels, who are responsible for decision-making and choices regarding instruments, bank business, bank areas and risk management. Thus a sort of automatism should be introduced in the application of financial penalties on the administrators by the supervisory authorities, especially at the top level of the bank in question, who should be instructed to “fix” the damage on the basis of new and more severe rules in the event of crisis or bank failure. They should be very clearly aware of the warning signs and of initiatives to prevent or offset the worsening of bank situation.

   Due to the fact that recent financial crises have dramatically focused attention on the adverse  impact of bank crises on banking, and on the economy of crises and failures in the banking context, a tool against any morally hazardous behaviour is required. In this context, the new proposal concerns the creation of various precautionary funds fed through a percentage of administrators’ high salaries, to be used in the event of crisis or bank failure, and to be returned in the event of no crisis or bank failure. Administrators, especially at the top level, are always held responsible for crisis or failure; and therefore the bail-in should have a more serious and more incisive effect on the category in question.

   Also necessary is a complete revision of corporate governance bank models, as well as a turnover of top management, raising the level of professional competence and capacities with the introduction of operators capable of accurately evaluating the risk-return relation in the medium and long term.

6.Capital raising for satisfying regulatory and supervisory capital requirements contribute to increasing the capital level and therefore the absorption capacity in the event of unexpected losses. A higher level of capital will be able to handle negative economic results, and bank survival: solvency can be measured at given times.

Improving  risk management and efficiency allows banks to achieve  structural conditions to recreate positive premises towards positive trends in costs and revenue and, at the same time, in the evolution of assets, liabilities and capital. This is the key point to pursue in the evolution of management conditions within European banks and within world banks.

There is a relationship between risk management and efficiency: improving risk management allows creation of the best conditions that will lead to bank efficiency, as it implies costs’ reductions and, in good experiences, revenue’ increases and, consequently, a more effective reshaping of costs and revenue in the composition of the profit and loss account. This means that improved risk management can be considered as a good premise for improving both bank efficiency and the bank’s soundness and survival capacity. Additionally, an increase in bank resilience will enable a  bank to reinforce its efficiency and economic account, moving from one position to another along a path of modernisation of business models with upgraded production and distribution conditions. These improvements  constitute indicators of better survival capacity.

Capital raising can be useful to satisfy the need for solvency risk measurement at a given time; on the other hand, when moving through time periods the situation can change within a short or medium length of time, recreating adverse economic results.  In particular, the capital problem may reappear, creating a vicious circle in which both capital need and capital “wasting” will be intensified.

 As an example, regulatory authorities could allow the efficient banks, especially on the plane of X-efficiency with high quality management, to benefit from greater flexibility on capital leverage. As another example, regulatory authorities could allow efficient banks with high quality loan screening and monitoring procedures to benefit from more flexible capital requirements. Uniformity in capital ratios will not, in itself, create conditions for excellent screening and monitoring methods and the application of  the “one size fits all” is not adequate for modern times. Therefore changes, incentives and competition constitute lines for reshaping regulation in Europe. They are inspired by the two fundamental lines of change, namely risk management and efficiency.

The extensive presence of NPLs in banking due to financial crises and related economic recessions has generated the credit crunch towards enterprises, especially those of small and medium size. Accordingly, the possibility of progressive reduction of NPLs, at economic conditions, is being explored,  essentially by means of loan sales and bad bank creation. This would make it possible to move towards  more favourable conditions for loan granting and economic development.

Quality criteria for risk analysis and evaluation, and, especially, for credit risk assessment  through asset quality review, stress tests, on-site inspections and SREP assessment carried out by the ECB Banking Supervision over European banks, are of notable importance. The SREP assessment  considers and evaluates the following aspects: the business model, governance, risk management, risks to capital, risks to liquidity. The overall SREP score reflects the supervisor’s assessment  of the bank’s viability.

It is particularly important to make progress in supervisory cooperation between the ECB and the NCAs for improvement of performance in supervision of large banks, but even more so with regard to the supervision of small and medium sized banks, as these constitute the back-bone of the banking system in terms of the number involved across Europe.

The information is gathered and implemented at different national levels, and ensuring uniform criteria will not be easy, especially since different methodologies and different practices were used in the past as compared to the present-day set-up. The building of a ground of uniform principles requires hard work to be done in conjunction with supervisory authorities at a central level and at  a national level. Without appropriate coordination, medium and small banks in different countries will be supervised and treated in different ways by NCAs whose operators differ in skills and competences.

As it is unable to create the premises for a sound and stable bank in the future time, looking at only the capital level is misleading. Improving risk management through the identification, measurement and management of all risks linked with bank instruments and bank business areas is the best strategy to achieve structural reinforcement and, therefore, to ensure the soundness of individual banks and the banking system in the medium and long term.

This strategy can be completed by an improvement of efficiency in the various forms of cost, revenue and profit, as this would be in line with the structural premises for sound and viable conditions leading to better frameworks for the economic account from one period of time to another.

The following issues can be taken into  consideration in order to complete the broad picture of capital management. Firstly, capital level is necessary to offset the solvency risk at a given time in a bank. Secondly, improving risk management and efficiency is the key issue in order to create structural premises for a bank positive evolution and performance in the future time. Thirdly, residual toxic assets in European large banks from the subprime mortgage financial crisis still constitute a weak factor in order to achieve profits. Fourthly, political choices in the economic and financial field which take into account the importance of the timing of their adoption and consequent impact which, even if considered positive, is less effective in the presence of indecision and uncertainties.

 Therefore, the crucial point is the  setting up of better internal conditions and premises for reinforcing the economic  performance and the banks’ resilience in the medium and long term.

 

 

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Author

Fabiano Colombini is Full Professor of Economics of Financial Institutions and Markets, University of Pisa. E-mail: fabiano.colombini@unipi.it