Effect of Capital Regulation on Bank Investment Strategies and Systemic Risk

Project Start: 04/2016
Status: Completed
Researchers: Rainer Haselmann, Deyan Radev, Vikrant Vig
Category: Financial Intermediation
Funded by: LOEWE

Topic & Objectives

The stricter regulatory changes in the last decades were targeted not only at reducing the risk of individual banks, but also at increasing the safety of the overall financial system. One of the main novelties of the new regulation is the introduction of mandatory capital surcharges to cover banks’ trading activity. The model-based regulation of market risk introduced in 1996 under Basel I became an integral part of the Basel II Accord. It gave banks the choice between two approaches – a standard approach (SA), with a fixed capital requirement and an internal models approach (IMA), with a capital requirement that corresponds to the value-at-risk (VaR) of the trading portfolio within a certain time period. In an amendment to the Basel II Accord, the Basel Committee introduced an additional component to the capital surcharge for IMA banks, called Stressed VaR. This component represents a substantial increase in the capital requirements if banks actively trade on the capital markets. The question arises, how the new rule affects banks’ investment strategies and whether it could lead to an increase or a decrease of systemic risk. This project aims at answering these from a regulatory perspective important questions.

The project comprises two parts. First, using Deutsche Bundesbank’s Securities Statistics database, we investigate whether German banks changed their investment strategies by observing the composition of their trading portfolios before and after the introduction of the stricter regulation. The aim is to gauge whether the new regulation leads to more or less diversified bank trading portfolios. The second part tests whether investments in the same or similar asset classes have led to an increase in the correlation between portfolios across banks. In this case, a rear event would affect all banks and hence, the correlated investments pose a risk for the whole financial system (Acharya, 2009; Acharya et al., 2014).

Key Findings

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    Initial project results already have been presented at various conferences.

  • The research in a following project, however, should focus not on investment strategies in general but on market making activities by banks only.

 

 

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