The Application of Macroprudential Capital Requirements in Managing Systemic Risk

Complexity, Jan 2018

When setting banks regulatory capital requirement based on their contribution to the overall risk of the banking system we need to consider that the risk of the banking system as well as each banks risk contribution changes once bank equity capital gets redistributed. Therefore the present paper provides a theoretical framework to manage the systemic risk of the banking system in Nigeria based on macroprudential capital requirements, which requires banks to hold capital that is proportional to their contribution to systemic risk. Using a sample of 10 Nigerian banks, we reallocate capital in the system based on two scenarios; firstly in the situation where the system shocks do not exist in the system, we find that almost all banks appear to hold more capital; secondly, we also consider the situation where the system shocks exist in the system; we find that almost all banks tend to hold little capital on four risk allocation mechanisms. We further find that despite the heterogeneity in macroprudential capital requirements, all risk allocation mechanisms bring a substantial decrease in the systemic risk. The risk allocation mechanism based on ΔCoVaR decreases the average default probability the most. Our results suggest that financial stability can be substantially improved by implementing macroprudential regulations for the banking system.

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The Application of Macroprudential Capital Requirements in Managing Systemic Risk

The Application of Macroprudential Capital Requirements in Managing Systemic Risk Hong Fan, Chirongo Moses Keregero, and Qianqian Gao Glorious Sun School of Business and Management, Donghua University, Shanghai 200051, China Correspondence should be addressed to Hong Fan; nc.ude.uhd@nafgnoh Received 4 July 2017; Revised 15 December 2017; Accepted 21 December 2017; Published 22 January 2018 Academic Editor: Ahmet Sensoy Copyright © 2018 Hong Fan et al. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. Abstract When setting banks regulatory capital requirement based on their contribution to the overall risk of the banking system we need to consider that the risk of the banking system as well as each banks risk contribution changes once bank equity capital gets redistributed. Therefore the present paper provides a theoretical framework to manage the systemic risk of the banking system in Nigeria based on macroprudential capital requirements, which requires banks to hold capital that is proportional to their contribution to systemic risk. Using a sample of 10 Nigerian banks, we reallocate capital in the system based on two scenarios; firstly in the situation where the system shocks do not exist in the system, we find that almost all banks appear to hold more capital; secondly, we also consider the situation where the system shocks exist in the system; we find that almost all banks tend to hold little capital on four risk allocation mechanisms. We further find that despite the heterogeneity in macroprudential capital requirements, all risk allocation mechanisms bring a substantial decrease in the systemic risk. The risk allocation mechanism based on ΔCoVaR decreases the average default probability the most. Our results suggest that financial stability can be substantially improved by implementing macroprudential regulations for the banking system. 1. Introduction The downfall of Lehman Brothers in mid-2008 unveils that the modern financial system was extremely fragile. The financial system deteriorated due to the distress and in some cases failure of important institutions, leading to further distress and the spread of shocks to the real economy [1]. The crisis emphasizes the need of identifying the underlying factors that destabilize the financial institutions, which could result in systemic risk. Bisias et al. [2] have defined systemic risk as the risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences on the real economy. Systemic risk is created endogenously within the banking system due to banks’ common exposures to macroeconomic factors and propagated through interbank connections (contagion); thus systemic risk encompasses two aspects which are basic and contagious defaults. To deal with the systemic risk better, the financial stability board has pinpointed the need for a macroprudential approach to financial system analysis. Researchers like Galati and Moessner [3], Cerutti et al. [4], Ebrahimi Kahou and Lehar [5], Lehar (2005) [6], and Hanson et al. [7] argue that macroprudential policy is aimed to mitigate the systemic risk and reduce its aggregate cost for the real economy; thus the bank regulation should be designed on macroprudential perspective so as to downsize the amount of systemic risk. On the other hand, Basel III requires a capital conservation buffer in normal times consisting of a further amount of core Tier 1 equity capital equal to 2.5% of risk weighted assets. This provision is designed to ensure that banks build up capital during normal times so that it cannot be affected when losses are incurred during periods of financial distress. Therefore it is much easier for banks to raise capital during normal times than during periods of stressed market conditions. In a situation where the capital conservation buffer has been wholly or partially used up, banks are required to constrain their dividends until the capital has been replenished. However, the bank regulators in some countries require banks to hold more capital than the minimum specified by the Basel Committee and some banks themselves have a target for the capital they will hold that is higher than that specified by their bank supervisors. In a banking system both the overall risk and each bank’s contribution are endogenous and hinge on the banks’ equity capital. This means that as banks hold more capital the probability of default through either direct losses or contagion is less; therefore redistributing bank capital changes the banks’ default probabilities, overall risk of the banking system, and each bank’s risk contribution. In this work we investigate one regulatory mechanism that is macroprudential capital requirements that require each ba (...truncated)


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Hong Fan, Chirongo Moses Keregero, Qianqian Gao. The Application of Macroprudential Capital Requirements in Managing Systemic Risk, Complexity, 2018, 2018, DOI: 10.1155/2018/4012163