國
立 政 治 大 學
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N a tio na
l C h engchi U ni ve rs it y
1. Introduction
The Global Financial Crises during 2008-2009 results in great damages to the financial system stability over the world, which raises a question about the adequacy of financial liberalization. Financial liberalization has led to financial deepening and higher growth in several countries from the history. However, it has also led to a greater incidence of financial crises, such as excess risk taking, higher macroeconomics volatility, and the financial contagion. Among all these phenomena, the financial contagion is of the greatest emphasis because of its property to expand the regional financial shocks to other regions and finally affect the entire system.
Therefore, to figure out the characteristics the contagion and develop a preventive regulation from the policy maker’s view become the main purposes for our study.
In this paper, we discuss two important issues regarding the financial contagion.
The first one is about the financial contagion itself. What causes the contagion to happen? A commonly held view of financial crises is that they begin locally, in some region, country, or institution, and subsequently “spread” out to elsewhere. This process of the spread out is often referred to as “contagion”. What might justify contagion in a rational economy? There are two broad classes of explanations. The first class of explanations thinks that the adverse information that precipitates a crisis in one institution also implies adverse information about the other. This view emphasizes correlations in underlying value across institutions. A second type of explanation begins with the observation that financial institutions are often linked to each other through direct portfolio or balance sheet connections. For example, entrepreneurs are linked to capitalists through credit relationships; banks are known to hold interbank deposits. While such balance sheet connections may seem to be
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desirable at the first sight, during a crisis the failure of one institution can have direct negative payoff effects upon stakeholders of institutions with which it is linked.
Here we adopt the settings of Allen and Gale (2000) as our fundamental model, which is based on the assumptions of the inter-bank claims and the incomplete market structure. Because the liquidity preference shocks are imperfectly correlated across regions, banks hold interregional claims on other banks to provide insurance against liquidity preference shocks. When there is no aggregate uncertainty, the first-best allocation of risk sharing can be achieved. However, this arrangement is financially fragile. A small liquidity preference shock in one region can spread by contagion throughout the economy. The key here is that the possibility of contagion depends strongly on the completeness of the structure of inter-regional claims.
The second one is about the regulation method. According to Jean Charles Rochet (2008), the safety and soundness regulatory instruments used in the banking industry could be classified into six broad types: 1. Deposit interest rate ceilings, 2.
Entry, branching, network, and merger restrictions, 3. Portfolio restrictions, 4. Deposit insurance, 5. Capital requirements, 6. Regulatory monitoring and supervision. In this paper, we emphasize on the role of capital requirement, which is the key focus of the Basel Accord since 19981.
The Basel Accord set a simple standard for harmonizing solvency regulations for internationally active banks of the G-10 countries. It requires that banks meet the minimum capital ratios of 4% tier 1 capital2 and 8% tier 1 plus tier 2 capital to risk-weighted assets by the end of 1992. However, it is criticized for taking too
1 The Basel Accord, elaborated in July 1988 by the Basel Committee on Banking Supervision (BCBS), required internationally active banks from the G10 countries to hold a minimum total capital equal to
2 Tier 1 capital consists mainly of common stock and some perpetual preferred stock.
Tier 2 capital includes preferred stock, subordinated debt, and allowance for loan losses. In calculating risk-weighted assets, assets are classified into 4 risk-weight categories: zero percent, 20 percent, 50 percent, and 100 percent risk-weight category.
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profession, the Basel Committee on Banking Supervision announced the Basel II which relies on three pillars: minimum capital requirements for credit risk, supervisory review of an institution’s capital adequacy and internal assessment process, and effective use of market discipline as a lever to strengthen disclosure.However, since the global financial crises in 2008, the existing system of Basel II has been reviewed and questioned. Finally, at the Seoul G20 Leaders summit in November 2010, the Group of Governors and Heads of Supervision announced a substantial strengthening of existing capital requirements. The Committee's package of reforms increased the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress, which brings the total common equity requirements to 7%. This reinforces the stronger definition of capital and the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011. What's more, the countercyclical capital charge and forward-looking provisioning method were also raised to deal with the procyclical risk-taking problem among the banking system. The comparison of Basel II and Basle III is showing in
Core Tier 1 Capital Ratio (Common Equity
after deductions) = 4.5%
3 Resource from "Basel III: A global regulatory framework for more resilient banks and banking systems", 2010, Basel Committee on Banking Supervision.
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requirement can be met with Tier 2 capital.
Capital Conservation
Buffer
No regulation Banks will be required to hold a capital
conservation buffer of 2.5% to withstand
future periods of stress bringing the total
common equity requirements to 7%.
Capital Conservation Buffer of 2.5 percent, on top of Tier 1 capital, will be met
with common equity, after the application of deductions.
Countercyclical
Capital Buffer
No regulation A countercyclical buffer within a range of
0% – 2.5% of common equity or other fully
loss absorbing capital will be implemented
according to national circumstances.
Banks that have a capital ratio that is less than 2.5%, will face restrictions on
payouts of dividends, share buybacks and bonuses.
Referred to the structure of the Basel arrangement, here we considered the capital requirement (k) to the original Allen and Gale model in order to discuss whether the mandatory capital regulation can effectively reduce the liquidity risk over the banking system and further prevent the bank runs from happening. In our model, the capital requirement k is the capital amount per unit of deposits the banks hold, which can be seen as the owner’s capital. The stockholders can only be rewarded in the long term, that is, we assume the stockholders have a low time preference and value the consumption at date 2. This will alter the form of the feasibility constraint.
Here, the cost of capital, , plays an important role in our model. The relationship between and R, the return from investing in long assets, has a significant meaning
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國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
over the effectiveness of the regulation. We’ll discuss the relationship in full detail in the following chapters.
The rest of this paper is organized as follow. Section 2 we will review some of the related literature regarding the capital requirement, or prudent regulation. Section 3 presents the form of our model. Section 4 characterizes the equilibrium of the model when there is a minimum capital requirement. Section 5 we discuss the welfare issue, and finally in Session 6 we come to the conclusion.