Bank Risk, Governance and Regulation

Elena Beccalli,Federica Poli

• Editore: Palgrave Macmillan
• Anno: 2015
• ISBN:
  9781137530943
• Argomento: Business
• Categoria: Financial Services

This book presents research from leading researchers in the European banking field to explore three key areas of banking. In Bank Risk, Governance and Regulation, the authors conduct micro- and macro- level analysis of banking risks and their determinants. They explore areas such as credit quality, bank provisioning, deposit guarantee schemes, corporate governance and cost of capital. The book then goes on to analyse different aspects of the relationship between bank risk management, governance and performance. Lastly the book explores the regulation of systemic risks posed by banks, and examines the effects of novel regulatory sets on bank conduct and profitability. The research in this book focuses on aspects of the European banking system; however it also offers wider insight into the global banking space and offers comparisons to international banking systems. The study provides in-depth insight into many areas of bank risk, governance and regulation, before finally addressing the question: which banking strategies are actually feasible?

1

Credit Quality, Bank Provisioning and Systematic Risk in Banking Business

Josanco Floreani, Maurizio Polato, Andrea Paltrinieri and Flavio Pichler

1.1 Introduction

Managerial behaviour and accounting policies have a huge impact on corporate earnings and their information content. Reporting of non-performing loans and loan-loss provision (LLP) practices are among the major concerns in the banking industry. Asset quality, exposure to credit risk and provisioning bear great implications in relation to earnings volatility and capital adequacy. Managers may rely on discretionary provisioning as a means of smoothing earnings. While there is a large debate in literature about the incentives to discretionary LLP, there is no doubt that such a practice might hinder the true riskiness of the bank and distort market perceptions. In the same vein, discretionary provisioning may be regarded as a tool for optimizing a bank’s capital.

The aim of this chapter is to investigate the impact of the loan-loss provisioning and other significant credit-risk exposure variables on the banks’ cost of capital proxied by betas. The issue is of great interest for at least three reasons.

The first reason is related to the peculiar nature of banking industry’s business. A chain of influences stemming from the social and economic environment, together with managerial strategies, significantly impact on earnings and exposure to risk. Since banks stand at the heart of the transmission mechanism of monetary policy, they play an important role in spreading or absorbing shocks. The structure of the financial system together with monetary authorities’ policies and the regulatory framework affects banks’ stability more extensively than other financial and non-financial firms. Structural changes in the macroeconomic framework, financial system and political institutions affect the banking business and relations with shareholders.

The second reason is that international competition, differences in the economic cycle and various industrial arrangements might be accountable for differences in the cost of capital across countries. The issue has obvious practical implications in an era when banks across countries are forced to substantially rise their capital bases, both by regulatory requirements and as a result of capital assessment exercises. Within this framework, differences in the cost of capital might alter competition among banks.

The third reason is tightly related to the new proposed EU regulations referring to LLP and non-performing loans reporting. A convergence in reporting standards across European banks is expected to lead to a levelling of the playing field in assessing banks’ stability and the conditions of accessing capital markets. This leads to obvious implications as regards the pricing of risks, eventually overcoming distortions in the allocation of funds across the banking sector.

This chapter makes an important contribution in this field, as there is a lack of literature assessing the impact of LLP on the cost of capital.

Although several studies have individually analysed these two factors, this is the first study trying to evaluate the influence of a particular accounting policy on a risk indicator in the banking sector. Indeed, much of the literature has investigated the LLPs as a tool for income-smoothing to reduce earnings volatility or to manage regulatory capital. But it has not focused on the potential effect on banks’ overall risk.

Furthermore, many studies focus on US banks (Wetmore and Brick, 1994, and Bhat 1996, among others) and emerging markets (Ismail et al., 2005), but only a few of them analyse European banks, mostly investigating single countries, such as Spain or the Netherlands (Pérez et al., 2008; Norden and Stoian, 2013). Instead, our sample includes 59 European banks in 10 countries.

Our study has several implications, in particular considering the change of European regulation on non-performing exposures reporting and forbearance practices, the adoption of the Basel III capital accord and in light of regulators forcing banks to substantially reinforce their capital base.

This chapter is organized as follows. Section 2 provides an overview of bank-manager behaviour and its impact on earnings quality and capital endowments in light of prominent literature. Section 3 defines the theoretical framework with reference to the determinants of betas. Section 4 describes sample, data and methodology. Section 5 summarizes the main results, while section 6 discusses policy implications. Section 7 concludes.

1.2 Literature review

The topic of loan-loss provisions (LLPs) has been broadly investigated in the literature, but a consensus is still lacking on whether bank managers use LLPs for income-smoothing, capital management or with a signalling effect. An important feature of the literature on LLPs is that it is mainly focused on the US banking system, since only in recent years have researchers also started investigating non-US banks. Moreover, there are studies that focus solely on one hypothesis – either income-smoothing, capital management or signalling – and studies that test for all.

Our review is divided into four parts. In the first part we analyse the most important contributions related to the income-smoothing hypothesis only. In the second part we review the studies related to capital management only. In the third part we analyse the literature on both the income-smoothing and capital management hypotheses. Finally, we review the studies on the role of LLPs as signals of the current as well as of the future economic financial situation of banks.

The rationale for the income-smoothing hypothesis lies in the fact that LLPs can be used to reduce the volatility of earnings. The early studies in the income-smoothing literature date back to the end of the 1980s, and the first contributions were those by Greenawalt and Sinkey (1988) and Ma (1988), who find evidence of earnings management in the US banking industry. Greenawalt and Sinkey (1988) use a sample of 106 large bank holding companies for the period 1976–84 and find that bank managers effectively tend to use LLPs to reduce reported earnings through an increase in LLPs when income is high, while they tend to reduce LLPs when earnings are low. Moreover, they show that regional banking companies smooth their income more than money-centre banks. Ma (1988) uses data on the 45 largest US banks in the period 1980–84 and finds strong evidence of bank managers using LLPs to reduce (raise) their earnings when the operating income is high (low). Wahlen (1994) tests the income-smoothing hypothesis on a group of 106 commercial banks for the period 1977–88 and finds that when future cash flows are expected to be positive, bank managers increase LLPs. On the contrary, Wetmore and Brick (1994) find no evidence of income-smoothing practices in the analysed sample of 82 US banks for the 1986–90 period. Bhat (1996) tests the income-smoothing hypothesis for 148 large US banks in the period 1981–91 and finds banks that manage their earnings through LLPs have low growth, low book-to-asset and market-to-book ratios, high loan-to-deposit and debt-to-asset ratios, low ROA and total assets. In other words, income-smoothing is typical of small, badly capitalized banks and those with poor financial conditions. More recently, Kanagaretnam et al. (2003) use a sample of 91 public listed US banks for the period 1987–2000 and find that bank managers reduce current income through LLPs to “save” income for the future when earnings are high and vice versa when current income is low. Liu and Ryan (2006) investigate whether banks’ income was lower during the 1991–2000 period, which covers also the so-called 1990s boom. The results show that profitable banks tended to decrease their income in the sample period using LLPs, in particular on homogenous loans.

In the most recent years, studies also have been conducted for non-US banks. Ismail et al. (2005) base their analysis on a sample of Malaysian banks, including bank-specific as well as macroeconomic factors peculiar to the Malaysian economy. They find that Malaysian banks do not smooth their incomes through LLPs. Norden and Stoian (2013) investigate a group of 85 Dutch banks in the period 1998–2012. They find that banks tend to increase (decrease) their LLPs when their income is high (low), thus giving strong supporting evidence to the income-smoothing hypothesis.

The second hypothesis used to explain the use of LLPs is the need to manage regulatory capital. The changes in regulation at the end of the 1980s may have indeed modified the incentives for bank managers to use LLPs for capital adequacy reasons. This stream of literature can be dichotomized into two categories, pre- and post-1989 capital adequacy regulation. In 1989 the US regulatory agencies changed the capital ratio computation to adhere to the then newly adopted Basel I framework excluding loan-loss reserves from the numerator of the capital ratio. Two main contributions (Moyer, 1990 and Kim and Kross, 1998) focus solely on the capital management hypothesis.

Moyer (1990) finds evidence that prior to 1989 US bank managers tended to increase LLPs to raise the capital ratio and to prevent it falling under the minimum level of 5.5 per cent while, after Basel I entered into force, LLPs were no longer used to manage regulatory capital ratios. Kim and Kross (1998) use a sample of 193 US bank holding companies for the period 1985–92, which is then divided into two sub-periods according to the entrance into force of the Basel I regulatory framework, namely 1985–88 and 1990–92. The results show that banks with low capital ratios used LLPs in the 1985–88 period more than in the 1990–92 period, since incentives to use them in the latter period were non-existent. However, regulation after 1989 seemed to have no effect on banks that, in the 1985–88 period, had higher capital ratios.

A growing body of literature has focused on both hypotheses, thus investigating whether bank managers use LLPs to smooth income and/or manage the regulatory capital ratios. These contributions can be divided into those studying US banks and those studying non-US banks, the latter being the most recent literature on LLPs. As regards the former, Collins et al. (1995) use data from 160 US banks in the 1971–91 period and find supporting evidence of the income-smoothing hypothesis, while no relationship exists between LLPs and capital ratios, meaning that bank managers do not use loan-loss reserves to manage their regulatory capital. Beatty et al. (1995) and Ahmed et al. (1999) find contrasting evidence to that of Collins et al. (1995). Beatty et al. (1995) use a slightly different sample from that of Collins et al. (1995). Their sample is made up of a smaller number of banks (148) and covers a shorter period (1985–89). The results show no use of LLPs by bank managers to smooth income, while LLPs are used in the management of capital ratios. Ahmed et al. (1999) also use a smaller sample that Collins et al. (1995), made up of 113 banks, but test a shorter, even though more recent, time period (1986–95). They find no supporting evidence for the income-smoothing hypothesis, but find that bank managers use LLPs for capital management purposes, since in the pre-1989 analysis banks showed a higher level of LLPs than in the post-1989 period.

In recent years studies have focused on non-US banks, in particular from Australia (Anandarajan et al., 2006), Europe (Curcio and Hasan, 2008 and Curcio et al., 2012), Spain [Pérez et al. 2008]), Taiwan (Chang et al., 2008) and the Middle East region (Othman and Mersni, 2014).

Anandarajan et al. (2006) focus their attention on a sample of 50 Australian commercial banks, ten of which are listed, for the period 1991 to 2001. The results show that bank managers use LLPs to manage their regulatory capital, but only in the pre-1996 period. The year 1996 is considered the cutoff date for the implementation of the Basel I framework in Australia, even though some banks may have adopted it earlier: still, the authors say that in 1996 all Australian banks had adopted the Basel I rules. Moreover, results indicate that Australian banks and, in particular listed ones, use LLPs to smooth their income. European banks’ attitude towards using LLPs has been investigated both in 2008 and in 2012.

Curcio and Hasan (2008) compare the earnings- and capital- management incentives of 907 banks belonging to different countries, all geographically part of the European continent, and in particular: (1) the 15 EU/pre-2004 countries; (2) the 10 EU/2004 countries; and (3) 23 non–EU/2006 countries. The time period is 1996–2006. The results show that both EU and non-EU banks use LLPs for income-smoothing purposes. Moreover, EU banks, both pre- and post-2004, use LLPs to manage regulatory capital, while non-EU banks do not.

Curcio et al. (2012) use a sample of commercial, cooperative and savings banks belonging to 19 out of the 21 European countries of origin of the credit institutions subject to the 2010 and 2011 EBA’s stress tests, for the period 2006–10. The results support the hypothesis of income-smoothing through LLPs for the sample banks, in particular for listed banks, but reject the hypothesis of capital management, only for non-tested banks. Indeed, the authors find that banks that were tested under the EBA’s 2010 and 2011 stress tests use LLPs more to manage their regulatory capital than to reduce the volatility of their earnings. Pérez et al. (2008) focus their attention on Spanish banks. The importance of this banking system relates to the strict rules the Banco de España had on loan-loss provisions, which were expected to prevent bank managers from using LLPs for either income-smoothing or capital management purposes. The results show that in the period from 1986 to 2002 Spanish banks effectively used LLPs to reduce the volatility of their income, but they did not manage their regulatory capital ratio through loan-loss provisions.

Chang et al. (2008) study the income-smoothing and capital management hypotheses for a group of banks listed in the Taiwan Stock Exchange for the period 1999–2004. Their results provide support to the income-smoothing hypothesis, since bank managers effectively use LLPs to manage their earnings while there is no evidence to the capital management hypothesis. Othman and Mersni (2014) conduct a comparative study between banks belonging to the Middle East region. These banks differentiate, because 21 are Islamic banks, 18 are conventional banks but with Islamic windows and 33 are conventional banks. The results show no important differences in bank managers’ use of LLPs: indeed, Islamic banks use LLPs to smooth their i...

Indice dei contenuti

• Cover
• Title
• 1  Credit Quality, Bank Provisioning and Systematic Risk in Banking Business
• 2  The Estimation of Banks Cost of Capital through the Capital at Risk Model: An Empirical Investigation across European Banks
• 3  Moving towards a Pan-European Deposit Guarantee Scheme: How Bank Riskiness Is Relevant in the Scheme
• 4  Back to the Future: Prospective Bank Risk Management in a Financial Analysis Perspective
• 5  Financial Innovation in Banking
• 6  Risk and Efficiency in European Banking Does Corporate Governance Matter?
• 7  Towards a Macroprudential Policy in the EU
• 8  Italian Banks Facing Basel 3 Higher Capital Requirements: Which Strategies Are Actually Feasible?
• Index