Francesca Erica Di Girolamo, Andrea Pagano, Marco Petracco

Does CRDIV Provide an Efficient Way to Deal with Banks' Simultaneous Defaults?

  • Article
  • pp. 193-216
  • DOI: 10.12831/88827
  • Abstract

Keywords: Banking Regulation; Capital Requirements; CoCo Bonds; Basel III; Banking Crisis.

The Capital Requirement Directive IV issues detailed rules on the new global regulatory standards for bank capital adequacy. For instance, it requires all instruments in the additional Tier 1 layer of a credit institution to be written down or converted into equity as soon as the Common Equity Tier 1 capital falls below 5.125% of risk weighted assets. Whether or not the new framework has made the banking sector more resilient, there is still one issue that regulators have never dealt with. The Basel accord imposes a regulatory minimum capital on each bank that is meant to cover unexpected losses, as if the banks were isolated entities. In reality however, banks are exposed to common borrowers. The present study performs a quantitative assessment where banks are part of a shared economic environment. Through a micro simulation portfolio model we estimate the aggregate distribution of bank losses assuming banks are interconnected via a correlation structure and, possibly, a contagion network. Our results show that systemic loss in the presence of a correlation across banks is 5% higher than what the system may experience without such correlation. The increase increases to 40% when adding secondary effects. Hence, a modelling framework has been developed to assess how different rules for allocating extra capital are able to cancel out the losses due to commonalities. We show that the regulatory rule, namely requiring extra capital as soon as the common equity falls below 5.125% of risk weighted assets, is more efficient than asking Global Systemically Important Banks (GSIBs) or all banks to increase their Common Equity Tier 1. Results provide evidence that allowing debt instruments that can be converted into equity into the additional Tier 1 may be an efficient macro-prudential tool to face banks' simultaneous defaults and this would help to deal with a key missing piece in the Basel framework.

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