Bank capital and risk in ECA ten years after the crisis

Source: Anginer, Demirgüç-Kunt, and Mare 2020.

Note: EU = Western Europe, Southern Europe, and Northern Europe; CE & BC = Central Europe & Baltic countries; WB = Western Balkans; SC = South Caucasus; CA = Central Asia; EE = Eastern Europe; ROW = rest of the world.

Since capital acts as a buffer against unforseen losses, the quality of capital is important in determining the solvency of a bank. Lower quality capital, that is, capital instruments other than common equity, can be significantly undervalued during times of distress, reducing their effectiveness in acting as a cushion against shocks. Risk exposures are also difficult to estimate, and current regulations provide substantial discretion to banks in determining risk weights. Thus, banks can manipulate the risk weights to fulfill regulatory requirements or concoct their capital positions.

In the paper, we also show that bank risk in ECA is more sensitive to changes in simple leverage ratios than it is to regulatory capital ratios. This is because the numerator only includes equity capital and the denominator is a measure of exposure that does not rely on risk weights.

Overall, there has been progress in the region in strengthening capital regulations. Whether regulatory capital proves to be adequate in the next crisis will depend on the accuracy of the risk weights in truly capturing forward-looking risk and on the loss-absorbing capacity of the lower quality capital that is now allowed in the computation of Tier 1 regulatory capital.  

Cited references

Anginer, D., Bertay, A. C., Cull, R., Demirgüç-Kunt, A., & Mare, D. S. (2019). Bank Regulation and Supervision Ten Years after the Global Financial Crisis. Policy Research Working Paper 9044, World Bank, Washington, DC.

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Anginer, D., Demirgüç-Kunt, A., & Mare, D. S. (2020). Bank Capital and Risk in Europe and Central Asia Ten Years After the Crisis. Policy Research Working Paper 9138, World Bank, Washington, DC.

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