Academic journal article International Advances in Economic Research

Time-Varying Leverage and Basel III: A Look at Canadian Evidence

Academic journal article International Advances in Economic Research

Time-Varying Leverage and Basel III: A Look at Canadian Evidence

Article excerpt

Abstract Why did the conventional leverage indicators not pick up any meaningful signal of the mounting systemic risk before the subprime crisis? They remained almost unchanged in recent decades, whereas the banking landscape underwent a tremendous metamorphosis. Market-oriented banking is characterized by a new type of systemic risk, a risk which essentially evolves off the radar screen, i.e., off-balance sheet (OBS) (Calmes and Theoret Journal of Banking and Finance 34 (7): 1719-1728, 2010, 2011). In this article, we argue that the standard leverage indicators are not fitted to capture this kind of new banking risk. We introduce a new empirical framework which enables us to exploit the cyclical properties of elasticity leverage measures, while at the same time controlling for the noisy information they usually deliver, In a nutshell, thanks to the Kalman filter, we are able to compute optimal levels of bank leverage. This methodology delivers cyclical, forward-looking measures signalling systemic risk bubbles years before their burst. By properly accounting for all activities, including market-oriented banking, these time-varying leverage measures tend to systemically capture regulatory capital arbitrage and the OBS risk it entails.

Keywords Leverage * Banking * OBS activities * Liquidity * Kalman Filter

JEL C13 * C22 * C51 * G21 * G32

Introduction

The activities performed by financial institutions such as banks have changed dramatically, notably with the emergence of market-oriented banking, or "shadow banking." As a result, bank balance sheets have become increasingly complex, and the off-balance-sheet components related to fee-based activities and securitization have developed at an accelerated pace. For example, successive legislative changes allowed Canadian banks to engage in investment banking in 1987 and in trust and insurance activities in 1992. These changes led to a relative reduction in the traditional role of banks as intermediaries between lenders and borrowers, a process referred to as disintermediation. At the same time, households decreased their deposits held in financial institutions and increased their investments in stocks and bonds, which provide greater returns than deposits. Finns were also funding an increasing share of their investments directly on financial markets and were relying relatively less on loans granted by banks (Fig. 1). As a result, the volatility of bank revenues and profits increased sharply during the last decades (Calmes and Liu 2009; Calmes and Theoret 2010, 2011).

The emergence of market-oriented activities poses challenges for regulators. For the purpose of financial stability, regulatory agencies monitor banks to ensure that financial institutions are able to meet their obligations and to stay solvent. Amid concerns in the early 1980s related to low capital levels of large international banks, regulators of major industrialized countries adopted the Basel Accord to work towards higher capital levels and greater convergence in the measurement of capital adequacy. With the latest iteration of this accord, Basel III, the control of leverage will be further strengthened.

In this article, we argue that, given the new banking environment, some of the measures of leverage currently used by policy-makers and regulators to define mandatory rules are to some extent unsatisfactory at tracking bank risk. These indicators, which are based mostly on ratios of on-balance-sheet items, do not fully account for the new risk associated with market-oriented banking. For instance, the conventional measure of bank leverage, defined as the ratio of total assets to equity, has been quite stable during the period preceding the subprime crisis, despite the fact that bank risk was obviously swelling. The lack of cyclicality of this ratio stems in part from its design and also potentially from regulatory capital arbitrage (Jones 2000; Calomiris and Mason 2004; Ambrose et al. …

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