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Understanding Bank Supervisors’ Risk Assessments

John O’Keefe, James A. Wilcox

A recurring criticism of U.S. bank supervisors is that their standards vary procyclicly with banking and economic conditions. The 2010 reforms of supervisory standards for bank capital adequacy and liquidity (Basel III) directly address procyclicality in supervision and its effects on credit cycles. We revisit the question of procyclicality in bank supervisors’ standards and find mixed support for the Basel III reforms. Using data on bank supervisors’ safety and soundness assessments of all U.S. FDIC-insured banks between March 1985 and December 2010, as well as information on banks’ financial and macroeconomic conditions, we develop a model of supervisors’ risk assessments of banks: the Ratings Rule Model.

We use the Model to examine the relationships between changing risk assessments of banks by their supervisors, bank conditions and economic conditions. Specifically, we estimate the marginal effects of changes in explanatory variables of the Ratings Rule Model on banks’ likelihood of receiving high (low) supervisory ratings. We next analyze the marginal effects and test for significant changes in effects between stressful and non-stressful periods for banking markets. We find evidence that supervisors’ standards for capital adequacy under pillar II of the Basel Accord have been procyclical in the past – becoming more stringent during periods of banking market stress and less stringent during non-stressful periods. In addition, these changes in supervisory risk tolerances for equity capitalization appear to have had a greater impact on risk assessments of sound, well-managed banks than on weak, poorly managed banks. We find, however, that supervisory standards for capital adequacy did not become more stringent during the current financial crisis (2007–2010). Finally, supervisors’ attitude toward other categories of risk – asset quality, earnings strength and liquidity – appear to be somewhat countercyclical.

The global financial crisis that began in early 2007 is still ongoing in 2012. While some countries’ economies show signs of recovering in 2012, most are experiencing aftershocks. Even though the full effects of the crisis are not yet known, bank supervisors have not hesitated in adopting regulatory reforms. In April 2009 The Group of Twenty Finance Ministers and Central Bankers (G20) committed to reforming banking and supervisory practices thought to have contributed to the crisis. Key G20 reforms we consider in this paper are those intended to strengthen capital adequacy and liquidity standards for banks and other financial institutions. In 2010 the Basel Committee of Bank Supervisors (BCBS) published guidelines for new capital adequacy and liquidity standards. The new standards, commonly referred to as Basel III, are scheduled for full implementation by January 2019. The delay in implementation is acknowledgement by the BCBS of the aforementioned aftershocks.

This regulatory regime change, like all others, raises questions about the motivations for and efficacy of reforms. This paper addresses two of these questions. First, are Basel III reforms of capital and liquidity standards well motivated? Second, how might bank supervisors integrate Basel III into their existing supervisory frameworks? To answer these questions we examine the historical relationships between banks’ financial condition, local macroeconomic conditions and supervisory assessments of overall bank safety and soundness. We first review the literature of banks’ conditions and supervisory risk assessments. We use the relationships between banks’ conditions, economic conditions and supervisory risk assessments in the following section to develop a Ratings Rule Model that mimics U.S. bank supervisors’ risk assessments of banks. More specifically, we develop a Ratings Rule Model intended to mimic supervisors’ evaluations of banks’ overall safety and soundness. The dependent variable of the Ratings Rule Model – composite safety and soundness (CAMELS) rating – is an ordered integer value varying between 1 (best rating) and 5 (worst rating) and, hence, the most appropriate statistical technique for explaining CAMELS ratings is ordered logistic regression. The explanatory variables in the Ratings Rule Model are financial measures of bank capital adequacy, asset quality, earning strength, liquidity and sensitivity to market risk (hereafter, CAMELS attributes), as well as measures of local macroeconomic conditions. In the subsequent section we use the results of estimations of the Ratings Rule Model to determine the impact of changes in the model’s explanatory variables on banks’ safety and soundness. Our empirical technique allows us to infer changes in marginal benefit (improvement in safety and soundness) from additional capital and liquidity during stressful and nonstressful periods for banks. In the conclusion we compare and contrast the historical evidence on supervisory risk assessments with the Basel III standards and discuss options for integrating Basel III into the current U.S. bank supervisory framework. While much research has been devoted to the policy questions discussed in this paper, we believe this is the first study to quantify the separate influences of banking and macroeconomic conditions from supervisory risk tolerances on capital and liquidity requirements under pillar II.

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