Basel II and solvency of Danish banks in the on-going economic crisis

Silja Valler

Student thesis: Master thesis

Abstract

The aim of this paper is to investigate how Danish banks managed the recent economic downturn (2007-2008) taking into account that Basel II, the new capital regulation, poses some constrains to the banks’ risk capital. In order to specify the scope of the research, three distinct research questions were formulated. The first question was related to the reasons for why Basel II is magnifying the banking sectors pro-cyclicality as well as how the solvency of the Danish banks has been affected in the recent economic downturn. The second question was about the reasons for different impact on banks’ solvency. The third research question addressed how the capital regulation of banks could be improved. For the explicit purpose of current research a study of 14 large and medium-sized Danish banks was conducted. In order to determine the downturn pro-cyclicality effect on banks’ solvency the model that encompassed 17 financial indicators was used. To explain the difference in the downturn effect the six-factor framework was employed. More theoretical analysis was conducted in order to explain why banking industry is inherently pro-cyclical and how Basel II magnifies this cyclicality. Data was gathered from both primary and secondary resources. Primary sources included banks’ annual reports and risk reports, records of Statistics Denmark, legal documents, international agreements and conventions. Secondary sources were gathered from local supervisory authorities (Danish FSA), Central Bank of Denmark, OECD, Orbis database, journals, books and existing research documents. Analysis identified few reasons, why banks are inherently pro-cyclical. First, banks’ business model is inherently pro-cyclical - they provide credit to the customers whose credit quality is depending on the general economic cycle. Second, since very large losses are extremely infrequent events, banks economic capital models may have been unable to take them into consideration when calculating the risk capital required for unexpected losses. It was also found that Basel II magnifies the industry’s pro-cyclicality, because it introduces closer alignment between the actual risk and capital adequacy. It was concluded that the more accurately the value, and relative risk, of each bank is measured at any point of time, the greater will be the pro-cyclicality of the prudential regime. Thus Basel II will be more pro-cyclical than Base I, advanced IRB more than foundation IRB, and IRB more than standard approach. The model determined that the standard banks in the sample (medium sized Danish banks) seemed to be more negatively affected by the downturn pro-cyclicality effect than IRB banks, which is somewhat contradictory to the general Basel II procyclicality critique. 7 out of 9 standard banks covered in the study had significantly deteriorated solvency in 2008. One reason for this inconsistency could be that large banks have more sophisticated methods and models to calculate both expected and unexpected losses. Another reason may be that IRB banks benefited more due to the implementation of Basel II than standard banks, because they could lower their risk weighted capital more than standard banks. The deterioration of profitability from 2006 to 2008 and the asset quality (indicated in 2008 impairment losses) seem to be part of the reasons for difference in the downturn pro-cyclicality impact. Four out of seven banks, whose solvency suffered most, had both severe decreases in their profitability and high impairment losses in 2008. High exposure to the real estate sector (property management business) and the relatively higher exposure to the corporate sector have in case of some banks also contributed to the severe negative solvency impact. The higher exposure to the financial institutions has in some cases too exaggerated the negative downturn effect. Two main solutions to how to improve the capital regulation were analyzed: extra capital buffers and time varying levels of risk curves. It was concluded that both could help to mitigate the pro-cyclicality in the sector, but regulators must carefully weigh the advantages and disadvantages of each measure, and be aware of that the more complex capital regulation is also more costly to supervise.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2009
Number of pages106