The “skin in the game” argument for more common equity

One of the traditional arguments for higher common equity requirements is that it increases the shareholders’ “skin in the game” and thereby creates an incentive to be more diligent and conservative in managing risk.

This principle is true up to a point but I believe more common equity mostly generates this desirable risk management incentive when the extra skin in the game (aka capital) is addressing a problem of too little capital. It is much less obvious that more capital promotes more conservative risk appetite for a bank that already has a strong capital position.

In the “too little” capital scenarios, shareholders confronted with a material risk of failure, but limited downside (because they have only a small amount of capital invested), have an incentive to take large risks with uncertain payoffs. That is clearly undesirable but it is not a fair description of the risk reward payoff confronting bank shareholders who have already committed substantial increased common equity in response to the new benchmarks of what it takes to be deemed a strong bank.

The European Systemic Risk Board published some interesting research on this question in a paper titled “Has regulatory capital made banks safer? Skin in the game vs moral hazard” . I have copied the abstract below which summarises the key conclusions.

Abstract: The paper evaluates the impact of macroprudential capital regulation on bank capital, risk taking behaviour, and solvency. The identification relies on the policy change in bank-level capital requirements across systemically important banks in Europe. A one percentage point hike in capital requirements leads to an average CET1 capital increase of 13 percent and no evidence of reduction in assets. The increase in capital comes at a cost. The paper documents robust evidence on the existence of substitution effects toward riskier assets. The risk taking behavior is predominantly driven by large and less profitable banks: large wholesale funded banks show less risk taking, and large banks relying on internal ratings based approach successfully disguise their risk taking. In terms of overall impact on solvency, the higher risk taking crowds-out the positive effect of increased capital.

I have only skimmed the paper thus far and have reservations regarding how they measure increased risk. As I understand it, the increased riskiness the analysis measures is based on increases in average risk weights. It was not clear how the analysis distinguished changes in portfolio riskiness from changes in the risk weight measure. That said, the overall conclusions seem intuitively right.

Tony

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

6 thoughts on “The “skin in the game” argument for more common equity”

  1. Possibly with a change of culture on the issue of “doing the right thing by the customer vs meeting profit targets” this will also spillover into an acceptance if capital requirements increase one can accept a lower return on that capital and greater profits (via riskier lending) to maintain ROE are not necessary. Perhaps one vision of the banking system going forward is not as an enormous profit machine that provides large franked dividends to super funds, but more as a heavily regulated utility like water, gas, electricity providing stability and service but not much growth?

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    1. Banks may have to accept a lower return but declines in ROE must in the long run be constrained by what investors need to accept an inherently cyclical return. The utility analogy has some validity in the sense that banks play a central part in the money creation – credit formation process that the economy depends on. The analogy breaks down when you consider the relative downside for investors. A utility will not experience the material spike in credit risk that a bank does. People will economise but they will still need to pay for access to power and other basic necessities. Banks in contrast will be in the front line of absorbing any economic downturn. The risk return proposition for investors is much more risky than a pure utility. That said, I don’t have a problem with the idea that there is value for banks in coming to terms with a lower growth path. The big challenge for them is to adjust their expense base (and its growth) to fit this lower growth trajectory. Lower growth has the benefit of less risk plus it makes it easier to sustain a reasonable dividend payout (and yield) provided they can defend a reasonable ROE target.

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  2. Hi Tony, again good to see you on Friday.

    I was looking at this 2012 paper related DTAs (backgrounding for my DTA capital inclusion idea). On p.17 he refs some work on on the capital vs risk question:

    “Thus, a higher Tier1Ratio could be indicative of greater risk and failure probability. Prior research on this matter is mixed (Shrieves and Dahl 1992; Aggarwal and Jacques 2001; Rime 2001; Bologna 2011).”

    For your ref, in the unlikely event you hadn’t come across those papers!

    Talk soon, BD

    >

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