What is financial profit?

The way to calculate profit determines the risk taking behavior of financial agencies.

As long as loan installments are served, banks don't provision the risk premiums in a separate account. Rather they distribute interest gains as profit to shareholders and as bonuses to managements.

Being aware of the twisted profits, financial regulators have introduced the countercyclical capital buffer (CCyB) and risk weighted capital requirements in the aftermath of the 2008 financial crisis.

The internal ratings-based (IRB) approach requires banks to assign a risk weight to each loan based on the risk assessment of each borrower. Banks thereby need to reserve more capital for riskier assets.

Special provisioning rules in accounting

The way to calculate profit determines the risk taking behavior of the financial agencies. A bank transfers all interest gains from loans to its revenues. In fact, the loan rate consists the risk premium charged from the borrower. As long as loan installments are served, banks don't provision the risk premiums in a separate account. Rather they distribute interest gains as profit to shareholders and as bonuses to managements. This accounting practice has serious consequences due to the time inconsistency between delinquencies and interest gains.

Delinquencies do not equally spread over time. Debt service capacity of borrowers is driven by business cycles. In boom times, borrowers can more easily serve debt due to increases in their disposable income. Nevertheless, in bust times, debt installments require to cut spending, rendering a higher portion of their falling disposable income. The ones with a poorer saving ability thereby default on their debt.

Banks' reaction to a higher delinquency rate in the form of credit contraction further exacerbates delinquencies. Stricter credit conditions enforce borrowers to a more extensive cut in spending. As a result, more borrowers default on their debt whereas others' efforts to reduce spending plunge aggregate income and, in turn, pile delinquencies over and over.

Monetary transmission mechanism

To overcome a recession, banks should do the reverse, in deed. They should expand credits, so borrowers can compensate their income losses with debt and, thus they can even spend more. A recession means a lower expenditure with respect to the potential output. Stimulation of expenditure would thereof help the economy recover. In such a case, banks would also be better off since delinquencies would not rise and hurt their equities. So, why do they not expand credits in a recession?

First reason is the need to collective action which will ensure credit expansion. Only a few banks' credit stimulus would bankrupt them as the fall in expenditure would not be compensated. Central banks were established as a result of such a need of coordination in crises. However, being stuck at the zero lower bound (ZLB), the interest rate tool exhausted to accomplish the coordination duty. A lower central bank funding rate does not boost bank credits any more. Instead, central banks abandoned hope from banks and directly intervened in the financial markets through asset purchases. Nevertheless, even a central bank may not boost demand in the absence of banks' cooperation. This is the situation economies are encountering against COVID-19.

Second reason involves the provisioning principles of accounting. To expand credits in the crisis time, banks need to feel comfortable in terms of equity, yet they don't. It is because they have already distributed the risk premiums charged from loans as profit and bonuses. Therefore, they fear the first wave of delinquencies at the beginning of a recession and play to be the last bankrupt, coming to terms with a financial crisis. Their weird strategy relies on the historical fact that the last insolvent never bankrupts. Governments step in at some point because letting the entire financial system collapse is not a good idea.

Countercyclical capital buffer and internal ratings-based approach

In severe crises, even a very strong real interest rate incentive may not impulse banks to expansion due to the capital concerns. In the precrisis times, banks need to build capital buffers. Being aware of the accounting loophole, financial regulators have introduced the countercyclical capital buffer (CCyB) in the aftermath of the 2008 financial crisis. However, authorities throughout the world were hesitant to raise the CCyB buffer while credit risk piled up in many countries. In consequence, banks were caught to COVID-19 with fragile capital structures.

A second tool designed against credit risk is the differentiation of risk weights in the capital requirement calculation. The internal ratings-based (IRB) approach requires banks to assign a risk weight to each loan based on the risk assessment of each borrower. Banks thereby need to reserve more capital for riskier assets. That is, the IRB approach fills the accounting loophole, adding the charged risk premia to equity.

Nevertheless, not all banks were required to calculate the risk at the borrower level due to the lack of data. In the standardized approach, each credit type and collateral is assigned a risk weight (BIS 2017). This approach does not allow distinguishing risky and resilient borrowers under the same credit type. While the capital cost does not vary between risky and solvent borrowers, a bank would choose the profitable one. Stavins (2000) found that banks charging high interest rates have higher revenues despite higher delinquency rates in credit cards. Raising the capital cost of all lending at the same rate would lead to the loss of solvent lending, which is less profitable than risky lending.

In a country where most banks apply an IRB method, a capital based sectoral tool may stil be ineffective due to leakages to shadow banking. That is, banks can abstain from additional capital requirements by selling their credit portfolio through securitization. Applying a sectoral capital tool could achieve financial stability without compromising economic growth in an ideal economy where banks dominate the financial system and largely use a sound IRB approach to calculate credit risk weights.

Nevertheless, banks can and do manipulate the IRB approach as banks are the designers of their own risk models. They reserve less capital in the IRB approach. The BIS has recently set minimum input floors for the risk models. As banks cannot specify values below minimum floors, they will need to reserve more capital in the IRB approach. KPMG (2018) estimated that capital ratios of European banks would worsen up to 35% due to the introduction of floor values and credit risk changes.

To sum up, risk based capital regulations have not matured yet. Due to the model risk, it may take a long-time until authorities ensure sound risk models. In the mean time, banks will continue to flounder in economic downturns with insufficient capital levels.

References

KPMG. 2018. Basel 4 The Way Ahead: Credit Risk - IRB Approach, Closing in on Consistency. https://assets.kpmg/content/dam/kpmg/xx/pdf/2018/05/basel-4-credit-risk-irb-approach.pdf