metadata: authors: 0: author: Anginer,Deniz
1: author: Demirguc-Kunt,Asli
2: author: Mare,Davide Salvatore
count: Europe and Central Asia
docna: 0: docna: Bank Capital and Risk in Europe and Central
            Asia Ten Years After the Crisis
docty: Policy Research Working Paper
subtopic: Banks & Banking Reform,Legal Institutions of the Market Economy,Financial Crisis Management & Restructuring,Financial Structures
teratopic: Public Sector Development,Finance and Financial Sector Development
abstracts: cdata!: This paper examines changes in bank
            capital and capital regulations since the global financial
            crisis, in the Europe and Central Asia region. It shows that
            banks in Europe and Central Asia are better capitalized, as
            measured by regulatory capital ratios, than they were prior
            to the crisis. However, the increase in simple equity ratios
            for the same banks has been smaller over the past 10 years.
            The increases in regulatory capital ratios have coincided
            with a reduction in the stringency of the definition of Tier
            1 capital and reduction in risk-weights. Further analyses
            show that bank risk in Europe and Central Asia is more
            sensitive to changes in simple leverage ratios than in
            regulatory capital ratios, consistent with the notion that
            equity ratios only include high-quality capital and do not
            rely on internal risk models to compute risk-weights.
            Although there has been some effort to increase capital and
            liquidity requirements for institutions deemed systemically
            important, the region has been lagging in addressing the
            resolution of these institutions.
repnme: repnme: Bank Capital and Risk in Europe and Central
            Asia Ten Years After the Crisis
display_title: Bank Capital and Risk in Europe and
            Central Asia Ten Years After the Crisis
listing_relative_url: /research/2020/01/31743946/bank-capital-risk-europe-central-asia-ten-years-after-crisis
topicv3: Bank Capital Adequacy m1326723 1241,Market Discipline m1326726 1248,Bank Regulation and Supervision m1327225 317,Financial Institutions m1505015 3797,Credit Risk m1505083 3885
publishtoextweb_dt: 2020-01-30T00:00:00Z
historic_topic: Public Sector Development,Finance and Financial Sector Development
origu: DECRG: Finance & Priv Sec Devt (DECFP)
no_of_pages: 37
author_keys: 0: author_key: 1057996
1: author_key: 94122
2: author_key: 1366794
model_extractions: Policy Research Working Paper 9138 Bank Capital and Risk in Europe and Central Asia Ten Years After the Crisis _Deniz Anginer Asli Demirgüç-Kunt Davide S. Mare_ Development Economics Development Research Group & Europe and Central Asia Region Office of the Chief Economist January 2020
Policy Research Working Paper 9138

# **Abstract**

This paper examines changes in bank capital and capital regulations since the global financial crisis, in the Europe and Central Asia region. It shows that banks in Europe and Central Asia are better capitalized, as measured by regulatory capital ratios, than they were prior to the crisis. However, the increase in simple equity ratios for the same banks has been smaller over the past 10 years. The increases in regulatory capital ratios have coincided with a reduction in the stringency of the definition of Tier 1 capital and reduction in risk-weights. Further analyses show that bank risk in Europe and Central Asia is more sensitive to changes in simple leverage ratios than in regulatory capital ratios, consistent with the notion that equity ratios only include high-quality capital and do not rely on internal risk models to compute risk-weights. Although there has been some effort to increase capital and liquidity requirements for institutions deemed systemically important, the region has been lagging in addressing the resolution of these institutions.

This paper is a product of the Development Research Group, Development Economics, and the Office of the Chief Economist, Europe and Central Asia Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at danginer@sfu.ca, ademirguckunt@worldbank.org, and dmare@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Bank Capital and Risk in Europe and Central Asia Ten Years After the Crisis**

**Deniz Anginer, Asli Demirgüç-Kunt, Davide S. Mare**<sup>1</sup>

_JEL Classifications: G18, G21, G28, E58_ _Keywords_ : Banking Regulation, Banking Supervision, Bank Capital, Basel Capital Requirements, Financial Stability 1 Deniz Anginer is with Simon Fraser University; Asli Demirgüç-Kunt, and Davide S. Mare are with the World Bank. We are grateful to Miquel Dijkman, Nadeem M. Karmali and Isfandyar Zaman Khan for useful suggestions and comments. We also thank Alena Kantarovich and Raquel Alejandra Letelier for providing the data on state-ownership of banks in developing Europe and Central Asia. This paper’s findings, interpretations and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, their Executive Directors, or the countries they represent. This research was supported by a grant from the Knowledge for Change Program at the World Bank.The authors may be contacted at <u>danginer@sfu.ca, ademirguckunt@worldbank.org, and dmare@worldbank.org.</u>
<!-- Start of picture text --> Cumulative Output Loss (% of Trend GDP)<br>120.00<br>100.00<br>80.00<br>60.00<br>40.00tt0.00 l l l TTL<br>Ss & & ss & e & s & FF St © & Ss 3 RS Ss<br><!-- End of picture text -->
<!-- Start of picture text --> Peak Liquidity Support (% GDP)<br>70<br>60<br>50<br>40<br>30<br>20<br>watt eatelliti<br><!-- End of picture text -->
of the GFC. In discussing capital regulations, it is important to keep in mind that the banking systems in ECA differ from the rest of the world in four key aspects.

First, banks in the ECA region are more interconnected through shared regulation, shared ownership structures and shared risk exposures. Due to geographical proximity, it is not uncommon to find banks operating in several ECA countries located nearby. Competing in the same markets exposes banks to common sources of market and credit risk shocks. Within the region, merger and acquisition (M&A) activity was at an all-time high prior to the GFC (Dermine, 2006) creating shared ownership structures within ECA. Banks located in countries that are members of the Euro Zone share a common currency and come under the regulatory purview of the European Central Bank and the European Banking Authority. All these interlinkages amplify risks and result in spillovers across national borders.

Second, banking sectors in ECA countries are highly concentrated. Figure 3 shows the share of assets held by the top three and top five largest banks. The figure shows average values for ECA countries grouped into different regions (see Table A1 for region classifications). Concentration is especially high in the EU group of countries (i.e., Western Europe, Southern Europe, Northern Europe) and in Central Asia. There is variation with some of the larger countries having more fragmented markets, whereas smaller countries are characterized by more concentrated banking sectors. The Russian Federation, in particular, has seen a substantial increase in bank concentration over the past 10 years.<sup>5</sup>

> 5 As reported in the BRSS 2019, part of the increase in concentration may be attributed to small bank failures during the period 2011-2016.

3
**Figure 3: Five bank concentration index (2007-2017, equally weighted)**

<!-- Start of picture text --> 92<br>83 85 86<br>75 80 78 77 75 78 73 80<br>70 68 69<br>64<br>60<br>29<br>20072017 20072017 20072017 20072017 20072017 20072017 20072017 20072017 20072017<br>EU CE & BC WB SC CA Russia Turkey EE RoW<br>100<br>80<br>60<br>40<br>20<br>0<br><!-- End of picture text --> Source: Global Financial Development Database (World Bank).

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW** for the rest of the world **.** Third, state ownership of banks is a key feature in the ECA region (Figure 4). State ownership is especially high in Eastern Europe and in Russia. Even in large high-income countries like Germany, the public authorities are still active players in the banking sector. After the GFC, governments stepped in to rescue distressed banks by injecting capital in order to stabilize markets (for instance in Belgium, The Netherlands, Slovenia and the United Kingdom). Government ownership naturally brings up issues of efficiency and political influence (Altunbas et al., 2001; Bonin et al., 2005; Dinç, 2005). Within the context of capital regulations, state ownership affects transparency, risk-taking and market discipline.

**Figure 4: State Ownership (% of Banking Sector Assets, equally weighted)**

<!-- Start of picture text --> 66.0<br>39.7<br>37.5 37.5<br>33.9 32.9<br>30.5<br>14.2 17.9 16.414.3<br>11.2 9.0 9.4<br>5.5 6.6 3.6 3.1<br>EU CE & BC WB SC CA Russia Turkey EE RoW<br>2008 2018<br>80<br>60<br>40<br>20<br>Banking system's assets government-controlled (%) 0<br><!-- End of picture text --> Source: Bank Regulation and Supervision Survey conducted by the World Bank and national sources. Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus – data not available for 2008; **CA** for Central Asia; **EE** for Eastern Europe; **ROW** for the rest of the world **.** Data for ECA sub-regions is as per year end 2018 and is obtained from national sources with the help of colleagues in Finance, Competitiveness and Innovation global practice of the World Bank. Data from the ROW is per year-end 2016.

4
Finally, the region includes a number of smaller economies at different stages of development. For smaller, developing economies in the region, the principle of proportionality must be kept in mind when thinking about policies designed to enhance capital rules. The level of public intervention should not exceed what is appropriate to achieve the social objectives. Developing countries in the region may lack market depth, scale and may face institutional capacity constraints. Therefore, some of the macroprudential regulations designed for more sophisticated banking sectors may not be appropriate for smaller countries in ECA, with banks engaging in traditional lending activities (i.e., raise deposits and provide loans).

# **II Changes in Bank Capital Structure Since the Crisis**

Bank capital is an integral part of financial stability as it provides a cushion for absorbing losses during times of distress (for example, Repullo, 2004; von Thadden, 2004). Capital requirements also have indirect stabilizing effects through their effect on the incentives of bank owners to improve risk management and curb excessive risk-taking. Consistent with this argument, a number of theories emphasize that higher capitalization improves the borrower screening and risk monitoring functions of banks, and thereby reduces bank risk (Coval and Thakor, 2005; Allen et al., 2011; Holmstrom and Tirole, 1997; Mehran and Thakor, 2011). It is thus not surprising that high capitalized banks had better performance during the GFC. Figure 5 shows the average return-on-assets (ROA) during the GFC for high and low capitalized banks in the ECA region. On average, highly capitalized banks have suffered lower losses. Central Asia is the only sub-region where highly capitalized banks have seen negative return on assets though low capitalized banks sustained larger losses.

5
**Figure 5: Average ROA 2008-2010 for High and Low Capitalized Banks.**

<!-- Start of picture text --> 3.00<br>2.50<br>2.00<br>1.50<br>1.00<br>0.50<br>0.00<br>-0.50 ROW EU CE WB SC CA Russia Turkey EE<br>-1.00<br>-1.50<br>-2.00<br>Low Capital High Capital<br><!-- End of picture text --> Source: Archived data from Bureau van Dijk’s Bankscope and BankFocus.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW** for the rest of the world **.** Capital is calculated using simple leverage (Equity/Total Assets). High (Low) capital banks are those that have capital ratios above (below) the median in a given country in 2007.

In discussions of bank capital, it is important to distinguish between economic capital and regulatory capital. Bank economic capital can be defined as the value of the equity of a bank that can withstand losses. It has the lowest priority if the bank liquidates. Although there are several types of equity instruments, equity consists mainly of common equity and profits retained by a bank or obtained from selling shares to investors.<sup>6</sup> Regulatory capital is the amount of capital that banks are required to hold by domestic supervisors and regulators. Regulatory capital can include financial instruments other than common equity and is typically divided up into tiers. Tier 1 consists of higher quality capital that is made mostly of common stock held by a bank. Tier 2 capital is designated as supplementary capital and includes items such as revaluation reserves, undisclosed reserves, hybrid instruments, and subordinated debt. Items (other than common equity) that can be included as part of Tier 1 capital varies across countries. Regulatory capital ratio is calculated as the sum of Tier 1 and Tier 2 capital divided by risk-weighted assets (RWA). To calculate RWA, the assets on a bank’s balance sheet are assigned weights based on their risk level. Domestic sovereign bonds, for instance, typically receive a weight of zero.<sup>7</sup> The notion of risk-

> 6 Measuring equity is not simple because its value depends on how all financial instruments and on– and off–balance sheet assets of banks are valued (Berger et al., 1995).

> 7 The regulatory treatment of sovereign debt has been subject to heated debate especially in Europe following the 2012 sovereign debt crisis (BCBS 2017).  Sovereign bonds of fiscally distressed countries such as Greece receive a risk-weight of zero for the purposes of regulatory capital calculation.

6
weighting assets was introduced by the first Basel capital accord (BCBS, 1988) to distinguish risk of different asset types and require banks to hold more capital against portfolio items with higher risk.

Figure 6 below shows the minimum regulatory capital requirements. On average most of the ECA sub-regions set capital requirements (as % of RWA) well above the average for the rest of the world. There are, however, some important differences. On average EU countries set the lowest capital requirements, but these countries are also more apt to have in place additional capital surcharges, meaning that the minimum regulatory capital set for banks is, in practice, higher than before the financial crisis. Countries in Central Europe and Baltic countries, Turkey and Russia had higher capital requirements than the EU in 2008 but lowered their capital regulatory requisites by the end of 2016.

**Figure 6: Mean regulatory capital requirements (% of RWA, equally weighted)**

<!-- Start of picture text --> 2008 2009 2010 2011 2012 2013 2014 2015 2016<br>EU CE & BC WB<br>SC CA Russia<br>Turkey EE RoW<br>13<br>12<br>11<br>(% of RWA) 10<br>9<br>Mean regulatory capital requirements<br>8<br><!-- End of picture text --> Source: Bank Regulation and Supervision Survey conducted by the World Bank. Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW** for the rest of the world **.** Since capital acts as a buffer against liquidity, information and economic shocks, the quality of capital is important in determining the solvency of a bank. Lower quality capital tends to be made of components that are difficult to value and can be subject to information asymmetries. Capital elements other than common equity can thus be significantly undervalued during times of distress, reducing their effectiveness to act as a cushion against shocks. Risk exposures are also difficult to estimate, and current regulations provide substantial discretion to banks in determining risk-weights. Risk-weights can thus be manipulated by banks to meet or to improve regulatory requirements. A number of studies have shown that risk-weights only weakly reflect the actual risks of banks’ operations and can be manipulated through securitization and use of complex risk models (Le Leslé and Avramova, 2012; Acharya et al., 2013; Mariathasan and Merrouche, 2014). Consistent with the notion that there is significant discretion 7
in the computation of regulatory capital ratio, Demirguc-Kunt et al. (2013) find that stock returns of banks during the financial crisis were more sensitive to simple leverage ratios using common equity rather than regulatory risk-based ratios.

The recent Global Financial Development Report (GFDR) also highlights the importance of defining capital more narrowly. GFDR (2019/2020) shows that there was a relaxation in the definition of the elements that enter the computation of Tier 1 capital, with an increase in the number of countries now allowing hybrid debt capital instruments, asset revaluation gains and subordinated debt to be used in the computation of Tier 1 capital. Although there has been an increase in regulatory capital ratios after the crisis, GFDR (2019/2020) shows that these were largely driven by declines in risk-weighted assets. Improvements in simple leverage ratios were more limited especially for larger banks located in highincome countries.

The definition of the capital elements that constitute Tier 1 capital has also become less stringent in the ECA region.<sup>8</sup> Figure 7 below shows the changes in an index that captures the stringency of the Tier 1 capital definition. The index ranges between 0 and 8, and is based on the number of components that are allowed as part of Tier 1 regulatory capital (less stringent) and those that are not allowed as part of Tier 1 regulatory capital (more stringent).<sup>9</sup> The capital instruments that may be allowed into the definition of Tier 1 capital are: a) hybrid debt capital instruments, b) asset revaluation gains, and c) subordinated debt. The instruments that might be deducted from Tier 1 capital are: a) goodwill, b) deferred tax assets, c) intangibles, d) unrealized losses in fair valued exposures, and e) investment in the capital of certain financial intermediaries. Overall, in most of the ECA sub-regions the definition of Tier 1 capital was less stringent in 2016 than in 2010, except for Western Balkans, South Caucasus and Russia.

# **Figure 7: Tier 1 Stringency Index (equally weighted)**

> 8 One of the intended goals of the Basel III capital framework was to improve the quality of bank regulatory capital. To this end, the proportion of Tier 1 capital in the total regulatory capital has been increased. The additional items that are included in the Tier 1 capital are also now subject to more stringent eligibility criteria. Nonetheless, the quality of Tier 1 capital gets diluted when additional instruments other than common equity are allowed in its computation.

> 9 For an in-depth explanation on how the Tier 1 stringency index is computed, see Anginer et al. (2019).

8
<!-- Start of picture text --> 7.0<br>6.4 6.5 6.3 6.3 6.3<br>5.9 5.8 6.0 6.0 6.0 6.0 5.8<br>5.4 5.5<br>5.0 5.0 5.0<br>EU CE & BC WB SC CA Russia Turkey EE RoW<br>2010 2016<br>8<br>6<br>4<br>Tier 1 stringency ratio<br>2<br>0<br><!-- End of picture text --> Source: Bank Regulation and Supervision Survey conducted by the World Bank.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW** for the rest of the world **.** Having made a distinction between regulatory and economic capital, we examine how these capital ratios have changed in the region over the past 10 years using bank-level information on over 20,000 banks. In the analyses that follow, regulatory capital (RC/RWA) is calculated as the sum of Tier 1 and Tier 2 capital divided by risk weighted assets. The equity ratio (Equity/TA), also referred to as the simple leverage ratio, is calculated as total common equity divided by total assets. We also examine how risk-weighted assets have changed over time by calculating risk-weighted assets as a percentage of total assets (RWA/TA).<sup>10</sup> Figure 8 shows the evolution of regulatory capital ratios in the ECA subregions. Because many countries are dominated by a few large banks, we show changes in capital ratios for both large and small banks. Large banks are defined as banks that are in top 20th percentile in terms of total assets in a given country for each year. Although there is variation across countries, overall there has been an increase in regulatory capital ratios especially for larger banks. Excluding EU countries, on average in ECA regulatory capital has increased 5 percentage points between 2007 and 2017.

> 10 The time trends for the ratios in Figures 8, 9 and 10 are given in the appendix (Figures A1, A2, and A3, respectively).

9
**Figure 8: Regulatory capital over RWA**

**Panel A: Top 20% banks**

**Panel B: Bottom 80% banks**

<!-- Start of picture text --> 28.7<br>27.7<br>25.1 25.4 25.4<br>24.4<br>21.3 21.8 21.8 22.4 22.8 23.0 23.1<br>19.6 19.1 19.1<br>17.116.9 16.417.9 15.9 15.6 16.5 17.2 18.4 18.4 15.617.6 16.8<br>14.9 14.6<br>13.9 13.9 13.9<br>11.4 11.6<br>EU CE & BC WB SC CA Russia Turkey EE RoW EU CE & BC WB SC CA Russia Turkey EE RoW<br>2007 2017 2007 2017<br>30 30<br>25 25<br>20 20<br>15 15<br>10 10<br>RWA over Total Assets (%) RWA over Total Assets (%)<br>5 5<br>0 0<br><!-- End of picture text --> Source: Archived data from Bureau van Dijk’s Bankscope and BankFocus.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe. We report means weighted by bank size.

While regulatory capital has been increasing, the increases in simple leverage ratios have been more limited. Figure 9 shows how average capital over total assets ratio (simple leverage ratio) has changed over the past ten years. EU countries started from a lower base in 2007 and have increased their leverage ratios more than other ECA sub-regions over time. Nonetheless, on average large banks in EU still have lower capital holdings than large banks in other ECA sub-regions. In general, by the end of 2017 smaller banks hold more capital (as a % of total assets) than their larger counterparts except for Central Europe and Baltic countries, Turkey and Western Balkans. In the same vein, by the end of 2017 there appears to be on average a wide gap between leverage ratios of small banks and large banks, especially in Russia, Eastern Europe and South Caucasus. Overall, simple leverage ratios increased 1.3 percentage points between 2007 and 2017 excluding ECA EU countries.

10
**Figure 9: Capital over Total Assets (%) – top 20% banks and bottom 80%**

**Panel A: Top 20% banks**

# **Panel B: Bottom 80% banks**

<!-- Start of picture text --> 21.8<br>19.8 19.8<br>19.1<br>18.4<br>17.5<br>15.6 16.0 16.2 16.1<br>13.9 14.4 13.6 14.713.7 14.1 14.0<br>13.0<br>12.1 12.2 12.0 12.0 11.9<br>11.0 11.310.6 10.5 10.6 10.5<br>8.7 9.4 9.6 9.7 9.1<br>7.8<br>5.6<br>EU CE & BC WB SC CA Russia Turkey EE RoW EU CE & BC WB SC CA Russia Turkey EE RoW<br>2007 2017 2007 2017<br>22 22<br>20 20<br>18 18<br>16 16<br>14 14<br>12 12<br>10 10<br>8 8<br>Capital over Total Assets (% 6 Capital over Total Assets (% 6<br>4 4<br>2 2<br>0 0<br><!-- End of picture text --> Source: Archived data from Bureau van Dijk’s Bankscope and BankFocus.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe. We report means weighted by bank size.

Regulatory capital could have increased because of increases in the level and quality of regulatory capital or because of decreases in the measures factored into calculating total risk exposure. As we have seen, Tier 1 stringency has declined. We examine if there has been a similar decline in risk-weighted assets. Figure 10 shows the development over time of RWA (as a % of total assets). In general, for both small and large banks, the RWA ratio has declined over the past 10 years. This is especially true for EU banks that have the lowest average value in 2017. This development could be explained in part by a portfolio composition effect with an increase in the share of government bonds, which carry lower risk weights, due to the introduction of the Basel III liquidity requirements (Bonner, 2016), and the monetary policy interventions of the European Central Bank (Krishnamurthy et al., 2018).

11
**Figure 10: RWA over Total Assets (%) – top 20% banks and bottom 80%**

**Panel A: Top 20% banks**

**Panel B: Bottom 80% banks**

<!-- Start of picture text --> 89.8 88.0 90.5<br>84.5<br>81.4 80.1 76.0 78.1 77.6 80.679.8 79.1 78.0<br>70.9 67.6 68.8 70.9 70.0<br>62.9 63.6 59.2 65.1 62.559.5 58.0 63.2 63.759.0 65.7 61.765.4<br>53.7 55.5<br>50.4<br>48.5<br>39.3<br>EU CE & BC WB SC CA Russia Turkey EE RoW EU CE & BC WB SC CA Russia Turkey EE RoW<br>2007 2017 2007 2017<br>90 90<br>80 80<br>70 70<br>60 60<br>50 50<br>40 40<br>30<br>RWA over Total Assets (%) RWA over Total Assets (%)<br>20<br>10<br>0<br><!-- End of picture text --> Source: Archived data from Bureau van Dijk’s Bankscope and BankFocus.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe. We report means weighted by bank size.

The declines in risk-weighted assets could be driven by improvements in asset quality in the aftermath of the crisis. As risk-weights only weakly reflected the true asset risks of banks prior to the crisis, this decline raises concerns about the accuracy of measures of risk-weighted assets and questions about the improvements in regulatory capital ratios. When we examine the difference between regulatory capital ratios and simple leverage ratios, we find that the gap between the two ratios has been widening over the past decade. Figure 11 shows the gap or the difference between these two ratios. We observe that in most ECA regions the gap between total regulatory capital and capital to assets ratios has increased between 2007 and 2017. The gap is larger for the largest institutions and for banks located in the EU, Central Europe and the Baltic countries, Eastern Europe and for large banks in Central Asia. This suggestive evidence highlights the importance of the computation of risk weights in the assessment of the capital adequacy of banks in ECA countries.

12
**Figure 11: Difference (gap) between regulatory capital over RWA and capital over total assets Panel A: Top 20% banks Panel B: Bottom 80% banks**

<!-- Start of picture text --> 11.7<br>10.9<br>10.4<br>10.1<br>9.6<br>9.2<br>8.7 8.7<br>8.2<br>7.6 7.6<br>7.3<br>7.0<br>6.7<br>5.9 5.7 6.3 6.0 6.1 6.2<br>5.3 5.1<br>4.0 4.6 4.3 4.4 4.8 4.6 4.6 4.3 4.3<br>3.1 3.2<br>2.8 2.5<br>1.9<br>EU CE & BC WB SC CA Russia Turkey EE RoW EU CE & BC WB SC CA Russia Turkey EE RoW<br>2007 2017 2007 2017<br>13 13<br>12 12<br>11 11<br>10 10<br>9 9<br>8 8<br>7 7<br>6 6<br>5 5<br>4 4<br>3 3<br>2 2<br>Capital Gap - Top 20% (percentage points)<br>1 Capital Gap - bottom 80% (percentage points) 1<br>0 0<br><!-- End of picture text --> Source: Own calculation using archived data from Bureau van Dijk’s Bankscope and BankFocus.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe.

Significant changes in risk-weights and declines in the stringency of what constitutes Tier 1 capital call into question how informative these indicators are for bank risk. To test the importance of these variables, we next examine how bank risk is related to the quality of bank capital and risk-weights using bank-level information collected through Bankscope and Bank Orbis. Our measure of bank risk is the z-score, which is calculated as the sum of average bank returns on assets (net income divided by total assets) and the bank equity to assets ratio, scaled by the standard deviation of return on assets over a four-year rolling window. A higher z-score indicates lower bank risk (Mare et al., 2017).

In the first analyses we examine the relationship between bank risk (z-score) and regulatory capital (RC/RWA) and simple leverage (Equity/TA). The sample includes only developing countries in the ECA region and excludes high-income countries. In the analyses we control for a number of banklevel variables. These controls are: bank size (log(TA)), which is the natural logarithm of total assets; bank liquidity, which is liquid assets divided by total assets (LiquidA/TA); bank profitability measured as return-on-assets (ROA); reliance on short-term funding measured as short-term funding divided by total assets (ShortFund/TA); and loan ratio which is net loans divided by total assets (Loans/TA). All capital ratios and controls are lagged by one year. We also include year and region fixed effects to control for macro and region-specific factors that may affect the relationship between capital and bank risk. The descriptive statistics of the variables used in the regression analyses are reported in Table 1.

# **Table 1: Descriptive statistics**

13
|Variables|Obs|mean|St Dev|min|median|max|
|---|---|---|---|---|---|---|
|Z-Score|117209|51.406|80.964|0.003|24.640|518.494|
|RC/RWA|112559|18.322|9.735|0.010|15.790|100.000|
|Equity/TA|144116|12.209|10.107|0.000|9.888|81.818|
|RC/RWA - Equity/TA|112497|7.273|6.046|-4.054|5.957|35.518|
|T1C/TC|95711|90.280|9.212|0.521|92.518|100.000|
|RWA/TA|93078|64.203|15.856|0.007|65.363|100.000|
|size|144451|6.115|1.971|2.304|5.793|15.203|
|ROA|144100|0.718|2.511|-97.328|0.707|8.333|
|ShortFunds/TA|142766|9.143|13.530|0.000|3.575|70.990|
|Loans/TA|142845|59.011|18.569|0.000|61.465|92.130|
|Liquid A/TA|143980|17.158|16.326|0.000|11.888|85.586|

The results are reported in Table 2 below. We find that both regulatory capital and simple leverage reduce bank risk (columns 1 and 2). However, when we run a horse race between the two capital ratios (column 3), we find that only the simple leverage ratio retains its significance in reducing bank risk. In other words, after controlling for simple leverage, regulatory capital ratios do not have explanatory power for bank risk. In the last column (column 4), we examine how the gap between regulatory capital and simple leverage ratios (RC/RWA - Equity/TA) is related to bank risk. We find that after controlling for regulatory capital, bank risk increases with the gap. That is, the higher the gap, the higher becomes the banks’ risk.

**Table 2: Relationship Between Bank risk and Capital Ratios (developing ECA)**

|VARIABLES|(1)<br>Z-Score|(2)<br>Z-Score|(3)<br>Z-Score|(4)<br>Z-Score|
|---|---|---|---|---|
|size|-0.417|0.025|0.083|0.038|
||(0.724)|(0.712)|(0.716)|(0.704)|
|ROA|0.261|0.093|0.091|0.090|
||(0.285)|(0.301)|(0.303)|(0.301)|
|ShortFunds/TA|<br>-0.205***|<br>-0.185***|<br>-0.189***|<br>-0.189***|
||(0.061)|(0.059)|(0.060)|(0.061)|
|Loans/TA|-0.001|-0.045|-0.026|-0.027|
||(0.087)|(0.090)|(0.087)|(0.088)|
|Liquid A/TA|<br>-0.172**|<br>-0.136|<br>-0.146*|<br>-0.135|
||(0.087)|(0.088)|(0.087)|(0.087)|
|RC/RWA|<br>0.422***||<br>0.161|<br>0.687***|
||(0.137)||(0.151)|(0.158)|
|Equity/TA||0.655***|<br>0.510***||
|||(0.175)|(0.183)||
|RC/RWA - Equity/TA||||-0.668***<br>(0.239)|
|Constant|30.077***|27.661***|25.234***|<br>25.973***|

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||(9.370)|(9.242)|(9.397)|(9.319)|
|---|---|---|---|---|
|Observations|4,276|4,276|4,276|4,276|
|R-squared|0.130|0.133|0.133|0.133|
|Year x Country FE|Yes|Yes|Yes|Yes|

Note: *, **, and *** represent statistical significance at 10%, 5%, and 1% two-tailed level, respectively. Robust standard errors in parentheses clustered at the bank level. All independent variables are lagged one year.

Figure 12 shows the estimates from the regression results reported in column 3, Table 2. The figure shows the impact on z-score of increasing capital ratios by 10% after all controls. The lines represent one standard error around the point estimates. The impact of simple leverage ratios on bank risk is both economically and statistically more significant than the impact of regulatory ratios on bank risk. A 10% increase in simple leverage would result in a bank moving from median to the 60<sup>th</sup> percentile in risk rankings after all controls and after holding regulatory capital constant.

**Figure 12: Relationship Between Bank Risk and Regulatory Capital and Simple Leverage**

<!-- Start of picture text --> Z-Score<br> 9.0<br> 8.0<br> 7.0<br> 6.0<br> 5.0<br> 4.0<br> 3.0<br> 2.0<br> 1.0<br> -<br>RC/RWA Equity/TA<br><!-- End of picture text --> Source: Own calculation using archived data from Bureau van Dijk’s Bankscope and BankFocus. Note: We report the effect on the Z-Score of moving from increasing regulatory capital (RC/RWA) and simple leverage (Equity/TA) by 10%. The estimates are obtained after controlling for bank size (log(TA)), bank liquidity (LiquidA/TA), bank profitability (ROA), reliance on short-term funding (ShortFund/TA), and loan ratio (Loans/TA).

We also examine the impact on bank risk of having a higher proportion of bank capital in the form of Tier 1, which is captured by the coefficient on the variable Tier 1 Capital over Regulatory Capital (Tier 1C/ RC). In the second specification we capture the impact of having a higher portion of riskweighted assets, which is captured by the coefficient on the variable RWA/TA. We use the same bank control variables in both specifications reported in Table 1. All capital ratios and controls are lagged by one year. The coefficient on the Tier 1C/ RC variable captures the impact of having higher proportion of capital in the form of Tier 1. Since we control for the overall level of regulatory capital, the coefficient 15
on this variable captures the marginal impact of having greater proportion of capital in the form of Tier 1 capital, holding the overall capital ratio constant. Similarly, the coefficient on the RWA/TA variable captures the impact of having higher proportion of bank assets with higher risk-weights. We interact these variables with dummy variables for ECA high-income and ECA developing countries to estimate their differential impact by level of economic development.

The results are reported in Table 3 below. Overall, we find that risk-weights are less informative in the ECA region in both high-income and developing countries, though for high-income countries the magnitude of the negative relationship is higher. Higher regulatory risk-weights are associated with higher future bank risk. But this relationship is significantly muted for banks located in the ECA region (Table 3, columns 1 and 3). The results suggest that risk-weights are less informative in the ECA region compared to the rest of the world.

**Table 3: Relationship Between Risk-weights, Capital Quality and Bank Risk**

|VARIABLES|(1)<br>Z-Score|(2)<br>Z-Score|(3)<br>Z-Score|(4)<br>Z-Score|
|---|---|---|---|---|
|Size|-1.555***|-1.086***|-1.451***|-0.759***|
||(0.235)|(0.245)|(0.277)|(0.291)|
|ROA|6.007***|5.780***|5.527***|5.121***|
||(0.244)|(0.264)|(0.283)|(0.282)|
|ShortFunds/TA|-0.149***|-0.193***|-0.329***|-0.322***|
||(0.040)|(0.039)|(0.046)|(0.045)|
|Loans/TA|-0.194***|-0.367***|-0.179***|-0.411***|
||(0.042)|(0.037)|(0.046)|(0.041)|
|Liquid A/TA|-0.950***|-0.944***|-0.952***|-0.953***|
||(0.044)|(0.045)|(0.050)|(0.051)|
|RC/RWA|1.163***|1.393***|1.190***|1.343***|
||(0.096)|(0.101)|(0.099)|(0.104)|
|ECA High Income|-4.328|118.950***|||
||(4.489)|(8.522)|||
|ECA Emerging|||-36.760***<br>(6.713)|38.170***<br>(8.851)|
|RWA/TA|-0.496***||-0.522***||
||(0.045)||(0.046)||
|ECA High Income *|||||
|<br>RWA/TA|0.372***<br>(0.069)||||
|ECA Emerging* RWA/TA|||0.488***<br>(0.090)||
|T1C/RC||0.362***||0.456***|
|||(0.060)||(0.061)|

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ECA High Income * T1C/TC

|T1C/TC<br>ECA Emerging* T1C/TC||-1.094***<br>(0.096)||-0.524***<br>(0.103)|
|---|---|---|---|---|
|Constant|90.862***|28.654***|93.608***|24.845***|
||(4.502)|(6.810)|(4.727)|(7.292)|
|Observations|78,022|81,661|67,671|69,672|
|R-squared|0.105|0.104|0.094|0.090|
|Year FE|Yes|Yes|Yes|Yes|

Note: *, **, and *** represent statistical significance at 10%, 5%, and 1% two-tailed level, respectively. Robust standard errors in parentheses clustered at the bank level. All independent variables are lagged one year.

The figure below shows the estimates from the regression analyses. A 10% increase in RWA/TA results in a significant increase in risk (-3.5 decline in the z-score) in countries excluding ECA, which is represented by the first bar in the figure. However, the impact of a similar increase in the ECA highincome and developing regions is negligible, which are represented by the other two bars in the figure.

**Figure 13: Relationship Between Risk-weights and Bank Risk**

<!-- Start of picture text --> Z-Score<br>1.00<br>0.50<br>0.00<br>-0.50 ROW ECA High Income ECA Emerging<br>-1.00<br>-1.50<br>-2.00<br>-2.50<br>-3.00<br>-3.50<br>-4.00<br><!-- End of picture text --> Source: Own calculation using archived data from Bureau van Dijk’s Bankscope and BankFocus. Note: We report the effect on the Z-Score of increasing risk weighted assets (RWA/TA) by 10% for EU ECA countries and the other ECA countries (Emerging ECA). The estimates are obtained after controlling for bank size (log(TA)), bank liquidity (LiquidA/TA), bank profitability (ROA), reliance on short-term funding (ShortFund/TA), and loan ratio (Loans/TA).

Examining the impact of the proportion of Tier 1 in regulatory capital, we find that the quality of capital matters in reducing bank risk. Consistent with the notion that capital that is not Tier 1 can be severely undervalued during times of distress and not able to absorb shocks, we find that capital is less effective in reducing bank risk if a higher proportion of it is in the form of Tier 2 capital. However, as mentioned earlier, what constitutes Tier 1 capital varies across countries and Tier 1 stringency is lower in the ECA region. If supervisors can limit what can be included as Tier 1, we would expect a greater 17
proportion of Tier 1 capital to have a greater impact in reducing risk in countries that impose greater stringency. The results suggest that a higher proportion of Tier 1 is less effective in reducing risk in the ECA region in both high-income and developing countries (Table 3, columns 2 and 4).

These results highlight the importance of how capital is defined. In particular, we find that simple leverage ratios are more informative than regulatory capital when it comes to explaining bank risk. Lower quality capital that is not common equity has lower loss absorptive capacity. Properly measuring risk exposure for computing risk-weights is also very difficult especially for large and complex financial organizations. There is also much discretion in the calculation of risk-weights, which creates the possibility of manipulation. As a growing number of countries in ECA have adopted or implemented components of Basel II and III, more banks (especially large banks) are relying on internal models for the calculation of risk-weights. Figure 14 below shows Basel implementation in each ECA group. While smaller, low-income countries have been shifting out of Basel I, most have adopted Basel II/III compared to other developing countries.

# **Figure 14: Basel Implementation as of 2016**

<!-- Start of picture text --> EU CE & BC WB SC CA Russia Turkey EE RoW<br>Basel I Basel II Basel III<br>100<br>80<br>60<br>40<br>20<br>0<br><!-- End of picture text --> Source: Bank Regulation and Supervision Survey conducted by the World Bank. Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW** for the rest of the world **.** Basel III addresses some of the weaknesses related to quantity and quality of capital that we have highlighted. In particular, under Basel III the common equity ratio is 4.5% of risk-weighted assets, up from 2% under Basel II. Basel III also introduces an additional capital conservation buffer of 2.5% of common equity. Tier III capital is eliminated, and a supplemental minimum 3% leverage ratio is imposed as a backstop to the risk-based capital requirement. This leverage ratio is calculated as Tier 1 capital over total assets and is thus not based on risk-weighted assets. Although the use of a simple 18
leverage ratio is a step in the right direction, it is not clear whether 3% will be enough to cover bank losses should a crisis of a similar magnitude as the GFC occur again.

Reliance on internal models to compute risk-weights continues under Basel III. Figure 15 shows the percentage of countries in each ECA group adopting different approaches for calculating capital requirements for credit risk. Russia, Turkey and all countries in the CE and BC regions use an internal model for computing credit risk which determines risk-weights used in regulatory capital. Other developing countries in the ECA region have been selective in adopting some of the Basel II/III provisions, opting to use a standardized approach to calculating credit risk. As our analyses have shown, this is not necessarily a bad thing. It makes more sense to focus on a framework that is transparent and robust for computing credit risk. It is also important to keep in mind the notion of proportionality and incorporate the framework that reflects the characteristics of the local financial systems and refrain from incorporating unnecessarily complex and costly elements of Basel II/III.

**Figure 15: Approach for Calculating Capital Requirements for Credit Risk as of 2016**

<!-- Start of picture text --> EU CE & BC WB SC CA Russia Turkey EE RoW<br>Simplified standardized Standardized Internal ratings-based (IRB)<br>100<br>80<br>60<br>40<br>20<br>0<br><!-- End of picture text --> Source: Bank Regulation and Supervision Survey conducted by the World Bank.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for WesternBalkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW** for the rest of the world **.**

# **III Regulation of Systemically Important Financial Institutions in ECA**

One of the important objectives of the new capital regulations introduced after the GFC has been to protect the public from the economic damage caused by the failure of the so called systemically important financial institutions (SIFIs). Because of the market’s perception that these institutions are too-big and too-interconnected to fail, there is a concern that SIFIs may engage in excessive and correlated risk-taking. The governments are then forced to step in and provide capital and liquidity 19
support in order to avoid costly liquidation.<sup>11</sup> Growing size and concentration of banks poses a critical challenge for ECA because of the economic and political ramifications connected to the failure of these large financial institutions. Although the banks in the ECA developing region are small in absolute terms, they are large in comparison to the local economies. Sberbank in Russia with assets over US$400 billion, for instance, is one of the largest banks in Europe. Since 2007, the top 5 banks by asset size have grown larger in all ECA sub-regions except in Central Europe and the Baltic countries (Figure 16).

# **Figure 16: Top 5 Bank Assets as a % of GDP**

<!-- Start of picture text --> 191<br>169<br>114<br>67<br>63 53 56 59 63<br>44 48<br>34<br>26 28 28 29<br>18 20<br>EU CE & BC WB SC CA Russia Turkey EE RoW<br>2007 2017<br>200<br>180<br>160<br>140<br>120<br>100<br>80<br>60<br>Total assets - Top 5 banks (% GDP) 40<br>20<br>0<br><!-- End of picture text --> Source: Own calculation using archived data from Bureau van Dijk’s Bankscope and BankFocus. Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe.

Following guidelines and international standards set by the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS), new rules and regulations have been put in place to limit economic damage posed by SIFIs and to strengthen market discipline. Specifically, there are higher capital and liquidity requirements overall and additional surcharges for institutions deemed systemically important. There are also new rules for the orderly resolution of large banks and new requirements for these banks to hold bail-in debt.<sup>12</sup> These additional capital requirements are intended to provide enough equity cushion to make these institutions more resilient and to internalize the social impact of their failure.

> 11 Government interventions to support national banking systems were widespread during the global financial crisis, especially because of the systemic relevance of the distressed institutions. Systemic risk grows with bank size (Laeven et al., 2016) and with the degree of interconnection with the interbank network (Drehmann and Tarashev, 2013).

12 The BCBS set guidelines to identify both global and domestic systemically important banks. The assessment is based on the average of 12 indicators associated with five dimensions of systemic risk: size, interconnectedness, substitutability/financial institution infrastructure, complexity, and cross-jurisdictional activity (BCBS, 2018).

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The implementation of these new rules and regulations has been uneven across different countries in the region. Figure 17 below shows the percentage of countries in each ECA group that have implemented new capital and liquidity requirements according to the latest BRSS survey. Russia and Turkey, where some of the largest banks are located, have imposed new capital surcharges for banks deemed systemically important. Additional liquidity requirements are still to be implemented in the majority of ECA countries.

**Figure 17: Capital and Liqudity Requirements on SIFIs**

<!-- Start of picture text --> 100100 100<br>71<br>64<br>50<br>40<br>33 33 33<br>29<br>17<br>15<br>0 0 0 0 0<br>EU CE & BC WB SC CA Russia Turkey EE RoW<br>Additional capital requirements Additional liquidity requirements<br>100<br>80<br>60<br>40<br>20<br>0<br><!-- End of picture text --> Source: Bank Regulation and Supervision Survey conducted by the World Bank. Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW for** the rest of the world **.** Another important element of new regulations has been to provide a robust framework for the resolution of systemically important banks. The bankruptcy of Lehman Brothers in 2008 highlighted the many difficulties in resolving large banks with multiple business lines in different countries subject to local regulations in those countries. Moreover, without a specific resolution regime for large/interconnected financial institutions, supervisory authorities lack the tools to intervene in the preinsolvency stage and activate contingent plans to resolve large financial institutions in an orderly manner, preventing major disruptions to the financial system and the real economy, and minimizing the risk of loss for taxpayers. Figure 18 below shows the percentage of countries in each region that have implemented policies for the resolution of large financial institutions. The ECA region lags behind the rest of the world in addressing resolution of SIFIs. This is especially a concern for Turkey and Russia which host some of the largest banks that are internationally active in the ECA region.

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**Figure 18: Resolution of SIFIs**

<!-- Start of picture text --> 100<br>73<br>67<br>53 55<br>50<br>47<br>33 33<br>29 29<br>18 1717<br>10<br>0 0 0 0 0 0 0 0 0 0 0 0<br>EU CE & BC WB SC CA Russia Turkey EE RoW<br>Different processes for resolving SIFIs<br>Banks required to file resolution plans<br>Formal supervisory and regulatory framework for the resolution of international banks<br>100<br>80<br>60<br>40<br>20<br>0<br><!-- End of picture text --> Source: Bank Regulation and Supervision Survey conducted by the World Bank.

Note: **EU** stands for Western Europe, Southern Europe, Northern Europe; **CE & BC** for Central Europe & Baltic Countries; **WB** for Western Balkans; **SC** for South Caucasus; **CA** for Central Asia; **EE** for Eastern Europe; **ROW for** the rest of the world **.** Finally, it is important to note that some of the largest banks in the region are partially or wholly owned by the state. Hence, there is a concern that resolution procedures may not be fully implemented due to political and public pressures. Moreover, the resolution rules may also not have the intended effect of strengthening market discipline as bank managers and investors expect the governments to step in and rescue these institutions that they perceive to be too-important to fail. By the same token, there are challenges that arise in introducing the core bank resolution building blocks proposed after the GFC. For instance, in the absence of well-developed financial markets in many ECA countries, there is no market for contingent convertible debt that can turn into equity if a pre-specified financial stress occurs (Fontán et al., 2019; GFDR 2019/2020).

# **IV Conclusion**

The global financial crisis revealed significant weaknesses in capital regulations that were in place prior to the crisis. Financial institutions lacked high-quality capital to weather the crisis, resulting in government support to rescue these financial institutions. After the GFC, several reforms have been implemented to strengthen capital requirements and to address risk posed by systemically important financial institutions.

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Ten years after the crisis, the banks in the ECA region are better capitalized as measured by regulatory capital ratios. However, the increase in simple equity ratios for the same banks has been much more limited. Moreover, the increases in regulatory capital ratios have coincided with a reduction in Tier 1 stringency and reduction in risk-weights. We show that bank risk in ECA is more sensitive to changes in simple leverage ratios than it is for regulatory capital ratios. This is because the equity ratios only include high-quality capital and do not rely on internal risk models to compute risk-weights. Whether the regulatory capital proves to be adequate in the next crisis will depend on the accuracy of risk weights in truly capturing forward-looking risk and on the loss absorbing capacity of lower quality capital that is now part of Tier 1 during a crisis.

Although small in absolute terms, developing countries in the ECA region host some of the largest banks relative to the size of their economies. The region has been lagging behind in addressing the resolution of systemically important institutions within their borders. A number of these SIFIs are also internationally active and operate outside national borders. Progress has been slow in setting up international co-operation for cross-border resolution. Given the significant state ownership of banks in ECA, how resolution will work in practice also remains unclear.

23