Capital regulations and financial stability : a cross-country perspective

Abstract

Financial stability is without conjecture the primary policy objective of central banks today, in addition accounting for regulatory capital requirements as a solution to the problem, have preoccupied bank regulators since at least the onset of the Global Financial Crisis in 2007/08. Notwithstanding, systemic-risk channel of financial stability is still evolving and our understanding of it is very limited. Designing efficient regulatory capital framework that is not procyclical can be a desirable policy pursuit, as well as possible solution to the too-big-to-fail problem, which involves government indemnifying big corporations at public expense while at the same time be indifferent to smaller, struggling firms. This forms the key objective of this study. This thesis is the first coherent framework of credit risk for Australia and the U.S., conducting macro- stress-test analysis, providing a useful metric for systemic-risk evaluation. It outlines the overarching theme of this research by providing a historical overview of financial stability developments, often through the premise of banking-crises explanation. The study also reviewed theoretical and empirical literature to explore the niche for the current scholarship on financial stability. This study utilises a combination of theoretical and empirical frameworks for laying out the research plan. As part of the empirical exercise, credit risk and macro stress- test utilise weighted least squares and quantiles analysis, respectively. The cyclical nature of existing capital regulations in Australia has been examined using moving average (MA) regression, as well as unsmothered measure of minimum-capital requirement for extreme losses. Similarly, systemic-risk determination of financial stability is investigated through an empirical measure, taking the behaviour of counterparty risk premium during the Global Financial Crisis of 2007-2008 as a test case. Lastly, the effective-communication channel of financial stability, which is being recently adopted by many central banks, has been analysed, using the financial stability reports published by the Reserve Bank of Australia. It has been argued that short-term interest-rate expectation and debt levels play an important role in insolvency rates, which are at the heart of any credit-risk framework. It is not surprising that tail-risks can potentially exacerbate business cycles, i.e., it might feedback into pro-cyclicality, which supports our hypothesis that the current Basel regulatory requirements tend to decrease in the upswing of business cycles, and increase in downturns. Future attempts to make the current regulatory regime more robust, should include some measure of liquidity risk, for example, the Libor-OIS spread, in credit-risk modelling frameworks.

Date of Award	2011
Original language	English