Increased regulation and higher capital requirements: The profitability of US banks during implementation of Basel III

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Department of business administration

Increased regulation and higher capital requirements

The profitability of US banks during implementation of Basel III

Lars Edvardsson, Calle Nordlander

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Abstract

Since the financial crisis in -08 there has been a need in regulating banks and their behavior. After a while, the Basel committee took action and started to work on the third version of the Basel framework, forcing banks to maintain higher equity and to be prepared for fast drops in liquidity on the market. The banking industry quickly responded that this could create costs over the global economic market. The argument came from the idea that debt is generally cheaper to hold compared to equity. They also expected the lending growth to decrease since the economy declined, which in turn would lead to a lower net interest margin and loss of profit. There has been theory that supports their claim, but it is still lack of empirical evidence. Therefore, a need for statistical proof of what will happen to banks when regulation is increased. Based on the background, the study is aiming to answer the research question:

“What effects has the increased requirements (capital ratios, restructuring of capital) of the ongoing implementation of Basel III had on US Banks’ cost of capital, lending growth and net interest margin?”

Through several regression models tested, a quantitative study was performed which found that the increased requirements of capital and capital restructuring does not affect US banks’ lending growth. Although, the capital restrains did affect banks’ cost of capital negatively as it decreased and their net interest margin as it also decreased. The cost of capital analysis showed that there must be two counteracting forces that affects the variable, where the largest one decides which way it goes. The first one is that it should increase due to more expensive financing, and the other that banks become less risky for investors to invest in. This leading to the banks’ profitability not being as threatened as one might believe.

Contributions that the study brought are showing regulators that it is a necessity to be careful when implementing new regulation, as banks might lose some of their profit from the action which could be damaging for them. It also made sure that one must not discount for the effect of reduced systematic risk, and the gain that comes from it. In the end, developing of new regulation comes down to one thing; to make our economic society safer.

Keywords: Increased requirements, Basel III, net interest margin, lending growth, cost of capital, US Banks.

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Preface

This study was conducted at Umeå School of Business & Economics within Civilekonomprogrammet. This thesis is the authors degree thesis and concludes four years of academic studies.

The authors wish to thank Professor Jörgen Hellström for providing guidance throughout the writing process and Larsson & Carlsson for the much needed emotional support.

Calle Nordlander och Lars Edvardsson Umeå, 2019-05-16

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Definitions

BIS - Bank for International Settlements, Collaboration organ for 60 central banks which also hosts the BCBS, Basel Committee on Banking Supervision.

Capital structure – How a firm is choosing to finance the company, chosen by debt and equity or a mix of the two

Capital ratio – The capital ratio is the amount of capital divided by total value of the company.

CDO – Collateral Debt Obligation, a type of asset-backed security. If a loan defaults and the cash collected from the CDO is not enough, the lowest tranches suffer losses

Cost of equity – A firms’ cost of equity capital, or the return expected because of the market on other investment with similar risk to the firm Cost of debt – The cost of debt capital, how much it costs for a firm to borrow CRD-IV – Capital Requirements Directives, number four. A part of the Basel framework that was introduced in 2013.

Debt ratio – The debt ratio is the amount of debt divided by the total value of the company.

LCR – Liquidity coverage ratio, refers to the amount of highly liquid assets held by financial institutions.

Leverage – A company’s amount of debt compared to the amount of equity Liquidity – A company’s ability to reach its financial obligations in the short term

NFSR - Net stable funding ratio, helps to give banks incentives to fund activities with more stable sources.

OLS - Ordinary least squares, an estimator for the unknown parameters in a linear regression model.

Risk free rate – The return of a potential investment with no risk of a financial loss over a given period of time

Risk Premium – The extra amount that an investor would like to receive for taking on risk, compared to the risk free rate.

WACC – A firm’s average cost of debt- and equity capital financing that is weighted after the company’s debt- and equity ratios. “Weighted Average Cost of Capital”

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Table of Content

1. Problem background 1

1.1 Research question 5

1.2 Purpose of research 5

1.3 Research Gap 5

1.4 Delimitations 6

1.5 Theoretical and practical contribution 7

2. Theoretical Methodology 8

2.1 Preconceptions 8

2.2 The topic of choice and researcher background 8

2.3 Ontological standpoint 8

2.4 Epistemological standpoint 9

2.5 Research Approach and research method 10

2.6 Time perspective 10

2.7 Critical evaluation of sources 11

3. Background on the Basel framework 13

3.1 Basel I 13

3.2 Basel II 14

3.2.1 Pillar 1 14

3.2.2 Pillar 2 14

3.2.3 Pillar 3 15

3.3 Basel III 15

3.3.1 The capital conservation buffer 16

3.3.2 Non-risk based leverage ratio 17

3.3.3 Changed liquidity standards 17

3.3.4 New capital standards 18

4. Theoretical point of departure 20

4.1 Perfect Capital Markets 20

4.1.1 The Irrelevance theorem 20

4.2 The static tradeoff hypothesis 21

4.2.1 Costs of adjustment 21

4.2.2 Debt and taxes 21

4.2.3 Cost of financial distress 22

4.3 Regulation 23

4.4 Cost of Capital 24

4.4.1 Cost of Capital determinants 24

4.4.2 Regulation and cost of capital 24

4.5 Lending Growth 26

4.5.1 Lending Growth determinants 26

4.5.2 Regulation and lending growth 26

4.6 Net interest margin 28

4.6.1 Net interest margin determinants 28

4.6.2 Regulation and net interest margin 28

4.7 Theoretical summary 29

4.8 Hypotheses 30

5. Practical Methodology 32

5.1 Data Collection 32

5.1.1 Regression analysis 33

5.1.2 Regressions model and description of variables 35

5.2 Regressions 35

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5.2.1 Dependent variables 35

5.2.2 Independent variables 36

5.2.3 Control variable 37

5.2.4 Calculating risk premium 37

5.3 Regression assumptions 38

5.4 Model criticism 41

6. Results 42

6.1 Descriptive data 42

6.2 Results of regressions 45

6.2.1 Regression 1 45

6.3 Summary of regression testing and relation to hypothesis 52

6.3.1 Hypothesis 1a and 1b: 52

7. Analysis 54

7.1 Hypothesis 1a and 1b: 54

8. Conclusion 61

8.1 Increased capital requirements and cost of capital 61 8.2 Increased capital requirements and lending growth 61 8.3 Increased capital requirements and net interest margin 62

8.4 Research question 62

8.5 Practical and theoretical contribution 63

8.6 Future research 64

8.7 Ethical and social consideration 64

9. Quality Criteria 67

9.1 Reliability 67

9.2 Replication 67

9.3 Validity 67

List of References 69

Appendix 74

Appendix 1, list of banks 74

Appendix 2, scatter plot of net interest marign 74

Appendix 3, scatter plot of cost of capital 75

Appendix 4, scatter plot of lending growth 75

Appendix 5, histogram of the residuals of net interest margin 75 Appendix 6, histogram of the residuals of cost of capital 76 Appendix 7, histogram of the residuals of lending growth 76

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Tables

Table 1. Stages of implementation of Basel III ... 16

Table 2. Correlation matrix ... 39

Table 3. White's test for heteroscedasticity with the dependent variable lending growth ... 40

Table 4. White's test for heteroscedasticity with the dependent variable cost of capital ... 40

Table 5. White's test for heteroscedasticity with the dependent variable net interest margin ... 40

Table 6. Descriptive statistics – variables 2011-2017... 43

Table 7. Descriptive statistics – variables 2011 – 2014 ... 44

Table 8. Descriptive statistics – variables 2015- 2017... 44

Table 9. Regression model 1.1 ... 45

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1. Problem background

Background for the crisis

The financial crisis 2007-2008 is the largest financial crisis since the great depression in 1929. The crisis erupted when the housing market bubble burst and the banks had to write down loans for several hundred billion dollars. Several factors laid the base for the crisis.

The interest rate in the US was low due to the large inflow of capital, especially from Asia, simultaneously the Federal Reserve kept the interest rate low to stimulate growth (Brunnermeier, 2009, p. 77). Low-interest rates gave banks the opportunity to approve more loans than previously, and to top it off these loans were often very risky.

There were a couple of new trends in the banking sector that led to the final downfall.

One of them was banks changing their lending strategy. They ventured from the old model that exposed the banks to the risk of the loans until they were repaid, to a new model who involved new financial securities. Collateralized Debt Obligations, (CDO’s) were one of the securities that were going to have a big impact on the financial markets. CDO’s made it possible for banks to resell their customer’s loans to other financial institutions, by doing this they were only exposed to the risk for a shorter period of time. This created opportunities for banks to use techniques that would lower their risk-weighted assets, thus the amount of required capital to hold, while staying on their overall risk-level (Pakravan, 2014, p. 212). CDO’s were constructed by several mortgages with different kinds of risk, the mortgages were placed in different tranches and were given a new credit rating.

Further, the CDO’s were sold to investors with different kinds of risk appetite (Brunnermeier, 2009, p. 78-79). At the same time, another trend altered the banking sector. Banks started to finance their investments and daily activities with securities that had shorter maturity. This made banks more vulnerable to a sudden dry up of the market liquidity (Brunnermeier, 2009, p. 78).

The new financial inventions became increasingly popular, trading with instruments like CDO´s surged and huge amounts of credit washed over the markets. This led to that the standard for mortgage loans fell and banks approved mortgage loans on an ongoing basis without detailed inquiries. A big part of the loans was highly risky and was granted to low-income citizens with low credit ratings. The premises were that the prices on houses were continuing to go up and borrowers could always finance their loans with their houses. A huge bubble started to form on the mortgage market, which eventually would burst when prices started to consolidate and then began to fall (Brunnermeier, 2009, p.

82).

One of the biggest reasons for the financial crisis was that banks and other financial actors were not sufficiently regulated. Because of this, the banks had been building up an excessive on-and off-balance sheet leverage which was accompanied by a shrinking capital base. On top of this, banks had an insufficient liquidity buffer. When the crisis erupted they did not have enough funds to absorb the losses, which got even higher because of the leverage. Further, this led to the demise of peoples trust in banks. Many chose to liquidate their funds and hesitated to invest, which became one of the reasons for the credit crunch and no liquidity within the banks (BCBS, 2010, p. 1). It became obvious that the framework that existed prior and during the crisis was not sufficient. An updated framework was needed to invoke stability and trust in the financial market. This

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led to that the leaders of G20 prioritized the reformation of the current regulatory framework and they established a plan for the process. The Basel Committee who published the first regulatory framework back in 1988 was given the task to strengthen the framework with new standards, recommendations, and guidelines which were going to be called Basel III (Blundell-Wignall & Atkinson, 2010, p. 3).

The US economy is the largest one in the world and the financial intermediaries based in the US are connected to every continent all over the globe (Focus-economics, 2019).

Therefore, it is interesting to see if parts of the implementation of Basel III regulation has affected some of the largest banks in the US and their profitability. As the financial crisis in -08 showed, the US financial sector are affecting the entire world when afflicted by a crisis such as the housing bubble.

The Basel framework

The Basel Committee sets the primary global standard for the regulation of banks and provides a possibility for banks to cooperate on banking supervisory matters. Their goal is to strengthen the regulation, supervision and practices of banks all over the world to enhance the financial stability. The Basel framework has in its role as a primary regulatory body for international banking been criticized. Even though the thought of Basel I and having a benchmark for banking regulation was broadly appreciated, there were troubles that came with it (Balthazar, 2006, p. 32). Basel I was perceived as too simple with its only demand on a certain capital ratio, Basel II, on the other hand, was viewed as very complex (Pakravan, 2014, p. 211). With Basel II, banks were allowed to use their own internal models to calculate their risk-weighted assets. This led to high variability in the risk-weighted assets between banks that were otherwise quite similar (Le Leslé &

Avramova, 2012, p. 13).

Basel III continues to build upon the structure of Basel II. Basel III is supposedly a comprehensive set of reform measures to enhance risk management, regulation and supervision of the banking industry and has its main focus on empowering bank´s capital requirement (Chockalingam et al. 2018, p. 226). The reform measures were introduced in different stages from 1 January 2013 (BIS, 2010). It started with a 3.5% limit on minimum common equity capital ratio, and 4.5% minimum tier 1 capital. In 2014 the common equity capital ratio increased to 4%, minimum tier 1 capital rose to 5.5%, and the minimum total capital became 8%. In the end of the phase-in in 2019, the goals are to have a minimum common equity capital ratio on 4,5%, minimum tier 1 capital of 6%, liquidity coverage ratio 100% and a minimum standard on the net stable funding ratio are some of the ratios (BIS, 2010). The tier 1 capital is the core capital and consists of common shares, stock surplus, retained earnings and accumulated other comprehensive income (BCBS, 2010, p. 13).

The liquidity coverage ratio makes sure that there is a sufficient amount of high-quality liquid assets held to withstand a potential liquidity crisis for 30 days and the net stable funding ratio promotes resilience during a longer time frame by trying to motivate financial institutions to fund their activates with more stable funding (BCBS, 2010, p. 9).

These changes involved new updates to capital requirements and a new capital buffer were introduced. The capital buffer is a further layer of common equity that will restrict payouts of earnings to help protect the minimum common equity requirement if breached.

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The idea is that the buffer will help strengthen the resilience of banks in case of a crisis and help to rebuild the capital buffer during the first stages of recovery. The capital conservation buffer has to be made up by Common Equity Tier 1 and as of 1 January 2019 the common equity tier 1 needs to be 2,5 %, if a bank falls below these level constraints will be imposed against them (BCBS, 2010, p. 55).

The financial crisis 2007-2008 was preceded by a long period of excessive credit growth which made the losses in the banking sector extremely large. Hence, the importance to build up additional capital defenses prior to an eventual emerging crisis. Because of this, the BCBS introduced a countercyclical buffer in Basel III (BCBS, 2010, p. 57). The countercyclical buffer will reflect the geographical environment of a portfolio consisting of credit exposures and has to be made up by Common Equity Tier 1 or other full loss- absorbing capital (BCBS, 2010, p. 58-59). Basel III also increased the required amount of Common Equity Tier 1 which rose between the years 2013-2015 (BCBS, 2010, p. 27- 28).

As one of the major reasons for the crisis was the build-up of a huge amount of on- and off-balance sheet leverage, the Committee introduced a minimum leverage ratio in Basel III. This will help to make sure that banks in the financial sector act as an absorber of risk instead of transferring it to the financial system (BCBS, 2010, p. 4-5). Further, new liquidity requirements were introduced as a strong liquidity base is equally important as a stable capital base. This new base was introduced as the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The LCR makes sure that there is a sufficient amount of high-quality liquid assets held to withstand a potential liquidity disruption for 30 days. The NSFR aims to promote resilience during a longer time horizon by creating more motivation for financial institutions to fund their activities with more stable sources of funding (BCBS, 2010, p. 9).

There were also other sorts of regulation beside of Basel III that came into place right after the financial crisis. The Frank Dodd-act was instated which forced banks to be more transparent and regulated the banks’ derivative instruments (Acharya, 2012, p. 5). This was not focused on capital ratios, but more on the internal behavior within the banks work to reduce the risk in the human factor (Acharya, 2012, p. 4).

Criticism towards Basel

The implementation of Basel III met criticism. One of the critics was The Institute of International Finance (IIF) which consists of economists and regulatory experts from numerous banks. In June 2010 they wrote an interim report on the cumulative impact of increased regulation of the banking industry. The report covers the impact on the economies of the United States, Euro area, Japan and emerging markets. The report states that the Euro Area is hit the hardest by the regulations, followed by the US and Japan (IIF, 2010, p. 5). Overall the IIF concludes that the GDP growth over the studied economies would slow down, fewer jobs would be created and global banking flows may be hindered as financial institutions will face balance sheet constraints (IIF, 2010, p. 5).

The Basel Committee answered the critique by publishing their own report in August 2010. They conclude that there still is significant room to have even stricter capital requirements while still achieving net benefits (BCBS, 2010, p. 28). They argue that a risk-averse society would be prepared to pay a premium to avoid the cost of a financial

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crisis and as higher capital and liquidity requirements would reduce the extremity of the crisis and the benefits would, therefore, be higher (BCBS, 2010, p. 5). Blundell-Wignall

& Atkinson (2010) criticized IIF´s conclusion for being exaggerated. They argue that the effects on the lending spread would be less than what was concluded in the IIF report.

Because of this, raising the capital to meet Basel III standards would be far less troublesome than the result in the IIF report (Blundell-Wignall & Atkinson, 2010, p. 20- 21).

There are some that argue for deregulating proponents; that it would be optimal for banks to have a high leverage capital structure. Pfleiderer et al. (2011, p. 4) implied that capital structure will affect the value of the firm. This statement is contradicting to one of the fundamentals in corporate finance theory, Modigliani-Miller Theorem (1958). M&M suggests that the firm’s market value will not change in case of a different capital structure. According to this, Modigliani-Miller theorem proposes that increases in bank’s equity in portion to the total assets will, in fact, reduce total risk and the required return on equity. Pfleiderer et al. (2011) argues that for settling this debate, there needs to be a discussion about whether the theorem is applicable to the banking industry or not.

The change in capital structure and regulation could also have other impacts on banks.

Some studies discovered that increased requirements would decrease loan growth in the first years, but at three years would have made a complete recovery (Bridges et al. 2014, p. 23). Further, there are studies that has provided support for IIF statements. According to Roulet (2017), European banks have experienced a steady drop in lending-growth between the years of 2008-2015. For larger banks, the lending growth on commercial loans and retail has even come to a negative since 2012-2013 (Roulet, 2017, p. 30). The study was performed using measures inspired by the Basel III framework and showed how increased regulation has a negative impact on large European banks’ lending growth.

Other studies have previously investigated variables in the relationship between bank profitability and net interest margin. Angbazo (1997), King (2013), Memmel (2010), and Rosen (2007) shows in their research how the Basel III regulation of the banking sector requires banks to possess a higher NSFR and how it leads to a lower net interest margin in 10 of the 15 countries from the specific sample. The US is although one of the countries that have had the same net interest margin up until the year-end 2009 which the data is based upon (King, 2013, p, 23)

Further, the change might also lead to an increase in the cost of capital. Most banks daily activities constitute of lending towards institutions and individuals. Stulz (1999) describes in a study that because of agency problems (the difference in information between management and investors) a firm’s cost of capital will depend substantially on the corporate governance system. This is because investors might think a project will contribute less value than management has projected, which leads to management being forced to sell on discount, increasing the effective cost of capital (Stulz, 1999, p. 9). If investors believe banks’ profitability will decline because of regulation they will choose to invest their money elsewhere leading to the increased cost of capital for banks.

As the Basel Accords is recognized globally as the key regulatory framework, new research showed that it might not fulfill the goals as it was set out to do. Bitar et al. (2018, p. 236) found in their research that the risk-based capital ratios that all Basel regulation is referring to do not, in fact, reduce the banks default risk, whereas non-risk based ratios do. Of course, this is an issue for the Committee since their main regulation is the risk-

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based capital ratios from the start, with some capital restructuring. Proving through research that the measures do not work as intended, could reduce faith in the committees’

ability to provide the best regulatory framework as possible and reduce risk in the banking sector.

The chosen variables are common in measuring bank profitability. In 1992 a paper was published where the authors investigate optimal bank interest margin under capital regulation and deposit insurance. Zarruk et al. (1994) presented a model and from it concluded that changes in a banks regulatory parameter have a direct effect on the bank’s optimal interest margin. Further, decreases in margins will affect a bank’s ability to endure loan losses (Zarruk et al. 1994, p. 148). As lending growth declined during the financial crisis (Meriläinen, 2016, p. 169) we find it interesting to look at this how this parameter has been affected since Basel III was introduced. In the paper “Do Strict Capital Requirements Raise the Cost of Capital” the authors argue that by introducing stricter capital requirements banks cost of capital may rise (Baker & Wurgler, 2015, p. 315).

How the banking industry has been affected by the increase of regulation are therefore not completely certain. This might be an issue for both banks as well as regulators as they do not know how to adapt to regulations in the best possible way, hence creating uncertainty in the industry. Not being sure how regulation affects the banking industry could be problematic, and that is something this study would like to help to prevent.

Due to the US adoption of Basel III, there should be possible to conduct a study on how it has affected the banking industry so far. Smaller US banks do not have the same demands on adopting Basel III, hence the study will be focused on larger banks instead.

1.1 Research question

What effects has the increased requirements (capital ratios, restructuring of capital) of the ongoing implementation of Basel III had on US Banks’ cost of capital, lending growth and net interest margin?

1.2 Purpose of research

The purpose of this study is to analyze how US banks are affected by the implemented Basel III framework by retrieving data and performing a quantitative study. The regulations were created to provide stability in banks and reduce their leverage by increasing held equity. We will look at some key variables, such as cost of capital, lending growth and net interest margin to see if the profitability of the chosen banks in the US is being increased, decreased or unchanged from the changes in the Basel Accords.

1.3 Research Gap

There have been studies devoted to theoretical costs of the new Basel III regulation, but none has thus far shown outcomes on an empirical level. Opinions are widespread, the banking industry thinks that with the new regulation, the economy as a whole will suffer from lower GDP and increased unemployment through increased lending costs (IIF, 2010). Academic work has been inconclusive, and the direction has been in the economy

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as a whole and not about the individual banks’ well-being. On the European banking sector, there has been coverage around the matter. This is not odd considering that the European banking sector was hit the hardest during the financial crisis 2007-2008.

However, in the US banking sector studies seem to lack depth in how the implementation of Basel III has affected certain key variables of profitability. With the US economy being the strongest in the world, it is important to find out if the implementation of further regulations could possibly halt the financial growth in the US financial sector (Focus- economics, 2019).

There has been studies that argue the increased regulation would only lead to small changes (Blundell-Wignall & Atkinson, 2010), others that the changes would be substantial but brief (Bridges et al. 2014), and some such as large institutions that see immense changes that might lead into regression (IF, 2010). We see a gap in this empirical research which this study will try to fill.

1.4 Delimitations

As previously mentioned, the performed study will put its focus on US banks. By only investigating banks that have implemented the new regulation, we have chosen 20 of the biggest banks as the smaller more regional banks do not have the same demands on following Basel III (Masera, 2013, p. 388), which can be found under Appendix 1. Our focus will be on the US banking industry as a whole and not on the individual institutions, which makes it possible to draw a conclusion to a larger population. The chosen banks have different main activities, the most common is commercial banking with a few that focuses on investment banking but all have banking as main activities. The small number of banks chosen might differ from the population, but due to limitations in time, it is a necessity to make scope restrictions.

The chosen time frame will be limited to data for a number of years before and during Basel III framework are being implemented 2011-2017. Going further back in time would not benefit the study since there would have been disturbances in the economy that might have affected the variables. Since Basel III is to be implemented over the years 2013- 2019, it is not possible to measure the full effect of the increased regulation. It can only be seen as a measure on how it has affected the banks until now, but could be used as a tool to see what might occur further in the future. The timespan chosen in this study should be satisfactory for its intended purposes.

The Frank-Dodd act was implemented in 2010 by the Obama administration in the US as a response to the disaster in the banking industry 2007-2008. The act was made to address the increasing propensity in the financial sector which was putting the system at risk and possibly be bailed out by the government at the taxpayer’s expense. It was created to make banks more transparent in banks’ use of financial instruments and supervise their trading. The highlights of it are:

• Regulate and identify systematic risk

• Proposing no bank is too-big-to-fail

• Giving the federal reserve more authority and responsibility

• Restricting regulatory interventions, preventing federal assistance to individual non-bank institutions

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• Limit bank holding company’s investments in trading activities such as hedge funds and private equity

• Regulating derivatives and forcing transparency, central clearing of standardized derivatives, regulating OTC-derivatives, etc (Acharya, 2012, p. 5)

When the focus on this study is to investigate how capital regulations have affected the US banking industry using key variables, there had to be limitations on which variables to pick. Hence, the three mentioned above were chosen as they are good measures of bank profitability. We believe that the Frank-Dodd act does not affect the banks’ capital ratios and restructuring of capital in a way that could be compared to the Basel III framework.

Still, it is a factor that must be considered.

1.5 Theoretical and practical contribution

The theoretical contribution to this paper will bring additional data to a subject that is constantly receiving new information. With data providing different outlooks on the Basel accords and the regulation, additional information might be needed to reach consensus.

We hope this research will contribute towards that. Further, no similar research has been found on the subject towards the US market using profitability variables. As the US is one of the strongest economic countries, their importance in the global economy is tremendous, proven by the financial crisis. Given this information, studies focused on the US banking market should attract growing interest.

The practical contribution of this paper is that it gives insight to both the industry getting regulated and the regulators. By presenting how the increased regulation has affected banks, regulators will be assisted in providing optimal regulations for banks and the economy as a whole. Regulators are most likely well aware of the theoretical costs of the regulation, but there has been no real empirical evidence on the actual cost. The banks could as well use this information on how it has affected them, if for no other reason, as leverage towards newly updated regulations.

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2. Theoretical Methodology

The purpose of this chapter is to introduce the reader to the theoretical methodology used in the study. This chapter will discuss researcher preconceptions, research philosophy, research approach, and research methodology.

2.1 Preconceptions

When writing a thesis, it is important to discuss preconceptions the authors may have prior to constructing a research strategy. The theoretical preconceptions regard theories, views, and experiences based on inner discipline, business economic, social and pedagogical factors. There is two parts to this, first-hand preconceptions and second-hand preconceptions. First-hand preconceptions stem from experiences the authors had encountered in the daily life and second-hand preconceptions stem from experience gained by for example lectures and academic literature. The preconception knowledge is an important step to remain objective along with the authors use of cross-sectional design, choice of literature and source criticism (Johansson-Lindfors, 1993, p. 76-77). The authors have only been in contact with capital regulation through academic courses where both sides of the regulation are showed. Therefore, the preconceptions are rather small, if not non-existing.

2.2 The topic of choice and researcher background

This study is part of the examination of the Civilekonomprogrammet Umeå University.

The authors have no practical experience of working in the banking sector and all experience stems from academical studies and by following the financial markets through media. The topic of choice comes from the author's interest in financial markets and by studying financial courses at Umeå University. The last course we read was risk management, which led us into the area of regulation and how it affects companies. We found it very interesting and decided to research it in some way. The financial crisis 2007- 2008 was a theme throughout the financial courses and regulation was also discussed in detail particularly through the implementation of Basel. When exploring the financial meltdown 2007-2008 through academic courses and by reading articles one realizes that Banks were in the midst of it all. As regulation was a topic on the later courses in the financial bracket this naturally led to the choice of topic.

2.3 Ontological standpoint

The main question when considering the ontological standpoint is to question whether social entities can, and should, be viewed as objective entities that have a reality outside of social actors or if they should be viewed as a social construction created by perceptions and actions of social actors. These two standpoints are supported respectively by objectivism and constructionism (Bryman, 2015, p. 32). A concept divided into two camps often causes conflicts and this is not an exception. Objectivism is often criticized for being too scientific in understanding reality, critics argue that science cannot be based on objectivity alone since the objective conclusions stem from the subjective worldview of its researchers. The constructionist standpoint stems from the conviction that there is

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nothing like “ultimate true knowledge”, but what is regarded as the “truth” is the result from subjective socio-cultural views, which in turn is regarded as “reality”. Because of this, constructionism is often criticized for the self-refutation of relativism (Chipangura et al. 2016, p. 264).

This study will have its base through a positivistic research paradigm which makes it natural to assume an objective view of reality. When emanating from an objective view of reality, personal opinions does not influence the result and no matter how many times the study is performed, the results will always remain the same. This study investigates how the implementation of Basel III has affected bank’s profitability so far, based on key variables such as cost of capital, lending growth and net interest margin. Given the purpose of the study, an objective view of reality comes natural. The testing will be conducted through quantitative testing, which enhances the choice of an objective view because there is only one way of looking at numbers. The results from the testing will then either confirm previous theories and studies or reject them showing more studies might be needed.

2.4 Epistemological standpoint

A central issue in epistemology is whether the social world can, and should be researched through the same principles, procedures, and ethos as the natural sciences. There are two important terms from the epistemological standpoint, positivism, and interpretivism.

Positivism is often regarded synonymous with the scientific but according to Bryman (2012), this is a mistake. Opinions differ on how to characterize scientific practice and when writers complain about the limitations of positivism it is not clear if they mean the term on a philosophical level or a more general scientific approach. However, since the model that is used to argue the appropriateness of the natural science model has largely positivist overtones, one can assume that positivism still can characterize scientific practice (Bryman, 2012, p. 28). As the positivistic standpoint is based on solid facts and science this study naturally follows the positivistic paradigm. Some critics argue that when assuming a positistic standpoint you could limit the philosophical aspect when collecting information. If this is the case it would not be a problem since this study does not aim to delve down in human behavior and instead use historical quantitative data in the process of obtaining new knowledge to present a scientific result. Also, as the data collected will be numerical, one can assume that it will be objective and unbiased which strengthens the choice of a positivistic standpoint.

Interpretivism argues that the scientific model outlined to study the social world have been influenced by different intellectual traditions. Further, the main subjects of the social sciences, people and their institutions, are essentially different from the natural sciences.

To study the social world, the need for a different approach which reflects the distinctiveness of humans as against the natural order is imminent (Bryman, 2012, p. 28).

If a study assumes a interpretivistic view, interviews as a form of information gathering would be more effective when collecting data because of the social aspect of interpretivism.

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2.5 Research Approach and research method

When choosing research method one has to consider the relationship between theory and research, the epistemological standpoint, and the ontological standpoint. The research method stems from these three areas. There are two approaches to the research method, qualitative and quantitative. MacIntosh & O’Gorman (2015) describes that for a quantitative approach, it is most common to possess an objective view of reality and a positivistic standpoint which is the opposite of what qualitative approach usually has. The quantitative approach emphasizes, just like the name implicates, quantification in the process when collecting and analyzing data. The qualitative approach usually stresses the importance of using words rather than quantification when collecting and analyzing data (Bryman & Bell, 2015, p. 37-38).

We have already described two of the three areas that are connected to the research method, the study follows the objectivistic view when it comes to the ontological standpoint and the positivistic standpoint when it comes to epistemology. Both these areas point towards a quantitative approach. The last area to consider is whether the study is going to be conducted through a deductive approach or an inductive approach. Theory possesses a key role in performing studies, but depending on how the study could be connected, the theory can vary depending on the type of research that is being performed.

MacIntosh & O’Gorman (2015, p. 54) describes that a deductive approach means that the study will achieve its results from statistical tests and hypothesis. The opposite to that would be to have an inductive approach and achieve new knowledge and new theories through an empirical analysis (MacIntosh & O’Gorman, 2015, p. 54). One could say that the deductive approach stems from theory to new results, while inductive approach stems from observations to new theory.

This study will follow the deductive approach to answer the research question since the purpose is to analyze how US banks are affected by the implementation of the Basel III framework. This will be investigated through already existing theory such as the tradeoff theory and Modigliani & Miller´s perfect capital markets and previous research that investigated how Basel III has affected banks. The study will also use known formulas such as cost of capital, lending growth and net interest margin to find out how the profitability has changed and create new hypotheses that will conclude if the theory and reports were in fact correct.

2.6 Time perspective

When performing a study, researchers can use different time-horizons, depending on what it is that they want to point out (Cooper & Schindler, 2014, p.128). There are two ways that are more often used, which are cross-sectional studies, where the goal is to investigate a certain phenomenon at a certain time, and longitudinal studies, which is ordinarily focused on tracking developments over longer time-spans (Cooper & Schindler, 2014, p.

128). Which way one chooses to go might affect the way the researcher collects their data.

Usually, cross-sectional studies prefer observing survey data and longitudinal studies prefer quantitative data that might be collected from various databases.

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This study will utilize a longitudinal perspective since the goal is to investigate how variables are changing over time, with a specific time-span and a break to see the difference in between them. The comparison made will be over time and not over different cases. The longitudinal choice of approach is important to see what effects Basel III and the increased regulation has had on bank profitability variables, by comparing the timespan before and after implementation. It would be preferable to observe before and after full implementation, but since the deadline for implementation was in the beginning of 2019 that is not possible.

2.7 Critical evaluation of sources

When performing a study, it is crucial to analyze the sources that are being used.

Especially when several institutional reports are used in the theoretical framework. It is important to realize that most of these institutions have their own agenda and might benefit in some way from certain results. One clear example of this is the opposing institutions IIF and the Basel Committee. IIF which consists of leaders within the commercial banking industry, and would benefit from minimizing the regulatory requirements. And the opposite side, the Basel Committee, that consists of the leaders of different countries central banks, which ambition is to ensure that no bank will go bankrupt and needs to be bailed out which would create a large cost to the society.

To make sure that the literature included in a study is evaluated properly, all literature used has been assessed such as that is satisfies a framework put forth by Harris (1997), and is called the CARS-framework. The CARS Checklist (Credibility, Accuracy, Reasonableness Support) is made to ease learning and use of literature.

1. Credibility refers to that if you would read an article claiming there will be flooding in the next six months, it is crucial for you to know whether or not to believe that information. Questions one might ask themselves are; What makes this source believable? How did the source receive this information? Why is this source more reliable than others? (Harris, 1997, p. 3) This criterion is satisfied since we are using credible scientific databases with articles that are peer- reviewed and cited in several other research papers on banking profitability and regulation. This is something that will increase the credibility of our study overall.

Further, information brought into this study that is not from these databases is considered credible because of their recognition of credibility.

2. Accuracy refers to assure that the information being brought up is actually correct, that is; factual, detailed, exact, comprehensive and up to date. For example, if a credible author made a statement that was correct 20 years ago, it does not make it correct today. Another example could be a source that gives credible, up to date information, but it does not give the full picture (Harris, 1997, p. 5). Modigliani

& Miller, (1958), is one of those examples, but which is necessary to be brought in to show where much of today’s research originate from.

3. Reasonableness refers to examining the information for objectivity, fairness, consistency, and moderateness (Harris, 1997, p. 7). This study has satisfied this criterion by observing the critique of the scientific articles and the chosen

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literature. When choosing relevant literature, it is done without any prejudice in order to be objective against other authors.

4. Support refers to the source and the corroboration of the information. A lot of information is coming from other sources, especially claims of fact and statistics.

If one would cite sources, that would strengthen the credibility of the information (Harris, 1997, p. 8-9). This criterion has been satisfied by utilizing several sources that confirm the information in certain articles and literature. However, since the authors have had different outcomes in their studies both sides will be discussed.

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3. Background on the Basel framework

The purpose of this chapter is to give the reader a larger understanding of the fundamentals of Basel, how the Basel accord has evolved and how it has affected banks’

capital structure.

The main part of this study is focused on banking regulation, therefore it is important to describe how banking regulation got to where it is today, and how the Basel institution works. It is without a doubt the Basel committee that is the primary organ in regulating banks which means that the main focus with the chapter will be to try to explain the Basel accords and how it has changed over time. The regulation that right now is active is naturally the most important throughout the study. To possess an understanding of how the first accord were created and has affected banks over time is therefore necessary.

3.1 Basel I

The Basel committee for supervision of banks was created as a response to the disruption on the international banking and currency markets 1974 (Bank for International Settlements, 2018). With the foundations for how supervision should affect internationally active banks being laid, the main focus quickly turned to capital adequacy as a key to succeeding. After the Latin American debt crisis in the early 1980s, the committee realized that when the capital ratios were decreasing within international banks everyone at a large international scale were at risk. They then created a weighted approach to how risk should be measured, both on and off banks’ balance sheets. This was called the Basel capital accord and was only focusing on credit risk (BIS, 2018).

One of its main objectives were to close gaps in international supervisory coverage so that no banking institution were to escape supervision, and to have equal supervision across member jurisdictions (BIS, 2018). They put out principles for how supervisory authorities between countries could help each other supervise banks’ foreign branches, subsidiaries and joint ventures.

The accord required the banks to have a capital to risk-weighted assets of at least 8%, and it to be implemented latest at the end of 1992 (BIS, 2018). It was shaped so it would increase security and solidity of the international banking industry and to create equal terms in banking regulation (Elizalde, 2007, p. 1).

Criticism towards Basel I

Basel I was a huge change in regards to regulating the financial sector, the Basel accord was a completely new innovation and it promoted safety and the growth of international banking among the G-10 countries. However, it was not perfect and had flaws and limitations. Basel I was too narrow as it only covers credit risk and concentrates on the G-10 countries. The authorities failed to translate the Basel I accord into common terms during the implementation which led Banks to believe that this accord was the last implementation needed to ensure stability in international banking. Further, Banks found ways to put more risk on their loan books because of the width of Basel I risk weightings (Balin, 2008, p. 15-16). This opened the possibility for banks to interpret the rules to their

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behalf thus taking improper risks and continue to hold low capital reserves (Balin, 2008, p. 4-5).

3.2 Basel II

Basel II was thought of before the year 2000 but became published in 2004 after over six years of intense preparation (BCBS, 2014, p.3). This served as an update of the Basel I standards, which stated an 8 percent minimum regulatory capital requirement. They also introduced three pillars with Basel II, and these were:

1. Minimum capital requirements used as an update and expansion from the standardized rules set in the 1988 accord;

2. Supervisory review of an institution’s capital adequacy and their internal assessment process; and

3. Effective use of disclosure, to help strengthen market discipline and encourage banks to engage in sound practices (BCBS, 2014, p. 3).

3.2.1 Pillar 1

This is mainly an update from the 1988 solvency ratio. Still, RWA is viewed as the most relevant ratio of control, as capital is the main buffer against sudden losses when profits turn negative. 8 percent is still the reference value but the way banks need to weigh their assets were significantly refined and capital requirements should be closely aligned with the internal economic capital estimates. (Balthazar, 2006, p. 44). Basel II also revised which activities, to combat financial innovation, would be included in the regulation of the trading book (BCBS, 2004, p. 150). There was also an important innovation in pillar 1, which was a new requirement for operational risk. There is an explicit capital requirement for risks that are related to errors performed by men, such as errors in processes, IT-problems and internal frauds (Balthazar, 2006, p. 45).

3.2.2 Pillar 2

The second pillar is giving regulators tools to control financial actors, and giving a framework for handling bank risk. The supervisors are needed to evaluate the banks risk and intervene when appropriate. This interaction will create a dialogue between the bank and the supervisors which will lead to more decisive action when deficiencies are identified. The Basel committee also created an outline with four key principles for banks to follow in order to be certain that the supervision was carried out in a similar manner in all countries (BCBS, 2004). These were:

Board and senior management oversight – The bank needs to have a sound risk management process. Management is responsible for understanding the level of risk being taken and the nature of it, and how it relates to adequate capital levels (BCBS, 2004, p.

159).

Sound Capital assessment – Supervisors are responsible for reviewing and evaluating banks’ internal capital adequacy strategies, as well as the banks’ ability to check up on their compliance with fair capital ratios (BCBS, 2004, p. 159-160).

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Comprehensive assessment of risks – All risks that the bank is faced with needs to be addressed in the capital assessment process. All risks cannot be measured precisely, but a process should be developed to estimate risk (BCBS, 2004, p. 161).

Monitoring and reporting – The bank needs to establish a system adequate for monitoring and reporting when it is exposed to risks, and how it changes the bank’s risk profile (BCBS, 2004, p. 162).

3.2.3 Pillar 3

The committee aims with this pillar to complement the other two by encouraging market discipline with creating disclosure requirements which will open up the market and letting market participants assess important information regarding the scope of application, capital risk exposure and therefore also the capital adequacy of the institutions. The committee believes that a disclosure like this will give especially great relevance under the framework, and assist in that reporting standards are similar in every country where Basel accord is implemented (BCBS, 2004, p. 175).

Criticism towards Basel II

There are several arguments that oppose Basel II and says that it is mainly causing issues.

Cannata et al. (2009) describes how Basel II could have been a main reason for the financial crisis in 2008 because of its new rules. The author argues that the level of average capital was too low, the regulation interacting with fair-value accounting made intermediaries suffer significant losses and that the internal models for risk measuring was not as fitting as the Basel committee thought (Cannata et al. 2009, p. 3). This created the so called bubble because of intermediaries and others needing to take more risk to be profitable (Cannata et al. 2009, p. 15).

Danielsson et al. (2001) had the same arguments even before the crisis, describing how banks are relying on credit rating agencies for the measurement of credit risk, creating inconsistent forecasts of individual’s creditworthiness (Danielsson et al. 2001, p. 3).

Decamps et al. (2003) concludes in their report about how to optimize the three pillars of Basel II, that the Basel II proposals are insufficient. The supervisory system needs to be reformed in order to guarantee that the banking supervisors act independently from political powers to prevent behavior that could lead to future crises (Decamps et al. 2003, p. 23)

3.3 Basel III

In September 2010, exactly one year after Lehman Brothers collapsed the Group of Governors and Heads of Supervision announced a new framework for commercial banks.

The framework introduced higher global minimum capital standards and followed the agreement reached in July regarding the design of the capital and liquidity reform package, which was referred to as Basel III. The new framework was agreed at the Basel Committee meeting in December 2010 (BCBS, 2010, p. 4). The new Basel framework reworked and enhanced the three pillars from Basel II and extended it with additional requirements. The stages of the implementation is viewed in Table 1 below.