An economic study on the impact of capital, leverage and liquidity requirements on banks' default risk : the case of global systematically important banks in Europe

Abstract

Using quarterly data of 13 European Global Systematically Important Institutions for the period 2003-2017, this thesis examines the impact of capital, leverage and liquidity requirements on the banks’ default risk. The capital adequacy ratio, the common equity to total assets ratio, the loan to deposit ratio, and banks, along with a time trend, were tested as the main determinants of large banks’ 5-year probability of default (PD), the latter viewed as a proxy for financial stability, and ultimately economic stability. Using the Statistical Package for the Social Sciences as econometric software, a general linear model estimation was estimated by applying the Maximum Likelihood Estimation technique. From the test of between-subjects effects, it was concluded that the regressed model found that all five predictors were statistically significant. This five-predictor model also explained 57.1% of the total variation in the PD. Subsequently, out-of-the-regression coefficient analysis, it resulted that the capital adequacy ratio, the common equity to total assets ratio, the loan to deposit ratio, and the time trend predictors were statistically significant as well. The capital adequacy ratio and the common equity to total assets ratio were negatively related to the 5-year PD, while the Loan to Deposit ratio displayed a positive relationship, as expected by economic theory. Moreover, the leverage ratio variable held the highest predictive power while the loan-to-deposit ratio had the least predictive power. On the other hand, not all the categorical predictors consisting of the large institutions displaced statistical significance. These robust findings appeared to support tighter supervisory standards and enhanced regulatory reporting requirements imposed by the European authorities provided a net benefit to the economy. Lastly, a concise case study containing of the Maltese core banks was undertaken in this regard, where it was conveyed that exercising due diligence on consumer, business and syndicated lending, followed by funding strategies and substantiated by ongoing compliance with the imposed minimum regulatory requirements, were found to be the main drivers for maintaining Maltese banks’ low default risk levels without impairing recent economic growth.