‘Extreme risk judgements and bank efficiency during the financial crisis: Implications for banking regulation’

The CCP seminar series returns for the Spring semester on Friday 10th January with a new programme of interdisciplinary presentations on competition and consumer policy. We kick-off this week with our Senior Research Associate Minyan Zhu (CCP) presenting her research on ‘Extreme risk judgements and bank efficiency during the financial crisis: Implications for banking regulation‘, which she has undertaken alongside Mette Asmild (University of Copenhagen). An abstract for her seminar can be found below.


The recent financial crisis highlighted how banks are exposed to risks arising specifically from their mixes of assets and sources of funding. In traditional assessments of bank efficiency, using Data Envelopment Analysis (DEA), banks are not only allowed to, but in effect also rewarded for, using extreme risk adjusted weights for the different input- and output factors. In this paper we propose a method of measuring bank efficiency, based on weight restricted DEA that limits the banks’ abilities to use extreme risk judgements.

Without a priori knowledge of ‘true’ risk levels, nor of a set of model banks whose weights can be imposed on all banks, we propose to use a range of allowable weights determined from the average weights across the efficient banks, in order to balance extreme judgements. Based on a data set comprising the largest European banks during the financial crisis, we illustrate the impact of the proposed weight restrictions in two different efficiency models; one related to the banks’ funding mix and one related to their asset mix. The results show that banks which were bailed out by their respective governments during the crisis are over-represented among those banks that are heavily affected by imposing these weight restrictions. This means that using a more balanced set of weights tend to reduce the estimated efficiency scores more for those banks that exhibited risky behaviour during the crisis, which confirms the potential bias within standard DEA which does not control for extreme weights applied by highly risky banks.

We also discuss the use of the proposed method as a regulatory tool to constrain discretion in complying with regulatory capital benchmarks such as the Basel regulatory capital ratios. Specifically the use of weight restrictions enables us to select a set of model banks and we suggest that these model banks’ internal estimates can be used as references to constrain the discretion in the choice of risk estimates (for instance, probability of default per rating grade) which are used to derive regulatory capital ratios. This will then reduce discretion in the derived capital ratios thus improving the effectiveness of the regulatory capital benchmarks.

The seminar will takes place from 13:00-14:00 in the Thomas Paine Study Centre, Room 1.4.

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