Is window dressing by banks systemically important?

Summary

Focus

Are banks window dressing their balance sheets to avoid tougher regulation? We explore this question by studying the assessment of global systemically important banks (G-SIBs). We examine the evolution of the G-SIB "score" around supervisory reporting dates for a large sample of banks in the European Union (EU). The score is the regulatory measure that determines banks' G-SIB status and the attendant capital requirements. It predominantly relies on a snapshot of banks' balance sheets at year-end.

Contribution

We illustrate how banks in the EU compress their G-SIB score at year-end. We approximate the score at quarterly frequency based on supervisory data and establish that G-SIBs' year-end adjustments differ markedly from those of other banks. Moreover, we highlight that these adjustments distort the supervisory assessment of banks' systemic importance. While a variety of factors may be driving banks' window dressing, we show that the tightness of capital requirements plays an important role and shed light on how the G-SIB rules interact with other regulatory requirements, such as national capital surcharges. 

Findings

Our analysis uncovers a large and systematic contraction in the score of EU G-SIBs at year-end. We show that several G-SIBs repeatedly lower their scores to an extent that they reduce their capital requirements. Moreover, a few banks appear to have avoided G-SIB designation altogether in some years. G-SIBs reduce their score in several ways, for instance by temporarily cutting back on intra-financial sector linkages and derivatives positions. G-SIBs with stronger capital ratios and those subject to higher national capital surcharges window dress less than other G-SIBs, which underscores the importance of regulation in banks' balance sheet decisions. Overall, our findings argue in favour of moving away from using point-in-time data in regulatory requirements and making greater use of averages. They also highlight the importance of supervisory judgment in the assessment of G-SIBs. This could help address banks' window dressing and mitigate any associated adverse impact on financial markets.

Abstract

We study banks' year-end window dressing in the European Union to assess how it affects the identification of global systemically important banks (G-SIBs) and the associated capital surcharges. We find that G-SIBs compress their balance sheet at year-end to an extent that they can reduce their surcharges or avoid G-SIB designation altogether. G-SIBs use several levers to adjust their balance sheets. Most notably, they compress intra-financial system assets and liabilities as well as their derivative books at year-end. Moreover, G-SIBs that are more tightly constrained by capital requirements window dress more than their peers. Our findings underscore the importance of supervisory judgement in the assessment of G-SIBs and call for greater use of average as opposed to point-in-time data to measure banks' systemic importance.

JEL classification: G20, G21, G28

Keywords: systemically important bank, systemic risks, regulatory arbitrage, financial stability