After a period of long and pronounced stability, the Great Financial Crisis of 2007-2009 moved the international financial systems into a condition of severe weakness, highlighting how the profitability levels previously achieved were often built on excessive risk taking, with significant erosion of the level and quality of the capital base, insufficient liquidity buffers, weaknesses of the whole organization and governance systems. Indeed, the magnitude of that crisis resulted particularly severe, so that an unconventional effort has been deployed, at different levels, in order to address several of those concerns characterizing the international financial systems of most developed countries. Despite the efforts already exploited and the ones which are expected to be pursuit in the next future because of the enforcement of supervision framework, more recently an increasing concern emerged about the almost exclusive focus on increasing capital requirements and applying a one-size-fits-all regulatory framework, suggesting to focus on a more structured approach to supervised entities, in order to mitigate the model risk of capital adequacy framework. Through our research, we aim to contribute to the actual debate which is focused on the issues to ameliorate the banking supervision framework, especially from an European perspective, balancing two fundamental objectives. On one hand, we aim to investigate and reduce the area of underestimated risks which can undermine financial stability. On the other hand, we aim to avoid that excessive burdens hamper the capability of banks to perform its role for financing the economy, especially for countries where that task remains crucial.
Banking instability escalated in recent times showing an intensity which was unexpected only a few years ago. The irony is that banking instability kept plaguing Europe in spite of the region¿s intense stiffening of regulation. According to some scholars, the almost exclusive focus on increasing capital requirements and applying a one-size-fits-all regulatory framework may have weakened the effectiveness of European regulators (e.g., Blundell-Wignall et al., 2014; Ferri & Neuberger, 2014). By this perspective, something European authorities have at length overlooked is the possibility that focusing on a more structured approach to supervised entities should mitigate the model risk of capital adequacy framework. More in particular, the EBA in 2014 has issued the ¿Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP)¿, where, among other facets, the necessity to overlook to 4 fundamental items, in order to proper assess the economic sustainability of a bank, is represented. More in particular, the EBA suggests to consider the business model (BM), the internal governance and institution-wide controls, the risks to capital and adequacy of capital to cover these risks, the risks to liquidity and adequacy of liquidity resources to cover these risks, as fundamental determinants of banks¿ soundness. Among the other elements, the BM represents in our view something very relevant, since it has been recently recognized it can play a determinant role in affecting a bank¿s risk taking. By this perspective, despite the economic literature has approached banks¿ business models with variance (Altunbas et al., 2011; Ayadi et al. 2011; Cavelaars & Passenier, 2012; Roengpitya et al., 2014; Bonaccorsi di Patti et al., 2016; Köhler 2016; Mergaerts & Vander Vennet, 2016), more recently Ayadi-Ferri-Pesic (forthcoming 2018) have showed the effectiveness of bank business model ¿ as defined through a cluster analysis built on a bank¿s assets and liabilities mix ¿ in order to predict banks¿ soundness. Therefore, the definition of banks¿ business model suggested in Ayadi-Ferri-Pesic (2018) can be particularly effective within the EBA¿s SREP Guidelines perspective, where the BM represents not only an area of investigation to be assess, but also the criterion to be considered in order to define the ¿peer groups¿ among the supervised entities, which are the groups of institutions with similar characteristics, which Authorities should consider in order to assess their economic sustainability. For all those reasons, the proper definition of banks¿ business model should therefore mitigate the biases that characterize the actual framework of prudential supervision. We refer to the literature which has recently started to investigate the potential bias characterizing credit risk regulatory metrics (RWA dispersion) because of regulatory arbitrage. Indeed, among other studies, Mariathasane & Merrouche (2014) and Ferri & Pesic (2017) have highlighted the determinants of RWA dispersion by focusing on the effect that the adoption of IRB methodologies can play in reducing capital absorption, via Basel risk-weights manipulation. Moreover, we refer to the whole area of risks which derives from market activity, which seems to be still in a need for a proper finalization. This in particular the case of the ¿Fundamental Review of Market Risks¿ which is still characterized by a lack of certainty about the time of delivering and the calibration of some fundamental facets. Moreover, we refer to the broader measure of market activity in the prudential regulation which seems to remain still underestimated, mostly because of the difficulty to achieve proper measure of fair value, although the magnitude of the exposure are sometimes very significant. This is, as highlighted in a recent paper of Bank of Italy (2017), the case of financial instruments classified for accounting purposes as Level 2 (L2) and Level 3 (L3), which are instruments whose fair value needs some form of estimation, as it cannot be directly observed from prices in active markets. Those instruments share several common features with non-performing loans (NPLs), although as in December 2016 they were estimated to achieved a total value (aggregating assets and liabilities) about 6.8 trillion, more than 12 times greater than net NPLs, with a very significant exposure achieved by few European banks, largely operating in ¿Core¿ European countries. Therefore, since despite its magnitude that issue still continue to be ignored by the supervisory agenda, we consider that a proper investigation has to be performed about, in order to contribute to shed light upon the potential myopic view of Prudential Supervision, which at the moment seems to pay too much attention on topic related to credit exposures and NPLs, almost ignoring other relevant source of risks.