Bank Capital Regulation and Soft Budget Constraints

Kenji Tsuji

doi:10.1007/s11294-014-9504-x

Abstract

This paper presents a model of soft budget constraints on firms where refinancing of poor projects is ex post inefficient when viewed in isolation, and analyzes how bank capital regulation affects the softness of firms’ budget constraints. A firm is said to have a soft budget constraint if a bank allows the firm to continue to operate even when continuation is ex post inefficient. It is shown that bank capital regulation may induce soft budget constraints on firms because banks have an incentive to roll over loans made to poor firms in order to comply with the regulation. It is also shown that soft budget constraints are more likely to arise when the regulation is less strict, that is, when banks’ minimum required capital ratios are lower. This paper also demonstrates that soft budget constraints may be more likely to arise under Basel III, that bank capital regulation may increase the probability of bank failures by inducing the soft budget constraint problem, and that the bank capital regulation of Basel I was one of the causes of soft budget constraints in the post-bubble period of Japan.

Highlights

This paper investigates how bank capital regulation affects the soft budget constraint problem.1 Du and Li (2007) argue that it is harder and less credible for countries with a larger fiscal capacity to commit to a hard budget constraint on banks because the ability of these countries to bail out failing banks is restricted by their fiscal capacity
Proposition 2 implies that the occurrence of soft budget constraints or a credit crunch on good firms depends on the level of the minimum required capital ratio cR
This paper analyzed how bank capital regulation affects the softness of firms’ budget constraints, and showed that bank capital regulation may induce soft budget constraints on firms. This occurs because banks have an incentive to roll over loans to poor firms in order to comply with the regulation

Summary

Introduction

This paper investigates how bank capital regulation affects the soft budget constraint problem.1 Du and Li (2007) argue that it is harder and less credible for countries with a larger fiscal capacity to commit to a hard budget constraint on banks because the ability of these countries to bail out failing banks is restricted by their fiscal capacity. This paper shows that bank capital regulation is one of the causes of soft budget constraints on firms. This paper assumes ex post inefficiency in order to show that soft budget constraints arise not from sunk costs but from bank capital regulation.

Results

Conclusion