Banking, Business Cycles, and the Basle Accord: Some Empirical Evidence

Abstract

This paper presents a theoretical and empirical analysis of the portfolio adjustments and financing adjustments of U.S. banks over the business cycle. The model describes a representative bank whose portfolio is financed with deposits and equity claims. At the core of the model is a moral hazard problem between relatively more risk averse depositors and relatively less risk averse equity investors. The solution to this moral hazard problem takes the form of shared management of the bank between depositors (or the deposit insuring agency) and equity investors. Towards this end portfolio decisions are made to conform to the risk aversion of equity investors, while financing decisions are made so as to offset any changes in portfolio risk caused by portfolio adjustments. Portfolio adjustments in turn are initiated by exogenous changes in the risk aversion of equity investors that are revealed to bank managers in equity share prices. The resulting portfolio adjustments and changes in portfolio risk then triggers financing adjustments that insulate depositors from any changes in portfolio risk. The model predicts that the loan component of a bank's portfolio is positively related to changes in bank stock prices, while the equity leverage ratio varies directly with the bank's loan to asset ratio. The regression evidence in this paper does not reject these two predictions. Finally the financing adjustments uncovered here were found to predate U.S. capital adequacy legislation for banks. This suggests that private arrangements may have achieved much the same qualitative results in the past as the Basle Accord now attempts to achieve with regulatory legislation.