Concentration Risk and Capital Requirements: Invisible Hands Driving Affect Bank Behavior in Bankruptcy Cases

Abstract

Capital adequacy and concentration risk are key regulatory concerns regarding banks, but regulatory pressure on banks to stay well-capitalized and diversified may have unintended consequences, especially during downturns. Extending existing literature exploring the effect of regulatory capital requirements on bank lending behavior, we examine in this Article the impact of capital requirements on the actions taken by banks in bankruptcy proceedings. Building on our earlier work finding that the financial distress of banks between late 2007 and 2008 contributes to their liquidation preference in the bankruptcy proceedings of their residential developer debtors, we have built a Monte Carlo simulation model of credit portfolio losses to elucidate bank decision-making based on the relationship between capital requirements and portfolio risk factors. Next, through a statistical analysis of a dataset combining FDIC and PACER data, we find evidence that a high concentration of acquisition, development and construction loans in a bank’s portfolio is significantly associated with the probability that the bank may obtain relief from the automatic stay in bankruptcy to pursue foreclosure. This helps to further the understanding of the subtle effects of bank capital regulation and suggest potential improvements in the regulatory responses to the banking crisis.