Macroeconomic effects of capital adequacy regulation in Japan

Abstract

The introduction of stricter capital adequacy regulation in Japan under the Basel Accord is often blamed for brining on a “capital crunch”: a reduction in bank lending in response to stricter regulations on bank capital. The capital positions of Japanese banks have been under pressure from several factors throughout the 1990s and pressur on banks to raise their BIS (Bank for International Settlements) capital adequacy ratios has been cited as a cause of the reduction in aggregate lending in the 1990s. Tight credit conditions have in turn been blamed for Japan’s “lost decade” of low economic growth in the 1990s. Despite the Bank of Japan’s zero interest rate policy, the Japanese economy has remained stagnant throughout most of this decade. Although real “headwinds”, overbuild commercial real estate and balance sheet adjustment pressure on firms, undoubtedly hampered economic recovery in both countries, the failure of financial intermediaries to play their traditional role in the transmission of monetary policy is often blamed for the ineffectiveness of loose monetary policy. This chapter explores the effect of regulatory change on real economic activity, in particular examining the effect of stricter bank capital adequacy standards introduced under the Basel Accord on the economy of Japan in the 1990s. At a macro level, the chapter analyzes to what extent Japan’s “lost decade” of the 1990s can be attributed to a credit crunch in the banking sector. The question of whether real economic activity was affected by the capital crunch is an important one. Even if banks in Japan facing pressure to meet capital requirements reduced the supply of loans, if borrowers had easy access to close substitutes for bank credit or were able to switch easily to lenders that were not facing capital pressure, real economic activity may not have been much affected by the reduction in bank credit. Thus, this study addresses the question of how important the health of the banking sector is to the performance of the overall economy and what real economic repercussions changes in banking regulation had in Japan in the 1990s.