Bank Capital Regulation Research Articles

Bank Capital Regulation in a Zero Interest Environment

Abstract How does the zero lower bound on deposit rates (ZLB) affect how banks respond to capital regulation? I study this question in a model in which households value the liquidity services of deposits yet do not accept negative deposit rates. When deposit rates are constrained by the ZLB, tight capital requirements disproportionately hurt franchise values and are therefore less effective in curbing excessive risk taking. The model delivers a novel rationale for “interest-dependent” capital regulation that is optimally laxer when the ZLB binds and tighter when the ZLB is slack but may bind in the future.

Funding Liquidity and Risk-Taking Behavior of Banks in India

This study, utilizing bank-level data for India, investigates the relationship between funding liquidity and banks’ risk-taking behavior. The study uses two risk measures: risk-weighted assets (encompassing credit, market, and operational risk) and liquidity creation (encompassing intermediacy risk). Findings reveal that banks with higher funding liquidity exhibit higher risk-taking behavior. This risk-taking behavior is more pronounced during economic recuperation and expansionary monetary policy phases. Notably, during economic recuperation, banks display heightened intermediacy risk, contrasting with the absence of such evidence during expansionary monetary policy phases. Larger banks with higher deposit shares demonstrate lower risk-taking behavior. Additionally, banks with a return on equity (ROE) below the average ROE exhibit a proclivity for increased risk-taking. This study advocates for liquidity regulation as a crucial complement to bank capital regulation, offering empirical support for moderate risk-taking among highly liquid banks and fortify their balance sheets for a stable banking system in India. JEL Codes: E32, E52, G21, G28

Seller-Orchestrated Inventory Financing Under Bank Capital Regulation

To help small firms secure bank financing, large sellers often orchestrate joint finance programs, linking their small dealers with major banks that lend to all participating dealers based on the information the seller provides. We examine supply chain decisions (pricing and inventory) and lending terms under such seller-orchestrated financing programs. In loan pricing, we highlight a form of financial friction that is of particular importance under such schemes—bank capital regulation. Banks are globally mandated to maintain regulatory capital to mitigate unforeseen loan losses, using either the standardized approach (where regulatory capital is a fixed percentage of the loan amount) or the internal rating-based (IRB) approach (where it depends on the loan’s value-at-risk). We consider a game-theoretic model consisting of a large seller and multiple capital-constrained newsvendor-type dealers, who obtain financing from banks that are subject to capital regulation. The seller decides the wholesale price and whether to orchestrate a joint finance program for its dealers by collaborating with a bank, and the dealers choose their inventory level and the financing channel. We find that a seller should only orchestrate the joint financing program when the bank adopts the IRB approach and the dealers are of low risk. Such a program is more profitable to the seller when the demand correlation among dealers is low, and there is a large number of dealers. Although always benefiting the seller, these programs may hurt dealers with intermediate risk. Facing dealers with varying financial situations, the terms under the joint finance program should be designed as if the financially strong dealers subsidize the weak ones. Finally, allowing the seller to share part of the loan loss could further enhance the performance of joint financing, but only when the seller’s opportunity cost of capital is low. Our findings provide guidance to large sellers on how to orchestrate joint finance schemes, and to small dealers on making their corresponding operational decisions.

ASSESSMENT AND WAYS TO MINIMIZE THE FINANCIAL RISKS OF THE BANKING SECTOR UNDER FINANCIAL INSTABILITY

The article is devoted to the assessment of financial risks of the banking sector, their impact on the activity of banks and their minimization in conditions of economic instability. The banking sector is a key link that ensures the development of the financial system, but banking activity is risky. Therefore, it is important to study banking risks and ways to minimize them in order to increase the efficiency and stability of the banking system. The article provides a classification of banking risks in accordance with domestic literature. Factors due to which banking institutions are exposed to risks are reflected. Financial risks of the banking sector affect the net profit, capital of the bank. Therefore, the impact of risks on the financial stability and efficiency of Ukrainian banks was analyzed. The bank's regulatory capital is one of the most important indicators of its activity, the main purpose of which is to cover the negative consequences of various risks. During the entire studied period, there is a tendency to increase this indicator, which is positive. Due to external risks, namely the difficult military and economic situation, the profit of Ukrainian banks decreased. The credit risk, which is one of the most significant in banking activity, is characterized. The causes of credit risk in banking are given. The dynamics of the assets of Ukrainian banks, the volumes of loans granted, were studied. It was concluded that in modern conditions of banking activity, there is a slight slowdown in lending to the population and an increase in the volume of loans granted to business entities. To reduce credit risks, commercial banks use various methods to protect against credit risk: diversification, limiting, insurance, risk distribution. The banking sector cannot exist without risk, so it is necessary to look for ways to minimize them. Minimizing the level of financial risks in the banking sector involves the implementation of risk management measures and methods. Measures to minimize banking risks include preventive and protective measures. Banking risk management methods include: methods of avoiding and accepting banking risks. The article reflects the peculiarities of these measures and methods. Keywords: financial risks, banking sector, bank profit, credit risk, bank assets, bank risk minimization.

Should macroprudential policy be countercyclical?

This paper investigates the influence of possible bank default and bank leverage constraints on monetary and macroprudential policy prescriptions. We build a New Keynesian model with banks that channel funds from households to firms. Banks face endogenous leverage constraints and are subject to costly default. We calibrate our model to the US economy and show that in the decentralized equilibrium, banks borrow more than the socially efficient level. A macroprudential policy that limits bank leverage reduces the risk of bank default and improves long-run welfare. In the short run, a “macroprudential-flavored” monetary policy can reduce financial propagation by affecting bank shadow values, while countercyclical capital regulation is effective for stabilizing bank leverage. While both policies are effective, our study shows that introducing countercyclicality to bank capital regulation achieves little welfare improvement if monetary policy is already used to mitigate financial acceleration. The jointly optimal policies suggest that policymakers should assign countercyclical macroprudential roles to monetary policy, and bank capital regulation should focus on the desired level of prudence.

The Cost of Bank Regulatory Capital

Abstract Basel I introduced capital requirements for undrawn commitments, but only for revolvers with an original maturity greater than one year. We use this regulatory discontinuity to estimate the impact of capital regulation on the cost and composition of credit. Following Basel I, short-term commitment fees declined relative to long-term commitments and issuance of short-term facilities increased. Our results highlight the sensitivity of credit provision to capital regulation, particularly for banks with less capital. We are able to infer that low-capital banks are willing to forego twice as much income from fees to reduce required regulatory capital by a dollar.

Dynamic bank capital regulation in the presence of shadow banks

Regulated banks expand relative to shadow banks in recessions and when credit spreads are high, while regulated banks shrink relative to shadow banks in expansions and when credit spreads are low. Motivated by these facts, I build a quantitative general equilibrium model with endogenous risk taking to study how competitive interactions between regulated banks and shadow banks affect optimal dynamic capital requirements. Limited liability and deposit insurance can lead regulated banks to provide socially inefficient risky loans when the returns on safer loans decline. Competition for scarcer funding can further lower the net returns on safe loans, making it more attractive for regulated banks to exploit the shield of limited liability with risky loans. Higher capital requirements can reduce inefficient risk at the cost of lower liquidity provision and some migration of credit from regulated banks to shadow banks. Accounting for the interactions of regulated and shadow banks can change the magnitude and direction of the optimal response of capital requirements to shocks that drive the business cycle. Moreover, Basel-III style rules that differentiate between the type of bank loans are much better at mimicking the Ramsey optimal capital requirements than standard rules that aggregate loans. The performance of such dynamic rules can be further improved once they are combined with a small static capital buffer.

Optimal capital adequacy ratios for banks

In this paper, we analyse the appropriate capital adequacy ratio for banks from a socio-economic perspective. More equity capital in banks can contribute to financial stability by reducing the risk of costly banking crises, but lending may become more expensive if banks are required finance their assets with more equity. When assessing optimal capital adequacy ratios, the economic costs of more expensive credit must therefore be weighed against the benefits of fewer and less costly banking crises. Importantly, we compute optimal capital adequacy ratios for Norway which allows us to take into account recent changes in bank capital regulation. The results indicate that banks should have a Common Equity Tier 1 (CET1) ratio of between 12 and 19 percent. The current CET1 ratio of around 18 percent in our sample is in line with this. Our estimates are consistent with results from international studies, but estimates vary considerably with changes in uncertain assumptions. However, banks’ capital needs during the Nordic banking crisis in the beginning of the 1990s show that such estimates are not unreasonable.

Research on the heterogeneity of domestic banks’ risk taking influenced by bank capital regulation based on DSGE model

ABSTRACT This article deeply integrates the characteristics of the China financial market under the background of the spread of the global new coronavirus pneumonia epidemic and integrates the multi-sector DSGE model including heterogeneous residents, manufacturers, banks, and macro-prudential supervision, and then numerically simulates the impact of technology and financial shocks on major economic indicators. Macroprudential capital regulation can help stabilize large economic waves, increase labour supply in the economic system, and restrain excessive transmission of systemic risks in the financial system. Meanwhile, the leverage ratio of banks will also change correspondingly with the price fluctuations of the real estate market. The relevant decision-making departments of the central government and the financial supervision departments coordinated in many ways to find the optimal internal balance point and increase the combined effect of effectively deflating systemic risks.

Bank Regulatory Capital Arbitrage: Evidence from Housing Overappraisals

The overstatement of asset collateral values reduces bank capital requirements. We identify this novel form of regulatory arbitrage by studying housing overappraisals, the difference between housing collateral values computed by appraisers and actual transaction prices. We leverage granular loan-level data from Spain and a kink in the scheme of residential mortgage risk weights to show that tighter regulatory requirements cause larger overappraisals. This bias depends on the relationship between appraisers and banks; appraisers inflate mortgage collateral values only for their major customer banks. On average, overappraisals lower risk-weighted mortgages by 9%. Mortgage overappraisals allow banks to free up regulatory capital to support additional risk-taking in the corporate loan market. This paper was accepted by Victoria Ivashina, finance. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.4805 .

Bank capital, lending, and regulation: A meta‐analysis

AbstractWe collected over 1600 estimates on the relationship between bank capital and lending and construct 40 variables to capture the context in which these estimates are obtained. Accounting for potential publication bias, we find that a 1 percentage point (pp) increase in capital (regulatory) ratio results in around 0.3 pp increase in annual credit growth, while changes to capital requirements cause a decrease of around 0.7 pp. Using Bayesian and frequentist model averaging, we show that the relationship between bank capital and lending changes over time, reflecting the post‐crisis period of increasingly demanding bank capital regulation and subdued profitability. We also find that the reported estimates of semi‐elasticities are significantly influenced by the empirical approach chosen by researchers. Our findings suggest that the literature fails to provide policymakers with reliable estimates of the effects of capital regulation on bank lending, and our study offers insights that could help guide future research.

Determinants of bank capital adequacy: International evidence from G7 countries

AbstractThe study presents the determinants of bank capital for the G7 countries from 1999 to 2017. It employs a dynamic ordinary least square panel methodology for empirical estimation. The findings suggest that bank capital to total asset, bank z‐score and the real output growth are positive determinants of bank regulatory capital. Conversely, bank return on assets is found to be a negative determinant. After constructing an index for profitability using the approach of the component analysis, the empirical result reveals an inverse relationship between bank profitability and the regulatory minimum capital. Diagnostic tests and robustness checks confirm the empirical consistency of the findings reported. Thus, in applying the panel pairwise causality test, the evidence of bi‐directional Granger causality suggests a feedback relationship for five significant scenarios and unidirectional nexus in others. For policy consideration, the results stressed the need for optimal due diligence weighing the benefit and cost implication of upward or downward adjustment of bank regulatory minimum capital.

Microprudential bank capital regulation in a complex system

This paper analyzes the efficacy of microprudential (bank-level) capital requirements in mitigating failure cascades in a network of interconnected banks. In simulation exercises, microprudential capital requirements redistribute the troubled assets of undercapitalized banks more broadly within the network, reducing the immediate likelihood of individual bank failures but increasing the likelihood of large failure cascades. This effect is strongest for simulation parameters that mimic economic downturns. If banks increase leverage in response to weaker capital requirements, failure cascades increase only minimally. These results suggest that current microprudential capital requirements might be counterproductive to the goal of mitigating bank failure cascades.

ОЦІНКА ТА ШЛЯХИ МІНІМІЗАЦІЇ ФІНАНСОВИХ РИЗИКІВ БАНКІВСЬКОГО СЕКТОРУ В УМОВАХ ЕКОНОМІЧНОЇ НЕСТАБІЛЬНОСТІ

The article is devoted to the assessment of financial risks of the banking sector, their impact on the activity of banks and their minimization in conditions of economic instability. The banking sector is a key link that ensures the development of the financial system, but banking activity is risky. Therefore, it is important to study banking risks and ways to minimize them in order to increase the efficiency and stability of the banking system. The article provides a classification of banking risks in accordance with domestic literature. Factors due to which banking institutions are exposed to risks are reflected. Financial risks of the banking sector affect the net profit, capital of the bank. Therefore, the impact of risks on the financial stability and efficiency of Ukrainian banks was analyzed. The bank's regulatory capital is one of the most important indicators of its activity, the main purpose of which is to cover the negative consequences of various risks. During the entire studied period, there is a tendency to increase this indicator, which is positive. Due to external risks, namely the difficult military and economic situation, the profit of Ukrainian banks decreased. The credit risk, which is one of the most significant in banking activity, is characterized. The causes of credit risk in banking are given. The dynamics of the assets of Ukrainian banks, the volumes of loans granted, were studied. It was concluded that in modern conditions of banking activity, there is a slight slowdown in lending to the population and an increase in the volume of loans granted to business entities. To reduce credit risks, commercial banks use various methods to protect against credit risk: diversification, limiting, insurance, risk distribution. The banking sector cannot exist without risk, so it is necessary to look for ways to minimize them. Minimizing the level of financial risks in the banking sector involves the implementation of risk management measures and methods. Measures to minimize banking risks include preventive and protective measures. Banking risk management methods include: methods of avoiding and accepting banking risks. The article reflects the peculiarities of these measures and methods.

Climate Change and the Macroeconomics of Bank Capital Regulation

Climate Change and the Macroeconomics of Bank Capital Regulation

Climate Transition Risk and The Role of Bank Capital Regulation

Climate Transition Risk and The Role of Bank Capital Regulation

Corporate debt choice and bank capital regulation

This paper proposes a macro-banking model with corporate debt choice and investigates the impacts of bank capital regulation. Compared to non-banks, banks provide restructurable debt that resolves firm liquidations. Capital regulation corrects deposit insurance distortions but reduces bank debt supply. The model calibrated to the U.S. economy suggests that the non-bank market booms in the short run but shrinks in the long run when capital requirements are tightened. While banks get stabilized, firms encounter liquidations more frequently despite their deleveraging. Welfare improves under tighter and counter-cyclical capital requirements.

Individualism, formal institutional environments, and bank capital decisions

We examine how individualism affects bank capital decisions worldwide and in the United States at the state level. Based on a sample of 7034 banks in 68 countries, we establish three major findings. First, individualism is negatively and significantly associated with bank regulatory capital, and the association is independent of the influence of formal institutional environments. Second, effective legal enforcement magnifies individualism's negative effect on bank regulatory capital. Finally, focusing on the United States, we also find that banks in individualistic states hold less regulatory capital than banks in collectivist states do. Effective state-level legal enforcement magnifies the effect of individualism. Our findings suggest that individualism constrains regulators, as regulatory guidelines or formal institutional factors operate very differently depending on the informal institutional environment.

Leaving the darkness: The emergence of shadow banks

This paper studies the interaction between bank capital regulation, moral hazard and co-existence of traditional and shadow banks. Bank managers can choose between traditional banking and off-balance sheet special purpose vehicles (SPV), in a setup with deposit insurance and moral hazard. We first show that in the absence of SPV intermediation, capital requirements are ineffective at preventing the moral hazard problem originated by deposit insurance. We find that shadow banks can improve financial stability, when there is full information sharing. Finally, we analyze the case of neglected tail risk. We find that under such circumstances, the SPV will increase financial risk by exposing the system to extreme events.

Bank Market Power and Monetary Policy Transmission: Evidence from a Structural Estimation

ABSTRACTWe quantify the impact of bank market power on monetary policy transmission through banks to borrowers. We estimate a dynamic banking model in which monetary policy affects imperfectly competitive banks' funding costs. Banks optimize the pass‐through of these costs to borrowers and depositors, while facing capital and reserve regulation. We find that bank market power explains much of the transmission of monetary policy to borrowers, with an effect comparable to that of bank capital regulation. When the federal funds rate falls below 0.9%, market power interacts with bank capital regulation to produce a reversal of the effect of monetary policy.