Bank Capital Regulation Research Articles

The Procyclical Effects of Bank Capital Regulation

We compare various bank capital regulation regimes using a dynamic equilibrium model of relationship lending in which banks are unable to access the equity markets every period and the business cycle determines loans' probabilities of default. Banks hold endogenous capital buffers as a precaution against shocks that impair their future lending capacity. We find that Basel II is more procyclical than Basel I but makes banks safer, and it is generally superior in welfare terms. For high social costs of bank failure, the optimal capital requirements are higher but less cyclically varying, like those currently targeted by Basel III.

Bank Capital Regulation and Secondary Markets for Bank Assets

How do regulators design bank capital requirements when banks can misreport the value of their assets? We show that the answer depends critically on the existence of secondary markets for bank assets. Without secondary markets, capital requirements based on banks' reporting are more socially desirable than a fixed capital requirement if savings on costly bank capital are sufficiently high. Yet with secondary markets, banks can reduce the burden of a fixed requirement by selling their assets. And they have stronger incentive to misreport and game capital requirements based on their reporting, because low quality assets can be sold for elevated prices. We argue that the contemporary banking system, where many bank assets are tradable, can benefit from simpler but harder to game forms of capital regulation.

Accounting Returns, Business Models and Bank Capital Regulation

In the light of banks’ intense competition for high return on equity, this paper develops a set of equations using profitability analysis to investigate banks’ capital structure measured by book capital ratios. Under the Efficient Market Hypothesis, these equations produce the same results as the model based on market returns derived using the Modigliani - Miller theory and the Capital Asset Pricing Model. Based on these equations, given that banks’ return on assets and its difference from net borrowing costs are determined by banks’ business model and the broad economy, banks’ capital structure is determined by banks’ target of return on equity. The empirical evidence of US commercial banks from 1934 to 2011 supports this inference and indicates that bank capital regulation which ensures banks to contribute to sustainable economic growth should consider the impact of banks’ target of return on equity and business model. From the perspective of both macroeconomic stability and capital market competition for equity capital, this paper proposes that sustainable bank capital regulation should be in line with and be adjustable to significant changes in bank business model and the broad economy so that banks will expect their return on equity to be close to that of nonfinancial firms which reflects the broader economic and institutional factors.

The Bank Capital Regulation and Monetary Policy

Bank capital regulation under Basel Accord has changed the allocation of credit funds and the operation rule of the economy in great degree, and subsequently affected the foundation condition and transmission mechanism of the monetary policies. Given the business cycle, this paper makes the extended analysis of the IS-LM model under capital regulation, and finds that capital regulation will induce the asymmetric effects of monetary policy through the bank lending channel, so theoretically demonstrates that the operation of monetary policy must consider the bank capital regulation. This paper also employs Stochastic Frontiers Analysis to test the joint effectiveness of monetary policy and Bank capital regulation in china from 2000-2009. This test shows that the effectiveness of the monetary policy on realizing economic objective would be weakened by bank capital regulation in China. Therefore, to achieve the objectives of stable price and output, the authority must consider the capital requirement of the banks when enacting the monetary policy,. Key words: Bank capital regulation; Monetary policy; Joint effectiveness

Bank Risk Factors and Changing Risk Exposures of Banks: Capital Market Evidence Before and During the Financial Crisis

Banks have been at the center-stage of the recent financial crisis due to their significant exposures to real estate and sovereign risks. In this paper we analyze the magnitude and changes in risk exposures that are reflected in bank stock returns within the European Monetary Union (EMU) and the United States (US) between 1990 and 2011. We use this period first to investigate bank risk in different economic environments including the introduction of the Euro and the recent financial and sovereign debt crisis. Second we examine whether banks have experienced a change in their risk exposures during the last two decades when the Basel regulatory framework with different bank capital regulations was introduced. In our multi-factor asset-pricing model we include the traditional bank risk factors such as interest-rate and foreign exchange rate risk. However, we extend the literature by including credit, sovereign, and real estate risk. We analyze the associated factor exposures and variance shares in a time-varying framework and draw inferences on their bank specific determinants in pooled regression setups with balance sheet characteristics. Our empirical findings indicate that banks’ risk factors are multi-dimensional but well reflected in stock prices. Sub-period analyses point towards the existence of pronounced time-variation in betas and variance shares. Changes in the banking business and in the crisis period are reflected in the form of dynamic risk exposures. Moreover, bank specific characteristics such as asset size and equity-to-asset ratios provide relevant information for identifying banks with economically significant risk exposures. Overall, our results yield valuable insights into the dynamics underlying bank risk, the associated exposures, and their reflection in equity prices. Understanding the sources of a banks’ riskiness may also help enhancing the bank supervisory process within the pillar of market discipline in the Basel regulatory framework.

Bank Capital Regulation with an Opportunistic Rating Agency

This paper models the strategic interaction between a rating agency, a bank and a bank regulator who lacks information about bank asset risk. The regulator can either (1) make bank capital requirements contingent on credit ratings; or (2) set rating independent capital requirements. Truthful ratings provide efficiency gains because they allow the regulator to constrain high risk bank investment without simultaneously reducing overall investment volume. However, if collusion between the rating agency and the bank corrupts rating quality, rating independent regulation enhances welfare. The welfare benefits are largest if regulators maintain rating contingent capital requirements and discipline rating agencies.

The Impact of Bank Capital Regulation in Nigeria 'A Macro Econometric Simulations'

This paper provides new evidence on the effects of banking sector recapitalization in Nigeria. It set up a simple model of the banking firm, to investigating the impact of capital regulation on banks behavior as well as having possible effects on the economy. Time series data covering the year 1970-2004 were fitted to the regression model using both Ordinary Least Square (OLS) and Vector Error Correction (VEC) method of estimations. The results of the two methods were not significantly different. The simulations based on Vector Autoregressive (VAR) method indicate the importance of growth of economic activities (growth of GDP) as a major determinant of change in deposits and change in loans. The view that banks choose to shrink their balance sheet activities during the capital shocks is consistent with the findings.

The Leveraging Process of Bank Capital During the Pre-Crisis Period

This paper studies the impact of bank growth on the quantity and quality of banks’ capital during the pre-crisis period. It presents an approach that combines traditional corporate finance theories, bank capital regulation and an analysis of the determinants to issue debt and capital instruments. Using data of Spanish banks during the period 1999-2007, we provide evidence that bank capital has been deteriorating as a result of a leveraging process within capital (increasing weight of hybrid capital) that responds to the same determinants that explain standard leverage. The reason is that banks financed the growing gap between loans and deposits with new debt issuances and the consequent capital needs were mainly covered with hybrid capital. The paper also presents evidence that capital regulation plays a key role in the decision to issue capital and debt instruments: debt issuances are preceded by the issuance of capital; capital issuances are substitutes of other internally-generated funds; and banks closer to the regulatory minimum are more likely to issue capital and limit the use of debt.

Debt Overhang and Capital Regulation

We analyze shareholders’ incentives to change the leverage of a firm that has already borrowed substantially. As a result of debt overhang, shareholders have incentives to resist reductions in leverage that make the remaining debt safer. This resistance is present even without any government subsidies of debt, but it is exacerbated by such subsidies. Our analysis is relevant to the debate on bank capital regulation, and complements Admati et al. (2010). In that paper we argued that subsidies that favor debt over equity are the key reason that banks funding costs would be lower if they “economize” on equity. Subsidies come from public funds, and reducing them does not represent a social cost. It is thus irrelevant for assessing regulation. Other arguments made to support claims that “equity is expensive” are flawed.Like reduction in subsidies, the effects of leverage reduction on bank managers or shareholders do not represent a social cost. In fact, we show that debt overhang creates inefficiency, since shareholders would resist recapitalization even when this would increase the combined value of the firm to shareholders and creditors. Moreover, debt overhang creates an “addiction” to leverage through a ratchet effect. In the presence of government guarantees, the inefficiencies of excessive leverage are not fully reflected in banks’ borrowing costs. Since banks’ high leverage is a source of systemic risks and imposes costs on the public, resistance to leverage reduction leads to social inefficiencies. The main beneficiaries from high leverage may be bank managers. The majority of the banks’ shareholders, who hold diversified portfolios and who are part of the public, are likely to be net losers. Our analysis highlights the critical importance of effective capital regulation and high equity requirements, especially for large and “systemic” financial institutions. We analyze shareholders’ preferences when choosing among various ways leverage can be reduced. We show that, with homogeneous assets, if the firm’s security and asset trades have zero NPV, and the firm has a single class of debt outstanding, then shareholders find it equally undesirable to deleverage through asset sales, pure recapitalization, or asset expansion with new equity. When these conditions are not met, shareholders can have strong preferences for one approach over another. For example, if the firm can buy back junior debt, asset sales are the preferred way to reduce leverage. This preference for asset sales, or “deleveraging,” can persist even if such sales are inefficient and reduce the total value of the firm.

Basel II procyclicality: The case of South Africa

This paper studies the impact of bank capital regulation on business cycle fluctuations. In particular, we study the procyclical nature of Basel II claimed in the literature. To do so, we adopt the Bernanke et al. (1999) “financial accelerator” model (BGG), to which we augment a banking sector. We first study the impact of a negative shock to entrepreneurs' net worth and a positive monetary policy shock on business cycle fluctuations. We then look at the impact of a negative net worth shock on business cycle fluctuations when the minimum capital requirement increases from 8 percent to 12 percent. Our comparison studies between the augmented BGG model with Basel I bank regulation and the one with Basel II bank regulation suggest that, in the presence of credit market frictions and bank capital regulation, the liquidity premium effect further amplifies the financial accelerator effect through the external finance premium channel, which, in turn, contributes to the amplification of Basel II procyclicality. Moreover, under Basel II bank regulation, in response to a negative net worth shock, the liquidity premium and the external finance premium rise much more if the minimum bank capital requirement increases, which, in turn, amplify the response of real variables. Finally, small adjustments in monetary policy can result in stronger response in the real economy, in the presence of Basel II bank regulation in particular, which is undesirable.

Can Accounting Rules Be Made Neutral for Bank Capital Regulation?

This paper evaluates several methods which can possibly be used to minimize the pro-cyclical impact of accounting rules on bank capital regulation. Improving accounting rules cannot eliminate the pro-cyclicality problem as the recently proposed expected credit loss impairment model for historical cost accounting may be moving towards using information inputs for fair values. Limiting the trading activities accounted for by fair values may reduce the pro-cyclicality. However, it cannot eliminate the impact of fair values in a liquidity crisis. The most effective method is to exclude the unrealized accounting gains or losses from regulatory capital. But it needs a report of capital ratios based on accounting measures to help regulators read the early warning signals emitted by the accounting information.

Deferred Tax Assets and Bank Regulatory Capital

Abstract: In this study, I examine three issues: (1) whether the probability of bank failure is increasing in the proportion of regulatory capital composed of deferred tax assets (DTA), (2) whether market participants incorporate the increased failure risk associated with the DTA component of capital into their assessments of credit risk, and (3) whether the rules governing the inclusion of DTA into capital encourage risk-taking behavior. Using a sample of U.S. commercial banks, I find that banks that had a larger proportion of capital composed of DTA at the beginning of the recent recession were more likely to fail during the recession, even after controlling for other determinants of bank failure. Furthermore, using a sample of U.S. bank holding companies, I find that banks with a larger percentage of regulatory capital composed of DTA have lower credit ratings and higher bond spreads, with the effect varying negatively with expected profitability. Finally, I find evidence that poorly capitalized banks increased risk-taking to count more DTA towards capital requirements. These findings contribute to the ongoing debate regarding the inclusion of DTA in regulatory capital, as well as the literatures examining the valuation of DTA and the association between regulatory capital and credit risk.

Deferred Tax Assets and Bank Regulatory Capital

Deferred Tax Assets and Bank Regulatory Capital

Bank Regulatory Capital Buffer and Liquidity: Evidence from US and European Publicly Traded Banks

The theory of financial intermediation highlights various channels through which capital and liquidity are interrelated. Using a simultaneous equations framework, we investigate the relationship between bank regulatory capital and bank liquidity measured from on-balance sheet positions for European and U.S. publicly traded commercial banks. Previous research studying the determinants of bank capital buffer has neglected the role of liquidity. On the whole, we find that banks decrease their regulatory capital ratios when they face higher illiquidity as defined in the Basel III accords or when they create more liquidity as measured by Berger and Bouwman (2009). However, considering other measures of illiquidity that focus more closely on core deposits in the United States, our results show that small banks strengthen their solvency standards when they are exposed to higher illiquidity. Our empirical investigation supports the need to implement minimum liquidity ratios concomitant to capital ratios, as stressed by the Basel Committee; however, our findings also shed light on the need to further clarify how to define and measure illiquidity and also on how to regulate large banking institutions, which behave differently than smaller ones.

Size Matters: Bank Capital Regulation With Asymmetric Countries

Financial markets are increasingly globalized, so that the impacts of national banking regulations extend beyond national borders. Strict regulation reduces global loan supply and thus widens interest rate spreads. This is an externality insofar as it affects foreign banks’ profitability and stability. The sovereign’s motivation to join an internationally coordinated regulatory regime, such as the Basel Accords, has been discussed in the literature. However, regulatory enforcement remains a domestic responsibility. In combination with asymmetric information, this gives national authorities room to deviate in the form of lax regulation. We show that each regulator’s enforcement choice is affected by the relative country size. Lax enforcement improves the profitability of home banks, but diminishes the global interest rate spreads. An authority regulating a small market has only a small effect on global interest rates. As such, it may choose lax regulation to improve domestic bank profitability without significantly diminishing global spreads. In contrast, an authority regulating a large market will have a significant impact on global spreads. Therefore, small country regulators have a stronger incentive to deviate from strict international regulatory standards.

Can accounting rules be made neutral for bank capital regulation?

This paper evaluates several methods which can possibly be used to minimize the pro-cyclical impact of accounting rules on bank capital regulation. Improving accounting rules cannot eliminate the pro-cyclicality problem as there cently proposed expected credit loss impairment model for historical cost accounting may be moving towards using information inputs for fair values. Limiting the trading activities accounted for by fair values may reduce the pro-cyclicality. However, it cannot eliminate the impact of fair values in a liquidity crisis. The most effective method is to exclude the unrealized accounting gains or losses from regulatory capital. But it needs a report of capital ratios based on accounting measures to help regulators read the early warning signals emitted by the accounting information.

Bank Capital Regulation with Asymmetric Countries

Financial markets are increasingly globalized, so that the impacts of national banking regulations extend beyond national borders. Strict regulation reduces global loan supply and thus widens interest rate spreads. This is an externality insofar as it affects foreign banks’profitability and stability. The sovereign's motivation to join an internationally coordinated regulatory regime, such as the Basel Accords, has been discussed in the literature. However, regulatory enforcement remains a domestic responsibility. In combination with asymmetric information, this gives national authorities room to deviate in the form of lax regulation. We show that each regulator's enforcement choice is affected by the relative country size. Lax enforcement improves the profitability of home banks, but diminishes the global interest rate spreads. An authority regulating a small market has only a small effect on global interest rates. As such, it may choose lax regulation to improve domestic bank profitability without significantly diminishing global spreads. In contrast, an authority regulating a large market will have a significant impact on global spreads. Therefore, small country regulators have a stronger incentive to deviate from strict international regulatory standards.

Macroprudential Policy, Countercyclical Bank Capital Buffers and Credit Supply: Evidence from the Spanish Dynamic Provisioning Experiments

To study the impact of macroprudential policy on credit supply cycles and real effects, we analyze dynamic provisioning, which implies pro-cyclical bank capital regulation. Introduced in Spain in 2000, revised four times and tested in its counter-cyclicality during the crisis, it affected banks differentially. Accessing an exhaustive credit register, we find that dynamic provisioning smooths credit supply cycles and, in bad times, supports firm performance. A policy-induced one-percentage point (pp) increase in capital buffers extends credit to firms by 9 pp, increasing firm employment (6 pp) and survival (1 pp). Moreover, there are important compositional effects in credit supply related to risk and regulatory arbitrage by non-regulated and regulated-but-less-affected banks.

Dynamic Prudential Regulation: Is Prompt Corrective Action Optimal?

The current U.S. bank capital regulation features prompt corrective action, which mandates regulators to intervene in and liquidate banks based on their book-value capital ratios. To see if prompt corrective action is optimal, I build a dynamic model of repeated interactions between a banker and a regulator. Under hidden choice of risk, private information on returns and limited commitment by the banker, and costly liquidation, I first characterize the optimal incentive-feasible allocation. I then demonstrate that the optimal allocation is implementable through the combination of a risk-based deposit insurance premium and a book-value capital regulation with stochastic liquidation.

New Evidence on Procyclical Bank Capital Regulation: The Role of Bank Loan Commitments

Previous research on procyclical bank capital regulation has largely focused on the role of increased losses and deteriorated credit ratings in economic downturns. Using the bank-level data of U.S. commercial banks, we present another independent source of procyclicality working through bank commitments, which we call loan commitments channel. We find that, as firms draw down more from their pre-existing credit lines when credit market conditions are tighter, this increased takedown raises bank risk-weighted assets via involuntary lending and thus lowers capital adequacy ratios of commercial banks, making them more procyclical. Our empirical results suggest that this commitments channel can explain 16.4\% of variaitions in large banks' capital buffers during the financial crisis. This effect is found to be quantitatively important during the recent financial crisis and needs to be addressed in designing the regulatory framework for reducing procyclicality.