Low-capital Banks Research Articles

Banks' Regulatory Capital Buffer and the Business Cycle: Evidence for German Savings and Cooperative Banks

This paper analyzes the effect of the business cycle on the regulatory capital buffer of German savings and cooperative banks in the period 1993-2003. The capital buffer is found to fluctuate anticyclically over the business cycle. The fluctuation is stronger for savings banks than for cooperative banks, as, for savings banks, risk-weighted assets fluctuate more strongly with the business cycle. Further, low-capitalized banks do not catch up with their wellcapitalized peers. The gap between low-capitalized and well capitalized banks even widened over the observation period. Finally, low-capitalized banks do not decrease risk-weighted assets in a business cycle downturn by more than well-capitalized banks. This finding seems to imply that their low capitalization does not force them to retreat from lending.

The Effect of Capitalization on Banks' Risk under Regulation and Managerial Moral Hazard: A Theoretical and Empirical Investigation

We investigate the relationship between banks' capitalization and risk-taking behavior. The conventional wisdom is that well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases with capitalization. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom. First, many studies neglect agency problems arising from the separation of management and ownership. Second, past studies rely on limited risk-return profiles of the asset choice set and do not consider profiles in which higher risk is associated with higher return. Finally, empirical studies on this issue provide only mixed evidence. The aim of this article is to shed new light on this issue by expanding existing models to account for the shortcomings identified. Thus, we explicitly model three different incentives of the agents that shape risk-taking behavior in banking; regulatory bodies, shareholders, and management. We consider how the respective incentives influence the riskiness of a bank-portfolio for four distinct assumptions about the characteristics of risk-return profiles. By combining these factors, we demonstrate that a bank's risk can either decrease or increase with capitalization depending on the relative forces of the three agents in determining asset risk and on various parametric assumptions about risk-return profiles. In the empirical study, the regression equations are modeled so that the differing incentives of the three agents are allowed to interact. The test results show differences in risk-capitalization relationships across high and low capital banks and across publicly and non-publicly traded banks. This indicates that risk-capitalization relationships are, indeed, sensitive to the relative forces of the three agents in determining asset risk.

Capital, Portfolio, and Growth: Bank Behavior Under Risk-Based Capital Guidelines

This paper examines banks' capital, portfolio and growth decisions from 1986 to 1995, when risk-based capital guidelines were proposed and implemented. Overall, we observe complementarity between equity financing and risk. We find no systematic differences in pre- and postregulation behavior consistent with banks reacting to risk-based capital standards implementation. We do find significant differences, however, between low-capital banks and other banks. For example, increases in equity generally do not lead to increases in assets unless the bank has low capital. We also find that the impact of regulatory variables, such as the ratio of equity to total assets or the of ratio risk-weighted assets to total assets, have the predicted, significant effects for low-capital banks but not necessarily for other banks.

Are There 'Bank Effects' in Borrowers' Costs of Funds? Evidence from a Matched Sample of Borrowers and Banks

We use a large matched sample of individual loans, borrowers, and banks to investigate whether financial health affects terms of lending, holding constant proxies for borrower risk and information costs. In particular, we focus on measuring effects of borrower and characteristics on loan interest rates; we also investigate implications of borrower and characteristics for indirect measures of credit availability. ; Our principal findings are six. First, even after controlling for proxies for borrower risk and information costs, the cost of borrowing from low-capital banks is higher than the cost of borrowing from well-capitalized banks. Second, this cost difference is traceable to borrowers for which information costs and incentive problems are a piori important. Third, weak effects on the cost of funds are higher in periods of aggregate contractions in lending. Fourth, estimated weak effects remain even after controlling for unobserved heterogeneity in the matching of borrowers and banks. Fifth, weak effects are quantitatively important only for high-information-cost borrowers, consistent with models of switching costs in bank-borrower relationships and with the underpinnings of the lending of monetary policy. Sixth, when we investigate determinants of cash holdings of borrowing firms, we find that firms facing high information costs hold more cash than other firms, all else being equal, and those firms (and only those firms) have higher cash holdings when they are loan customers of weak banks. These results suggest declines in banks' financial health can lead to precautionary saving by some firms, a response which may affect their investment spending. ; This evidence sheds light on two sets of questions. First, our estimated effects of characteristics on borrowing cost are consistent with models of switching costs for borrowers for whom banking relationships are most valuable. Second, our findings are consistent with switching costs for the borrowers stressed by the bank lending channel of monetary policy.

Effects of Risk-Based Capital Requirements and Asymmetric Information on Banks' Portfolio Decisions

This paper examines if asymmetric information about earnings prospects caused low-capital banks to reduce assets rather than raise capital between 1989 and 1992, the transition period from the leverage ratio to the risk-based capital requirement. The measure of asymmetric information here is the residual of an earnings prediction model based on publicly available information. If managers are significantly better informed than outside investors, a large residual indicates that inside information is more favorable and that the bank's stock is undervalued. The empirical results show an insignificant effect of asymmetric information on banks' portfolio decisions.

An empirical analysis of bank interest rate swaps

Considering the characteristics of banks that do and do not report interest rate swaps, the long-term interest rate exposure of a bank and the likelihood and extent of swap market participation are found to be positively related. Key to the finding is the inclusion of variables related to the provision of swap market intermediary services, which significantly explain both the likelihood of swap market participation and the notional value of outstanding swaps. The results suggest that the likelihood and extent of swap market participation by low-capitalized banks is less than for other banks.

A simple approach to better deposit insurance pricing

Abstract We examine the ability of simple insurance pricing schedules to match premiums with the values derived from a contingent-claim model of deposit insurance. We use a quadratic loss function to compare a flat-rate pricing system to alternative pricing schedules incorporating measures of risk. A simple two-bracket schedule that distinguishes between high and low capitalization is a substantial improvement. A pricing schedule under which the rate paid by low-capital banks depends on their degree of undercapitalization is better still. In addition, the gains from using market value measures of capital rather than book value are great.

A simple approach to better deposit insurance pricing

We examine the ability of simple insurance pricing schedules to match premiums with the values derived from a contingent-claim model of deposit insurance. We use a quadratic loss function to compare a flat-rate pricing system to alternative pricing schedules incorporating measures of risk. A simple two-bracket schedule that distinguishes between high and low capitalization is a substantial improvement. A pricing schedule under which the rate paid by low-capital banks depends on their degree of undercapitalization is better still. In addition, the gains from using market value measures of capital rather than book value are great.

Abstract: A Portfolio Model for Identifying Banks Operating under Capital Constraints

The paper presents evidence suggesting that banks with very low and very high capital positions respond to interest rate changes differently from other banks. The concept of a capital constraint is introduced to explain this phenomenon. The hypothesis is that banks with a binding capital constraint should exhibit different asset management decisions from those banks which are unconstrained. The regression results indicate that low-capital banks for the years 1973-74 and 1974-75 did not respond to earnings in an economic fashion.