Low-capital Banks Research Articles

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.

Regulation and information costs of sovereign distress: Evidence from corporate lending markets

We examine the effect of sovereign credit impairments on the pricing of syndicated loans following rating downgrades in the borrowing firms' countries of domicile. We find that the sovereign ceiling policies used by credit rating agencies create a disproportionately adverse impact on the bounded firms' borrowing costs relative to other domestic firms following their sovereign's rating downgrade. Rating-based regulatory frictions partially explain our results. On the supply-side, loans carry a higher spread when granted from low-capital banks, non-bank lenders, and banks with high market power. We further document an operating demand-side channel, contingent on borrowers' size, financial constraints, and global diversification. Our results can be attributed to the relative bargaining power between lenders and borrowers: relationship borrowers and non-bank dependent borrowers with alternative financing sources are much less affected.

Monetary Transmission through Bank Securities Portfolios

We study the transmission of monetary policy through bank securities portfolios for the United States using granular supervisory data on bank securities, hedging positions, and corporate credit. We find that banks that experienced larger market value losses on their securities during the monetary tightening cycle in 2022 extended relatively less credit to firms. Such a spillover effect was stronger for (i) available-for sale securities, (ii) unhedged securities, (iii) low-capitalized banks, and (iv) banks that have to include unrealized gains and losses on their available-for-sale securities in their regulatory capital. Our findings provide evidence for a forceful transmission channel of monetary policy that is shaped by the regulatory framework of the banking system.

Capital buffers, business models and the probability of bank distress: a dynamic panel investigation

PurposeThis paper aims to improve the debate linking the business models of banks to their riskiness by checking if diversification exerts different impacts on the probability of bank distress depending on the level of capital buffers.Design/methodology/approachThe paper focuses on a sample of listed bank holding companies observed between 2007:Q3 and 2022:Q4. The authors use three subindexes of bank diversification. The authors estimate a dynamic model specification using a system generalized method of moments with robust standard errors and consistent estimators under heteroskedasticity and autocorrelation within a panel. Sensitivity and robustness checks are performed.FindingsAsset and income diversification increase the probability of distress in low-capitalized banks during normal periods (excluding periods of crises and high uncertainty). Concerning crisis periods, a marginal increase in asset diversification during the global financial crisis (GFC) and the COVID-19 pandemic crisis induces a more important increase in the probability of failure of well-capitalized banks relative to low-capitalized ones. Contrary to the results obtained for the GFC period, well-capitalized banks were found to pursue more careful funding diversification in reaction to the sudden increase of uncertainty during the Russia–Ukraine war.Research limitations/implicationsPrudential supervision should concentrate on well-capitalized banks to encompass unexpected excessive risk-taking during crisis periods. Regulatory requirements should constrain fragile banks to avoid pursuing assets and income diversification strategies that increase earnings volatility.Originality/valueThe main originality of this paper is to consider the interaction between three different dimensions of bank diversification and capital regulation during stable and unstable periods using the marginal effect analysis. Moreover, this paper uses, initially, the GFC as the reference crisis period to study the impact of capital buffers and diversification interactions on the probability of bank distress. Then, the authors extend the observation period until 2022:Q4 to include two additional major events, namely, the COVID-19 pandemic and the Russia-Ukraine war.

Internal Ratings, Non-Performing Loans, and Bank Opacity: Evidence from Analysts’ Forecasts

We use a panel data set of large listed European banks to evaluate the effect of the usage of internal ratings-based (IRB) models on bank opacity. We find that a more intensive usage of these models is associated with lower forecast error and disagreement among analysts about bank earnings per share. These results seem to be driven by the more detailed disclosure of loan portfolios required of IRB users, and are stronger in banks adopting the advanced version of IRB models. In these banks the negative effect of non-performing loans on bank transparency is mitigated. However, the transparency-enhancing role of IRB models fades in low-capital banks, suggesting that capital constraints could favor an opportunistic usage of internal ratings that counterbalances their beneficial effect on bank transparency.

BANK REGULATION AND STABILITY: LESSON LEARNED FROM THE INDONESIAN BANKING SECTOR

This study aims to investigate the impact of bank regulations on bank stability. This study holds crucial significance in Indonesia’s long regulation journey within a bank-based economy to maintain stability in various business cycles, including the Asian financial crisis. Additionally, although the capitalization of the Indonesian banking sector is the highest among the G-20 countries, the capitalization of these more than 100 banks varies widely and is concentrated among large banks. Thus, it is necessary to implement the capital requirement policy meticulously. This study examines the impact of bank regulations in terms of capital requirement and bank capitalization on bank stability using a sample of Indonesian commercial banks and employs a dynamic panel regression. We expect to improve from the previous study by using the research period from 2001 to 2019 that captures different business cycles, analyzing three of Indonesia’s bank regulations, and providing further analysis by incorporating the role of bank market power and size in the relationship between bank capital and bank stability. The results show that capital discipline implemented in the capital requirements significantly supports bank stability. Furthermore, the findings show that low-to-middle capitalization banks are associated with weak bank stability in terms of solvency. However, low-capitalized banks tend to be more prudent in granting credit, so exposure to credit risk is low. Moreover, this study reveals that market power and size strengthen the impact of capital on bank stability. However, such an influence should be accompanied by intense supervision to avoid credit risk exposure.

Evergreening

We develop a simple model of relationship lending where lenders have incentives for evergreening loans by offering better terms to less productive and more indebted firms. We detect such lending behavior using loan-level supervisory data for the United States. Low-capitalized banks systematically distort firms’ risk assessments to window-dress their balance sheets. To avoid further reductions in their capital ratios, such banks extend relatively more credit to underreported borrowers. We incorporate the theoretical mechanism into a dynamic heterogeneous-firm model to show that evergreening affects aggregate outcomes, resulting in lower interest rates, higher levels of debt, and lower productivity.

Market Freeze and Bank Capital Structure Heterogeneity

We develop a theory wherein a priori identical banks may trade loans in a search market with reusable information. The equilibrium is unique, but its nature depends on the probability of a future market state. When the probability of a boom is high, all banks hold no equity and do no screening. When this probability is low, all banks choose a high level of equity and screen loans. For intermediate probability values, the equilibrium is heterogeneous, with some banks posting equity and screening and others avoiding equity and screening. This endogenously arising heterogeneity generates interbank trading. The credit market is partially frozen in a recession: only high-capital banks have continued funding access. Low-capital banks obtain funding by selling legacy loans to banks with “financial muscle,” so market funding is reallocated from low-capital to high-capital banks. This paper was accepted by Bruno Biais, finance.

Regulatory Treatment of Changes in Fair Value and the Composition of Banks' Investment Portfolios

ABSTRACTFollowing the financial crisis of 2007–2008, Basel III recommended that bank regulators include changes in the fair value of available-for-sale (AFS) debt securities in Tier 1 capital. However, the U.S. allowed smaller banks to continue excluding these changes through a one-time opt out election. This paper examines the investment decisions of smaller banks in the 1990s when changes in the fair value of AFS debt securities were temporarily included in regulatory capital. Using a sample of smaller banks and a difference-in-differences research design, we find that low-capitalized banks reduced their investments in more volatile asset classes (e.g., corporate bonds, non-agency MBS) and increased their investments in less volatile asset classes (e.g., treasuries and municipal bonds) after these changes were included. These findings suggest that providing smaller banks with an opt out election potentially allows low-capitalized, riskier banks to continue to hold more volatile securities in their AFS portfolios.JEL Classifications: M41; M48; G18; G21.

The leverage anomaly in U.S. bank stock returns

This article examines the relationship between capital ratios and returns on US bank stocks between 1973 and 2019. Banks with low capital ratios do not have higher, but rather lower returns than banks with intermediate levels of capital. This is not explained by standard risk factors. As a result, risk-adjusted returns (alphas) of low-capital banks are negative. Moreover, the stock returns exhibit a delayed reaction to changes in capital ratios. Low-capital banks that further increase their debt have high abnormal returns on the day of announcement, but tend to have low risk-adjusted returns in the 9 months that follow. The paper uncovers several explanations for this leverage anomaly: under-priced default risk, under-priced systematic risk and sensitivity to idiosyncratic volatility.

Credit Misallocation During the European Financial Crisis

Abstract Using data on bank-firm relationships in Italy during the Eurozone financial crisis, we show that: (i) compared to healthy banks, under-capitalised banks cut credit to healthy but not to zombie firms and are more likely to prolong a credit relationship with a zombie; (ii) in area sectors with more low-capital banks, zombies are more likely to survive; (iii) bank under-capitalisation does not hurt the growth rate of healthy firms. We provide evidence that extending credit to the weakest firms during the recession mitigated the disruption of supply chains and adverse local demand externalities.

Bank capital, government bond holdings, and sovereign debt capacity

I develop a model where the sovereign debt capacity depends on the capitalization of domestic banks. Low-capital banks optimally tilt their government bond portfolio toward domestic securities, linking their destiny to that of the sovereign. If the sovereign risk is sufficiently high, low-capital banks lend less to the productive sector to further increase their holdings of domestic government bonds, lowering sovereign yields. In this case, a government that regulates bank capital faces a trade-off. On the one hand, high-capital banks lend more to the productive sector. On the other hand, low-capital banks support the home sovereign debt capacity.

The transmission mechanism of credit support policies in the euro area

We use an original monthly dataset of 131 banks to examine the effectiveness and transmission mechanism of the Eurosystem’s credit support policies in the wake of the banking and sovereign debt crisis. First, we show that these policies were indeed succesful in stimulating the credit flow of banks to the private sector. Second, we find support for the “bank lending view” of monetary transmission. Specifically, the policies had a greater impact on loan supply of banks that were more constrained to obtain unsecured external funding, i.e. small banks (size effect), banks with less liquid balance sheets (liquidity effect), banks that depended more on wholesale funding (retail effect) and low-capitalized banks (capital effect). The role of bank capital was, however, ambiguous. Besides the above favorable direct effect on loan supply, lower levels of bank capitalization at the same time mitigated the size, retail and liquidity effects of the policies. The drag on the other channels was even dominant, i.e. better capitalized banks responded on average more to the credit support policies of the Eurosystem as a result of more favourable size, retail and liquidity effects.

The Cost of Bank Regulatory Capital

The Basel I Accord introduced a discontinuity in required capital for undrawn credit commitments. While banks had to set aside capital when they extended commitments with maturities in excess of one year, short-term commitments were not subject to a capital requirement. We use this difference to infer the price banks are willing to pay to reduce regulatory capital, and to ascertain the role capital regulation plays on the composition of credit in the economy. Our results show that following Basel I, short-term commitments increased as undrawn fees declined (relative to those of long-term commitments). These results are robust and appear to be driven by the Basel I Accord: they are more prevalent among low-capital banks and do not hold in several placebo tests. We estimate that banks are willing to pay at least $0.05 to reduce regulatory capital by one dollar. While this inferred cost might appear to be low, our results show that the relative decline in short-term commitment prices induced by Basel I triggered a large shift in quantities, underscoring the sensitivity of credit to regulatory capital regimes.

Market Freeze and Bank Capital Structure Heterogeneity

This paper develops a theory in which heterogeneity in bank capital choices arises in a general equilibrium despite ex ante identical banks. In a future state, the credit market is partially frozen in a crisis - high-capital banks have continued access to funding liquidity but low-capital banks do not. Inter-bank trading in legacy assets allows some frozen banks to sell assets to banks with “financial muscle” to obtain funding. Consequently, there is a reallocation of access to market funding from low-capital to high-capital banks. Inter-bank trading unfreezes the market without government intervention.

Bank Capital, Borrower Power, and Loan Rates

Abstract We examine how bank capital and borrower bargaining power affect loan spreads. Consistent with previous studies, higher bank capital has a negative impact on loan rates, but borrower cash flow has a significant effect on this impact: compared with high-capital banks, low-capital banks charge more for borrowers with low cash flow, but offer greater marginal discounts as these borrowers’ cash flow rises. These effects are largely focused on more bank-dependent borrowers. We find some evidence that low-capital banks charge a higher premium for bank-dependent borrowers’ systematic risk, but not for their total equity risk or default risk. Received January 27, 2015; editorial decision July 7, 2018 by Editor Philip Strahan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

The Illiquidity Fog

This paper develops a theory of how heterogeneity in bank capital choices due to differences in beliefs about the likelihood of a future crisis state leads to partially frozen credit markets in a crisis — some banks have continued access to funding liquidity but others do not, creating an “illiquidity fog”. Interbank trading in legacy assets allows some frozen banks to sell assets to obtain funding. Consequently, there is a reallocation of access to market funding from low-capital banks to high-capital banks. There are strategic complementarities in the capital choices of high-capital and low-capital banks, leading to a “capital structure contagion”.

Banks’ Incentives and Inconsistent Risk Models

This paper investigates banks’ incentive to bias the risk estimates they report to regulators. Within loan syndicates, we find that banks with less capital report lower risk estimates. Consistent with an effort to mitigate capital requirements, the sensitivity to capital is robust to bank fixed effects and greater for large, risky, and opaque credits. Also, low-capital banks’ risk estimates have less explanatory power than those of high-capital banks with regard to loan prices, indicating that their estimates incorporate less information. Our results suggest banks underreport risk in response to capital constraints and highlight the perils of regulation premised on self-reporting. Received September 21, 2016; editorial decision September 18, 2017 by Editor Philip Strahan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web Site next to the link to the final published paper online.

Balance sheet strength and bank lending: Evidence from the global financial crisis

Abstract We use the 2007-2008 financial crisis as a lens to study the link between banks’ financial health and the strength of transmission of financial sector shocks to the real economy. We find that banks with ex-ante stronger balance sheets, in particular higher levels of common equity, were better able to maintain credit supply when faced with liquidity shocks during the crisis. Bank recapitalizations mitigated the lending gap between high and low capital banks, but only in countries with strong sovereigns. These findings support the view that strong financial intermediary balance sheets are key for the recovery of credit and economic performance after large financial sector shocks.

Regulatory Treatment of Changes in Fair Value and the Composition of Banks' Investment Portfolios

In their implementation of Basel III, U.S. bank regulators are again including changes in the fair value of available-for-sale (AFS) debt securities in Tier 1 capital, but only for the largest U.S. banks. This paper investigates a potential impact of expanding this regulation by examining bank investment decisions in the 1990's when changes in the fair value of AFS debt securities were included in regulatory capital for all banks. Using a matched sample difference-in differences research design, we find evidence that low-capitalized banks reduced their investments in more volatile asset classes (e.g., corporate bonds, non-agency MBS) and increased their investments in less volatile asset classes (e.g., treasuries and municipal bonds) after changes in fair value were included in regulatory capital. We also find that low-capitalized banks change their holdings of these asset classes in the opposite direction after regulators subsequently excluded changes in fair value from regulatory capital. These findings inform regulators worldwide regarding a possible consequence of Basel III. We also contribute to prior research by suggesting that changes in maturity and credit risk around the passage of SFAS 115 (Beatty 1995; Hodder, Kohlbeck, and McAnally 2002) were partially obtained by changing the composition of asset classes within banks' investment portfolios.