Capital Requirements, Monetary Policy, and Aggregate Bank Lending: Theory and Empirical Evidence

TLDR: In this paper, the authors examined the impact of risk-based capital requirements on aggregate bank lending and showed that increasing the money supply can either raise or lower lending when capital requirements are linked only to credit risk.

Abstract: Capital requirements linked solely to credit risk are shown to increase equilibrium credit rationing and lower aggregate lending. The model predicts that the bank's decision to lend will cause an abnormal runup in the borrower's stock price and that this reaction will be greater the more capital-constrained the bank. I provide empirical support for this prediction. The model explains the recent inability of the Federal Reserve to stimulate bank lending by increasing the money supply. I show that increasing the money supply can either raise or lower lending when capital requirements are linked only to credit risk. THE MOTIVATION OF THIS article is first to examine the impact of "risk-based" capital requirements-namely those that link mandatory capital-to-asset ratios for banks to their loans- on aggregate bank lending. These requirements, called the Basle capital rules (or BIS guidelines), went into effect in March 1989 for banks in the leading industrialized nations. These rules initially required banks to maintain capital equal to 7.25 percent of business and most consumer loans, with the requirement increasing to 8 percent by the end of 1992. Secondly, I wish to understand the link between monetary policy and aggregate bank credit in the presence of risk-based capital requirements. My curiosity is sparked in part by two recent phenomena. One is the experience of the U.S. economy, which displayed sluggish growth during 1989-93 despite a monetary policy that attempted to spur bank lending and economic activity.' And the other is the striking decline in loans relative to security holdings (mostly government bonds) in the asset portfolios of U.S.