Evidence on the response of US banks to changes in capital requirements

TLDR: In this paper, the authors developed a structural, dynamic model of a banking firm to analyze how banks adjust their loan portfolios over time, and the optimal bank response to changes in capital requirements, shocks to bank capital, and changes to bank loan demand is simulated.

Abstract: This paper develops a structural, dynamic model of a banking firm to analyze how banks adjust their loan portfolios over time. In the model, banks experience capital shocks, face uncertain future loan demand, and incur costs based on their proximity to regulatory minimum capital requirements. Non-linear relationships between bank capital levels and lending are derived from the model, and key parameters are estimated using panel data on large US commercial banks operating continuously between December 1989 and December 1997. Using the estimated model, the optimal bank response to changes in capital requirements, shocks to bank capital, and changes to bank loan demand is simulated. The simulations predict that increases in risk-based and leverage capital requirements, negative capital shocks, or a decline in loan demand cause a reduction in loan growth. Nevertheless, by calculating the optimal portfolio response to these various changes, it is shown that changes in capital regulation are a necessary ingredient to explain the decline in loan growth and the rise in bank capital ratios witnessed nearly a decade ago. Thus, this study suggests that the current effort to redesign bank capital requirements should work under the assumption that banks will optimally respond to the economic incentives found in the regulation.

Figures

Table 3: Summary of simulation results and comparison to actual experience

Figure 1: Bank portfolio allocation Share of total bank credit

Figure 2: Marginal cost of capital requirements

Figure 3: The impact of a 1% increase in capital requirements on loan growth, securities growth, and equity issuing

Figure 4: The impact of a 1% negative shock to bank capital and a 1% negative shock to loan demand on loan growth, securities growth, and equity issuing

Table 1: Parameter estimates

Full text

BIS WORKING PAPERS
No. 88 – June 2000
EVIDENCE ON THE RESPONSE
OF US BANKS TO CHANGES
IN CAPITAL REQUIREMENTS
by
Craig Furfine
BANK FOR INTERNATIONAL SETTLEMENTS
Monetary and Economic Department
Basel, Switzerland

BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for
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ISSN 1020-0959

BIS WORKING PAPERS
No. 88 – June 2000
EVIDENCE ON THE RESPONSE
OF US BANKS TO CHANGES
IN CAPITAL REQUIREMENTS
by
Craig Furfine *
Abstract
This paper develops a structural, dynamic model of a banking firm to analyse how
banks adjust their loan portfolios over time. In the model, banks experience capital
shocks, face uncertain future loan demand, and incur costs based on their proximity
to regulatory minimum capital requirements. Non-linear relationships between
bank capital levels and lending are derived from the model, and key parameters are
estimated using panel data on large US commercial banks operating continuously
between December 1989 and December 1997. Using the estimated model, the
optimal bank response to changes in capital requirements, shocks to bank capital,
and changes to bank loan demand is simulated. The simulations predict that
increases in risk-based and leverage capital requirements, negative capital shocks,
or a decline in loan demand cause a reduction in loan growth. Nevertheless, by
calculating the optimal portfolio response to these various changes, it is shown that
changes in capital regulation are a necessary ingredient to explain the decline in
loan growth and the rise in bank capital ratios witnessed nearly a decade ago.
Thus, this study suggests that the current effort to redesign bank capital
requirements should work under the assumption that banks will optimally respond
to the economic incentives found in the regulation.
* The views expressed do not necessarily represent those of the Bank for International Settlements

Contents
1. Introduction .................................................................................................................1
2. The model....................................................................................................................4
2.1 The balance sheet.............................................................................................. 4
2.2 Capital requirements ......................................................................................... 5
2.3 Adjustment costs............................................................................................... 6
2.4 Market setting.................................................................................................... 7
2.5 Uncertainty and the evolution of capital ...........................................................7
2.6 The bank maximisation problem.......................................................................7
2.7 Estimation framework.......................................................................................8
3. Estimation....................................................................................................................8
4. Simulation results...................................................................................................... 11
4.1 An increase in capital requirements................................................................ 11
4.2 A negative shock to bank capital and a negative shock to loan demand.........12
4.3 Implications for the last US credit crunch....................................................... 13
5. Conclusions...............................................................................................................14
References................................................................................................................................. 20

Frequently asked questions

Q1. What are the contributions in "Evidence on the response of us banks to changes in capital requirements" ?

This paper develops a structural, dynamic model of a banking firm to analyse how banks adjust their loan portfolios over time. Thus, this study suggests that the current effort to redesign bank capital requirements should work under the assumption that banks will optimally respond to the economic incentives found in the regulation. 

Q2. What have the authors stated for future works in "Evidence on the response of us banks to changes in capital requirements" ?

11 These results do not preclude the possibility that changing loan demand influenced bank portfolios, but only preclude that a decline in loan demand alone can explain all of the actual portfolio adjustments.