Evidence on the response of US banks to changes in capital requirements
Summary (3 min read)
1. Introduction
- Bank supervision and regulation have again become timely topics in the light of the current banking problems in many Asian nations.
- This paper explores this issue by providing evidence on the response of banks to the last major overhaul of capital regulation.
- These authors find that a higher level of risk-based capital relative to a bank’s target affects bank loan supply.
- A different approach was taken by Hancock, Laing, and Wilcox [1995].
- Further, the results suggest that although many factors may cause a decline in loan growth, only changes in capital regulation can simultaneously explain all of the shifts in bank portfolios that occurred in the United States nearly 10 years ago.
2.1 The balance sheet
- Prior to risk-based capital (RBC) requirements, banks could only increase their regulatory capital ratios by either reducing assets or issuing equity.
- The introduction of RBC allowed a bank to increase its regulatory capital ratios by adjusting the composition of its assets, both on and off the balance sheet.
- For this reason, a model that analyses the risk-based capital requirements must disaggregate the assets of a bank.
- I assume that the asset side of a bank’s balance sheet consists only of loans L and default-free securities S.4.
- The model generalises to both n asset types as well as the inclusion of off-balance sheet items.
2.2 Capital requirements
- There are two types of capital requirements.
- When a bank fails to meet its capital requirement, regulators impose a variety of restrictions on bank activities.
- The closer a bank is to the regulatory minimum, the more likely these costs are to occur.
- The per dollar leverage requirement costs are multiplied by total assets to capture the fact that both loans and securities are subject to this requirement.
- The model assumes that a bank pays adjustment costs when it adjusts the growth of its loan portfolio over time at a rate different from what is dictated by its loan demand.
2.5 Uncertainty and the evolution of capital
- 7 Equation (5) implies that capital accumulates independent of adjustment costs j.
- That is, adjustment costs are incurred by management rather than bank equity holders.
- At the beginning of time t, the bank observes prevailing interest rates as well as the current period capital shock, εt.
- With these observable variables and their expectations, the bank chooses its lending, the quantity of default-free securities to buy, and the amount of equity to issue.
2.7 Estimation framework
- Equation 8 equates the marginal return to securities with the marginal capital requirement costs and equity costs.
- Equation 9 ensures the optimal issuance of new equity capital.
3. Estimation
- The data used in the estimation come from the Bank Call Reports.
- The data used are quarterly, beginning in September 1989 and continuing through December 1997.
- Interest rates were measured as the weighted average effective loan rate on all commercial and industrial loans taken from the Federal Reserve’s quarterly Survey of Terms of Bank Lending ( Ltr ), the rate on the two-year constant maturity treasury note ( Str ), and the rate on secondary market six-month CDs ( D tr ).
- The parameters η1 and ν1 influence the marginal cost of the bank’s capital positions.
4. Simulation results
- Table 2 below gives the assumed values of the unidentified parameters and the resulting steady state solution for loan growth, capital ratios, and the new equity to asset share that will be used in the simulations presented.
- Suppose the risk-based capital requirement d was increased by 1%.
- A bank would then reoptimise since its previous capital ratios were determined under the previous capital requirement regime.
4.1 An increase in capital requirements
- Figure 3 plots both dynamic paths of loan growth, security growth, and new equity 9 Following higher risk-based requirements, securities growth increases by nearly 35%.
- These larger percentage changes are driven both by the lack of adjustment costs assumed in the model, and by the fact that securities make up a smaller proportion of the overall portfolio.
- The optimal bank response actually entails curtailing equity issuing, which saves the cost of issuing equity, and reducing securities.
- That is, the bank’s risk-based capital ratio rises from 9% to 10% following a 1% rise in the risk-based requirement.
4.2 A negative shock to bank capital and a negative shock to loan demand
- This section investigates two other shocks to the bank steady state that one may be interested in exploring.
- The results from these two shocks are graphed in Figure 4.
- In other words, the shock is the size that in the absence of bank adjustment would lower the bank’s risk- 13 based capital ratio by 1%.
- That is, loan demand is presumed to return to its baseline value after four quarters.
- Since fewer profitable opportunities are needing funding, capital issuing can fall and the bank can still maintain its capital ratios at their original levels.
4.3 Implications for the last US credit crunch
- The simulations in the previous two subsections indicate that a variety of different factors cause a decline in the growth rate of lending.
- Each of the shocks considered e.g. (1) increase in riskbased capital requirements, (2) increase in leverage requirements, (3) negative shock to bank capital, and (4) negative shock to loan demand - has different implications with regard to securities growth, capital ratios, and equity issuing.
- These qualitative results as well as what occurred in the United States during the early 1990s are summarised in Table 3.
- In particular, only changes to capital requirements cause a bank to optimally increase its capital ratios.
- The model simulations suggest that implementation of risk-based capital requirements and a simultaneous, yet perhaps smaller, rise in required leverage ratios would be sufficient to explain the dramatic portfolio adjustment that occurred in US commercial bank portfolios.
5. Conclusions
- This paper develops a dynamic model of a banking firm in an environment with risk-based and leverage capital requirements.
- Implications of the model are estimated using data on US commercial banks to derive estimates of the marginal cost of bank capital requirements.
- In particular, it was shown that neither a fall in loan demand nor shocks to bank capital can simultaneously explain a decline in lending and a rise in bank capital ratios.
- The conclusions from this paper support the intuitive notion that changes to a bank’s incentives will cause a change in bank behaviour.
- This result should be appreciated in the light of the current review of bank capital requirements.
Did you find this useful? Give us your feedback
Citations
5 citations
5 citations
5 citations
4 citations
Cites background from "Evidence on the response of US bank..."
...For example, Cambell (1987), Lasser (1992), Hamilton (1996), Furfine (2000, 2001, 2002), Palobini (2003), Gaspa et al. (2004), and Acharya and Merrouche (2013) show that interest rates increase when banks need to maintain higher reserves as required at the end of a reserve period, the beginning of…...
[...]
...Moreover, the studies also document that higher price dispersion exists when there is a higher volume of trading in the market (Furfine, 2000; Gasper et al., 2004; Kiu et al., 2014, Klee et al., 2017)....
[...]
...Furfine (2000), Prati et al. (2000), and Gaspar et al. (2004) document that, in a period of increased demand for funds, market rates become more volatile as trading on the interbank market increases....
[...]
...For example: Furfine (2000) shows that specific liquidity needs on days with large payment volumes determine the intra maintenance period demand for reserves; Bech and Monnet (2013) find that as reserves expand, market volume decreases; Gaspar et al. (2004) shows an increase in volatility and…...
[...]
3 citations
References
18,117 citations
7,982 citations
5,822 citations
2,064 citations
[...]
1,446 citations
Related Papers (5)
Frequently Asked Questions (2)
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.