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

TL;DR: 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.

Summary

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.

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

Table 2: Implied steady state solutions

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
International Settlements, and from time to time by other economists, and are published by the Bank. The papers
are on subjects of topical interest and are technical in character. The views expressed in them are those of their
authors and not necessarily the views of the BIS.
Copies of publications are available from:
Bank for International Settlements
Information, Press & Library Services
CH-4002 Basel, Switzerland
Fax: +41 61 / 280 91 00 and +41 61 / 280 81 00
This publication is available on the BIS website (www.bis.org).
© Bank for International Settlements 2000.
All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.
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.