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Journal Article•DOI•

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

Craig H. Furfine1•
Northwestern University1
01 Jun 2000-Social Science Research Network (Bank for International Settlements, Monetary and Economic Department)-
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 (3 min read)

Jump to: [1. Introduction] – [2.1 The balance sheet] – [2.2 Capital requirements] – [2.5 Uncertainty and the evolution of capital] – [2.7 Estimation framework] – [3. Estimation] – [4. Simulation results] – [4.1 An increase in capital requirements] – [4.2 A negative shock to bank capital and a negative shock to loan demand] – [4.3 Implications for the last US credit crunch] and [5. Conclusions]

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.

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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
Citations
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Benefits and Costs of Bank Capital

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Jihad Dagher1, Giovanni Dell'Ariccia1, Giovanni Dell'Ariccia2, Luc Laeven3, Luc Laeven2, Lev Ratnovski3, Lev Ratnovski1, Hui Tong1 •
International Monetary Fund1, Economic Policy Institute2, European Central Bank3
01 Sep 2016-Social Science Research Network
TL;DR: In this paper, the authors find that capital in the range of 15-23 percent of risk-weighted assets would have been sufficient to absorb losses in the vast majority of historic banking crises in advanced economies.
Abstract: We find that capital in the range of 15–23 percent of risk-weighted assets would have been sufficient to absorb losses in the vast majority of historic banking crises in advanced economies. Further capital increases would have had only marginal effects on preventing additional crises. Appropriate capital requirements may be somewhat below this range, as banks tend to hold capital in excess of regulatory minima, and other bail-in-able instruments can contribute to loss absorption capacity. While long-term social costs associated with this level of capital appear acceptable, the short-term costs of transitioning to higher bank capital may be substantial, which calls for a careful timing of such transition.

77 citations

Book Chapter•DOI•
Procyclicality and Volatility in the Financial System: the Implementation of Basel II and IAS 39

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Ashley D. Taylor, Charles Goodhart
01 Jan 2006
TL;DR: The Basel II Capital Accord and the accounting guidelines IAS 39, which are to be adopted from the end of 2006 and January 2005 respectively, are designed to provide improved accuracy in assessments of the relative riskiness of banks and their asset values as mentioned in this paper.
Abstract: After many years of discussion, the implementation of two major reforms to international bank regulation and accounting practices is imminent. The Basel II Capital Accord and the accounting guidelines IAS 39, which are to be adopted from the end of 2006 and January 2005 respectively, are designed to provide improved accuracy in assessments of the relative riskiness of banks and their asset values.1 However, the informational and allocative efficiency benefits of such improvements may come at the potential cost of greater real procyclicality and volatility.2 For example, if risk-sensitive regulation requires banks to hold a higher capital ratio during economic downswings, reflecting the increased potential credit losses in their portfolios, then they may respond by reducing their loan book, or by passing on the funding costs of raising capital. The resulting rationing of credit, or its higher cost, may lead to real effects through reduced investment and consumption. Similarly, under IAS 39, losses during a market downturn on tradable assets, which are booked at fair value, could lead to greater volatility of income and profits which, due to market imperfections, may not reflect underlying fundamentals. These losses could eat into capital positions and again this could lead to a contraction in credit.

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Is bank capital procyclical? A cross-country analysis

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Jacob A. Bikker1, Paul Metzemakers•
De Nederlandsche Bank1
01 Jan 2004
TL;DR: In this paper, bestimmungsfaktoren for the internen Eigenkapitalziele of Geschaftsbanken and the potenzielle Sensitivitat der unterschiedlichen Kapitalhohen im Konjunkturzyklus untersucht.
Abstract: In diesem Artikel werden die Bestimmungsfaktoren fur die internen Eigenkapitalziele von Geschaftsbanken sowie die potenzielle Sensitivitat der unterschiedlichen Kapitalhohen im Konjunkturzyklus untersucht. Weltweit erhobene Daten zeigen klar, dass das Eigenrisiko der Banken nur geringfugig vom Konjunkturzyklus beeinflusst wird. Die Banken neigen dazu, uber das fur die Unterlegung mit Eigenmitteln erforderliche Mindestkapital hinaus weiteres Pufferkapital in substanzieller Hohe zu halten, woraus hervorgeht, dass sie Kapital auch fur Zwecke halten, die nicht ausschlieslich der strengen Einhaltung der Bestimmungen uber die Unterlegung mit Eigenmitteln dienen. Diese Daten legen die Vermutung nahe, dass die derzeitigen Kapitalhohen gemas dem neuen risikosensitiven Basel-II-Regime nicht wesentlich starker prozyklisch wirken durfen. Jedoch kombiniert eine Reihe von insbesondere kleineren Banken relativ stark risikobehaftete Portfolios mit Pufferkapital in begrenzter Hohe. Ein starker risikosensitives Regime fur die Unterlegung von Krediten mit Eigenmitteln konnte diese Banken dazu zwingen, hohere Eigenmittel vorzusehen, wodurch deren Wirkung starker prozyklisch sein wurde.

66 citations

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Effect of bank capital requirements on economic growth: a survey

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Natalya Martynova1•
De Nederlandsche Bank1
12 Mar 2015-Social Science Research Network
TL;DR: This article reviewed studies exploring how higher bank capital requirements affect economic growth and found that there is little evidence of a direct effect; research focuses on the indirect effects of capital requirements on credit supply, bank asset risk, and cost of bank capital.
Abstract: This paper reviews studies exploring how higher bank capital requirements affect economic growth. There is little evidence of a direct effect; research focuses on the indirect effects of capital requirements on credit supply, bank asset risk, and cost of bank capital, which in turn can affect economic growth. Banks facing higher capital requirements can reduce credit supply as well as decrease credit demand by raising lending rates which may slow down economic growth. However, having better-capitalized banks enhances financial stability by reducing bank risk-taking incentives and increasing banks' buffers against losses.

59 citations

Cites methods from "Evidence on the response of US bank..."

  • ...Using panel data on large US commercial banks between 1989 and 1997, Furfine (2000) develops a structural dynamic model....

    [...]

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Bank capital and lending behaviour: empirical evidence for Italy

[...]

Leonardo Gambacorta, Paolo Emilio Mistrulli
01 Sep 2003-Research Papers in Economics
TL;DR: In this article, the authors investigated the effect of bank capital on the response of Italian banks to monetary policy and GDP shocks. And they found that well-capitalized banks can better shield their lending from monetary policy shocks as they have, consistently with the bank lending channel hypothesis, an easier access to nondeposit fund raising.
Abstract: This paper investigates the existence of cross-sectional differences in the response of lending to monetary policy and GDP shocks due to a different degree of bank capitalization. The effects on lending of shocks to bank capital, that are caused by a specific (higher than 8 per cent) solvency ratio for highly risky banks, are also analyzed. The paper adds to the existing literature in three ways. First, it considers a measure of capitalization (the excess capital) that is better able to control for the riskiness of bank’s portfolio than the well-known capital-to-asset ratio. Second, it disentangles the effects of the “bank lending channel” from those of the “bank capital channel” in the case of a monetary shock; it also provides an explanation for asymmetric effects of GDP shocks on lending based on the link between bank capital and risk-aversion. Third, it uses a unique dataset of quarterly data for Italian banks over the period 1992-2001; the full coverage of banks and the long sample period helps to overcome some distributional bias detected for other public available dataset. The results indicate that well-capitalized banks can better shield their lending from monetary policy shocks as they have, consistently with the “bank lending channel” hypothesis, an easier access to non-deposit fund raising. A “bank capital channel” is also detected, with higher effects for cooperative banks that suffer a higher maturity mismatching. Capitalization also influences the way banks react to GDP shocks. Again, the credit supply of well-capitalized banks is less pro-cyclical. The introduction of a specific solvency ratio for highly risky banks determines an overall reduction in lending.

51 citations

Cites background from "Evidence on the response of US bank..."

  • ...The empirical investigations concerning the effect of bank capital on lending mostly refer to the US banking system ( Hancock, Laing and Wilcox, 1995, Furfine, 2000, Kishan and Opiela, 2000; Van den Heuvel, 2001b)....

    [...]

  • ...A relevant measure is instead the excess capital, that is, the amount of capital that banks hold in excess of the minimum required to meet prudential regulation standards....

    [...]

References
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Report•DOI•
A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix

[...]

Whitney K. Newey, Kenneth D. West
01 May 1987-Econometrica
TL;DR: In this article, a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction is described.
Abstract: This paper describes a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction. It also establishes consistency of the estimated covariance matrix under fairly general conditions.

18,117 citations

Journal Article•DOI•
Financial Intermediation and Delegated Monitoring

[...]

Douglas W. Diamond1•
University of Chicago1
01 Jul 1984-The Review of Economic Studies
TL;DR: In this paper, the authors developed a theory of financial intermediation based on minimizing the cost of monitoring information which is useful for resolving incentive problems between borrowers and lenders, and presented a characterization of the costs of providing incentives for delegated monitoring by a financial intermediary.
Abstract: This paper develops a theory of financial intermediation based on minimizing the cost of monitoring information which is useful for resolving incentive problems between borrowers and lenders. It presents a characterization of the costs of providing incentives for delegated monitoring by a financial intermediary. Diversification within an intermediary serves to reduce these costs, even in a risk neutral economy. The paper presents some more general analysis of the effect of diversification on resolving incentive problems. In the environment assumed in the model, debt contracts with costly bankruptcy are shown to be optimal. The analysis has implications for the portfolio structure and capital structure of intermediaries.

7,982 citations

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A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelationconsistent Covariance Matrix

[...]

Whitney K. Newey1, Whitney K. Newey2, Kenneth D. West3, Kenneth D. West2•
Massachusetts Institute of Technology1, National Bureau of Economic Research2, University of Wisconsin-Madison3
01 Apr 1986-Social Science Research Network
TL;DR: In this article, a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction is described.
Abstract: This paper describes a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction. It also establishes consistency of the estimated covariance matrix under fairly general conditions.

5,822 citations

Journal Article•DOI•
Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships

[...]

Steven A. Sharpe
01 Sep 1990-Journal of Finance
TL;DR: In this article, a dynamic theory of "customer relationships" in bank loan markets is presented, based on a traditional view of bank lending behavior, first spelled out by Hodgman and Kane and Malkiel (1965) and later elaborated upon by Wood (1975).
Abstract: Customer relationships arise between banks and firms because, in the process of lending, a bank learns more than others about its own customers. This information asymmetry allows lenders to capture some of the rents generated by their older customers; competition thus drives banks to lend to new firms at interest rates which initially generate expected losses. As a result, the allocation of capital is shifted toward lower quality and inexperienced firms. This inefficiency is eliminated if complete contingent contracts are written or, when this is costly, if banks can make nonbinding commitments that, in equilibrium, are backed by reputation. THIS PAPER DERIVES A dynamic theory of "customer relationships" in bank loan markets. The theory builds on a traditional view of bank lending behavior, first spelled out by Hodgman (1961) and Kane and Malkiel (1965) and later elaborated upon by Wood (1975). According to this view, an essential factor underlying a bank's loan pricing policy is its impact on the bank's stock of loyal customers, as well as on those customers' deposits. Rather than take relationships as a given, we examine the implications of the view expressed, for example, by Fama (1985), that they arise because of "inside information" generated by the history of bankfirm interactions. In our theory, customer relationships arise endogenously as a consequence of the asymmetric evolution of information sets. In contrast with most theories of pricing under asymmetric information, though, the key informational asymmetry postulated here is that which arises between agents on the same side of the market. We exploit the presumption, made by Kane and Malkiel (1965) and Fama (1985), that a bank which actually lends to a firm learns more about that borrower's characteristics than do other banks. A fundamental consequence of this asymmetric evolution of information is the potential creation of ex post, or temporary, monopoly power. If it is relatively costly for banks and firms to write multiperiod contingent contracts, this ex post monopoly power has undesirable effects on the allocation of capital. Even though banks earn zero expected profit over the lifespan of the average customer relationship, they are not disciplined by the market to offer

2,064 citations

Journal Article•DOI•
The Credit Crunch

[...]

Ben S. Bernanke, Cara S. Lown, Benjamin M. Friedman
01 Jan 1991
TL;DR: A notable lack of consensus about the importance of a credit crunch in the banking sector, its causes, and even the meaning of the term has emerged as mentioned in this paper, although it is too early to say whether the credit crunch played a role in the 1990s economic crisis.
Abstract: ACCORDING TO many popular accounts, the severity of the recession that began in July 1990 was worsened by financial distress-or, at least, by financial discomfort-in a number of sectors of the economy. Much of this discussion centered on the so-called "credit crunch" in the banking sector. ' As early as the spring of 1990, some months before the recession began, there were newspaper reports (mostly anecdotal) of banks cutting back on lending, sometimes with deleterious effects on retailers and other bank borrowers. In June the secretary of commerce called the credit crunch a serious problem,2 and congressional hearings on the issue were held during the summer. As the recession arrived in July and then deepened during the fall, the view that a credit crunch was playing at least some role in the downturn became increasingly widespread among policymakers, including some at the Federal Reserve. Despite these developments, there was, and still is, a notable lack of consensus about the importance of a credit crunch in the banking sector, its causes, and even the meaning of the term. Although it is too early to

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Frequently Asked Questions (2)
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. 

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.