Bank Capital and the Credit Crunch: The Roles of Risk-based and Leverage-based Capital Regulations
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We investigated whether in recent years banks have increased their holdings of securities at the expense of their holdings of business loans in response to short-falls of their capital relative to risk-weighted capital standards and relative to a capital standard that made no explicit allowance for credit risk. We estimated that bank credit fell by about $4.50 for each $1 that a bank's capital fell short of the unweighted capital standard. Banks that had less capital than required by the risk-weighted standard appear to have shifted away from assets with low risk weights (securities and single-family mortgages) and to have shifted toward assets with higher risk weights (commercial real estate and commercial and industrial loans). When we included both shortfall variables in a regression, shortfalls relative to the unweighted capital standard significantly affected bank credit, while shortfalls of capital relative to the risk-weighted standard did not. We found no significant effects of capital shortfalls at other, local-competitor banks on bank portfolios. Delinquencies in a given category of a bank's loans generally had significantly negative effects on that bank's holdings of loans in that category. In contrast, banks tended to increase holdings of loans in categories in which local-competitor banks were experiencing higher delinquency rates.Keywords:
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The policy response to the recent financial crisis has broadly focused on two themes: 1) Increasing the banking sectorsâ resilience to future financial shocks: 2) Improving credit availability to households and firms via lowering both short and long-term interest rates and thereby affecting short-term output and inflation. This dissertation studies how banks and firms have responded to these policy measures. The dissertation comprises of three chapters. The first two analyze the impact of capital regulation on bank lending for two different jurisdictions - United States and Switzerland. The third evaluates the response of U.S. non-financial firms to lower interest rates. The first chapter is joint work with Luisa Lambertini. We estimate the impact of bank capital regulation on lending spreads. We use U.S. firm-level data on syndicated loans matched with Bank Holding Company (BHC) data for the lending banks in our panel regressions. We find that higher bank capital leads to an increase in the loan pricing. Further, we investigate if stress test failure under the Supervisory Capital Assessment Program and Comprehensive Capital Analysis and Review leads to higher loan spreads, since financial institutions that failed were required to raise capital in the short run. Using a difference-in-difference framework, we find: 1) BHCs that failed the stress tests increased their loan pricing; 2) Loan pricing is higher for all banks after the commencement of the stress tests. These findings suggest that greater regulatory oversight and higher capital requirements have made syndicated loans more costly for firms. The second chapter is joint work with Luisa Lambertini, Dan Wunderli and Robert Bichsel. We use confidential loan-by-loan data of Swiss banks to study the impact of higher capital requirements on lending. Our data allows us to trace the link between bank capital and new credit granted at the bank level. Additionally bank-specific variation of capital targets allows us to analyze how deviation from the regulatory capital target impacts loan pricing and volume. We find that tighter capital regulation has small but statistically significant short-term effects on loan pricing and growth. We do not find a permanent effect of higher capital ratios on loan growth. In the third chapter, I study the behavior of U.S. non-financial corporates after the recent financial crisis. I document an increase in the real debt holdings and correspondingly the book leverage for these firms. Controlling for firm and time fixed-effects, I find a higher long-term debt to asset ratio to be associated with lower capital expenditures and growth in fixed capital post-crisis. This is also true for financially unconstrained firms, as determined by the Whited-Wu index, vis-a-vis pre-crisis. Moreover, firms with a higher share of long-term debt after the crisis appear to have a greater likelihood of repurchasing shares and larger dollar payouts to equity holders. The evidence points to the fact that any increase in long-term debt has had an impact on firms' capital structure but no positive effect on real investment.
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This paper estimates the relationship between banking market concentration and high-risk portfolio strategies at commercial banks. I use the unprecedented changes in the degree of competition in local banking markets that occurred after 1980 to estimate the impact of market competition on the risk profile of commercial bank lending. I find evidence that increasing concentration has been associated with reductions in the flow of bank capital to construction and land development loans, the highest-risk category of commercial bank loans. The magnitude of this effect is large: an increase in concentration from the 25th to the 75th percentile of the sample distribution is associated with a 15 percent drop in the share of bank lending going to construction loans. Robustness to a variety of econometric strategies supports a causal interpretation of this empirical relationship. Increasing concentration also appears to increase average bank capitalization, raise the average share of assets loaned out to borrowers, and reduce bank failure rates during this period. Because the Federal Deposit Insurance Corporation assumes the assets and liabilities of failing banks, changes in bank portfolio risk affect the value of the government's contingent liability to the banking sector, as well as the health and stability of the larger economy.
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This paper estimates the amount of tightening in bank commercial and industrial (CI while small banks tended to tighten less, they always charged more. ; Using loan size to proxy for bank-dependent borrowers, while small loans tend to have a higher spread than large loans, I find that small loans actually tightened less than large loans in both absolute and percentage terms. Hence, the results do not indicate that bank-dependent borrowers suffered more from bank tightening than large borrowers. ; The channels through which banks tightened loan rates include reducing the discounts on large loans and raising the risk premium on more risky loans. There also is evidence that noncommitment loans were priced significantly higher than commitment loans at the height of the liquidity shortfall in late 2007 and early 2008, but this premium dropped to zero following the introduction of emergency liquidity facilities by the Federal Reserve. ; In a cross section of banks, certain bank characteristics are found to have significant effects on loan prices, including loan portfolio quality, capital ratios, and the amount of unused loan commitments. These findings provide evidence o n the supply-side effect of loan pricing.
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The Basle Accord of 1988 imposed risk-based capital standards on banks. Risk-based capital was costly for U.S. banks. As one might expect, the new capital standards produced statistically and economically significant negative abnormal returns to shareholders of banks with the highest holdings of assets that were classified as in the Accord. Moreover, the new standards may have unfairly penalized banks that made good commercial and consumer loans. Among banks with large holdings of assets, returns were significantly negative for all three subsamples formed on the basis of loan quality and were most negative for banks with moderate loan quality. Thus, risk-based capital standards appear to tax investment in assets classified as high risk without regard to the actual quality of assets within types. In addition, there was a significant change in the relative price of bank loans versus other short-term borrowing. This change is consistent with an increase in the cost of capital for U.S. banks in the post risk-based capital period. Also, banks with the lowest asset quality prior to the new regulation experienced relative improvement in quality in the post-regulatory period while asset quality deteriorated for banks with high quality assets. Finally, interest rate risk increased after risk-based capital was implemented with weak banks experiencing the most significant increase in interest rate exposure. Therefore, while risk-based capital was costly for banks, it does not appear that the new standards led to a reduction in risk-taking by all banks.
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Credit crunch
Liberian dollar
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This paper examines the reallocation of bank from loans to securities in the early 1990s using data on virtually all U.S. banks from 1979 to 1992. The spectacular increase in bank and thrift failures in the 1980s raised concerns about depository institution risk and spurred interest in public policy prescriptions to reduce this risk. One of these pre-scriptions was the Basle Accord on risk-based capital, which mandates that international banks operating in the major industrialized nations hold capital in proportion to their perceived risks. Because capital is more expensive to raise than insured deposits, risk-based capital (RBC) may be viewed as a regulatory tax that is higher on assets in categories that are assigned higher risk weights. Therefore, it would be expected that implementation of RBC would encourage substitution out of assets in the 100% risk category, such as commercial loans, and into assets in the 0% risk category, such as Treasury securities. Thus, the allocation of away from commercial loans may have caused a credit crunch, which the authors define as a significant reduction in the supply of available to commercial borrowers. Consistent with these expectations, U.S. banks did reduce their commercial loans and increase their holdings of Treasuries in the early 1990s. A number of alternative explanations for this change in bank behavior have been offered. The authors suggest several other hypotheses including the leverage hypothesis reflecting banks' interest in reducing their required leverage capital ratio; the loan examination hypothesis reflecting the more rigorous examination process which encouraged substitution into safe assets; the voluntary risk retrenchment hypothesis reflecting management's voluntary substitution of safer assets to lower the cost of funding and reduce the risk of bankruptcy; and the macro/regional demand-side hypo-thesis reflecting the reduction in overall loan demand because of the downturn in the economy and the steep slope of the term structure. An additional hypothesis is that the decline in commercial lending reflects continuation of longer term trends in the declining demand for bank intermediation services. Unfortunately, all of these hypotheses are roughly consistent with the aggregate data, leaving unknown whether risk-based capital played a major part in the reallocation of bank or whether a supply side credit crunch even existed. It is possible that all of the theories were correct simultaneously. The paper takes a close look at the data at the micro bank level to try to distinguish among the alternative hypotheses, with emphasis on RBC. The method used by the authors is to examine how bank portfolios changed in the early 1990s from the 1980s, and to see how these changes are related to the risk-based capital ratios and other key variables. The authors' tests relate the growth rates of bank asset categories to several measures of perceived bank risk, including the Tier 1 and Total RBC ratios. The findings suggest that the RBC hypothesis fares the worst of all the alternative explanations of the bank reallocation of the 1990s. They find that the effects of the RBC ratios on lending did not get consistently stronger in the early 1990s, and that the Tier 1 and Total RBC ratios generally acted to counteract each other in their effect on allocation. The other theories examined are somewhat more consistent with the data, given that the relations to the leverage ratio and the problem loan categories generally have the predicted signs. However, the quantitative effects are not substantial. The only other evidence that is roughly consistent with the hypotheses is that large banks, banks with weaker capital ratios, and banks supervised by the OCC have much more substantial allocation effects and greater lending reactions to perceived risk than do other banks. While it is difficult to disentangle these groups, since large banks tend to have weaker capital ratios and national charters, in none of these groups are most of the decreases attributable to the hypothesis directly. The authors note that the findings do not rule out non-risk related expla-nations. The authors state that such theories cannot be easily identified econometrically because they are not associated with observ-able variables on which to base a test. They conclude that the demand-side effects on lending are relatively strong, but exact attribution to the different hypotheses cannot be determined from their model.
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Does high leverage incentivize banks to systematically originate and hold riskier loans? I construct a novel data set consisting of 3 million small business and home mortgage loans, matched to the specific banks that originated them and verified to be held on bank portfolios, rather than sold. I measure the capital ratio (the inverse of the leverage ratio, defined as equity divided by asset value) for each bank at the time of each loan’s origination. After controlling for both bank and time fixed effects, a one point increase in Tier 1 capital ratios (e.g. from 12% to 13%) is associated with a 4.9% decrease in the default risk of mortgage loans held on portfolio (from a mean foreclosure rate of 4.3% to 4.1% for loans originated between 2003 and 2012). When considering the average capital of banks in US counties between 2003 and 2006, a one point increase in Tier 1 capital ratios is associated with a 4.4% reduction in foreclosures between 2007 and 2012. These results are robust to an instrumental variables strategy for predicting bank capital, a wide range of measures of bank capital, different types of banks, types of loans, and time periods.
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