Liquidity Provision, Bank Capital, and the Macroeconomy (original) (raw)

Bank Capital and Financial Stability: An Economic Tradeoff or a Faustian Bargain?

SSRN Electronic Journal, 2013

Financial crises impose large and persistent social costs, making banking stability important. This paper reviews the central issues surrounding the role bank capital plays in financial stability. Because the socially efficient capital level may exceed banks' privately-optimal capital levels, regulatory capital requirements become germane. But such requirements may entail various bank-level and social costs. Thus, while there is agreement that higher capital would enhance banking stability, recognition of these costs has generated theoretical disagreement over whether capital requirements should be higher. The empirical evidence reveals that, in the crosssection of banks, higher capital is associated with higher lending, higher liquidity creation, higher bank values, and higher probabilities of surviving crises. Moreover, increases in capital requirements are met with modest declines in lending. The overarching message from the research is that lower capital in banking leads to higher systemic risk and a higher probability of a government-funded bailout that may elevate government debt and trigger a sovereign debt crisis. Thus, capital regulation reform, as well as tax policy, should seek to increase bank capital. The paper discusses the contemporary thinking on these issues, and concludes with open research questions.

Capital Regulation and Banks' Financial Decisions

SSRN Electronic Journal, 2007

This paper develops a stochastic dynamic model to examine the impact of capital regulation on banks' financial decisions. In equilibrium, lending decisions, capital buffer and the probability of bank failure are endogenously determined. Compared to a flatrate capital rule, a risk-sensitive capital standard causes the capital requirement to be much higher for small (and riskier) banks and much lower for large (and less risky) banks. Nevertheless, changes in actual capital holdings are less pronounced due to the offsetting effect of capital buffers. Moreover, the non-binding capital constraint in equilibrium implies that banks adopt an active portfolio strategy and hence the counter-cyclical movement of risk-based capital requirements does not necessarily lead to a reinforcement of the credit cycle. In fact, the results from the calibrated model show that the impact on cyclical lending behavior differs substantially across banks. Lastly, the analysis suggests that the adoption of a more risk-sensitive capital regime can be welfare-improving from a regulator's perspective, in that it causes less distortion in loan decisions and achieves a better balance between safety and efficiency.

The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety

Journal of Financial Intermediation, 1996

We show that in an imperfect information environment the equity value of an impaired bank may increase or decrease when it is required to meet a capital standard. Regardless of the change in the bank's equity value, however, its stock price will fall in response to a forced recapitalization, consistent with recent empirical evidence. Simulations of our model suggest that this stock price decline is likely to be larger the smaller is the share of ownership held by the managers of the bank, also consistent with recent empirical evidence in the literature. Our model further predicts a rise in bank's non-interest expenses following a required recapitalization. Given the increase in the regulator's exposure that would accompany a reduction in the bank's market value of equity, the regulator may choose not to enforce the regulation. Hence, capital regulation may be timeinconsistent in this situation and consequently not have its intended risk-mitigating incentives.

Macro-effects of higher capital and liquidity requirements for banks

2010

The crisis has demonstrated that the ability of banks to absorb shocks needs to be strengthened. The financial tensions that have emerged repeatedly since 2007 could assume such serious proportions because the exposure of the banks was too high and too risky in relation to their capital reserves. As a result, they had too little capacity to absorb the losses on the market positions they had taken and on the loans they had granted. Banks were forced to respond by reducing their highrisk positions. The liquidity buffers held by banks were also generally inadequate, making them vulnerable when market liquidity dried up. Against this backdrop, investors lost confidence at the height of the crisis in the autumn of 2008, and governments had to step in by recapitalising some banks and guaranteeing bank debts. Central banks made liquidity more readily available because the banks were unable to raise funding in the markets, including the interbank market.

Capital regulation and monetary policy with fragile banks

Journal of Monetary Economics, 2013

We introduce banks, modeled as in Diamond and Rajan (2000; 2001), in a standard DSGE macromodel and study the transmission of monetary policy and its interplay with bank capital regulation when banks are exposed to runs. A monetary expansion and a positive productivity shock increase bank leverage and risk. Risk-based capital requirements (as in Basel II) amplify the cycle and are welfare detrimental. Within a broad class of simple policy rules, the best combination includes mildly anticyclical capital ratios (as in Basel III) and a response of monetary policy to asset prices or bank leverage.

Does Going Tough on Banks Make the Going Get Tough? Bank Liquidity Regulations, Capital Requirements, and Sectoral Activity

IMF Working Papers, 2020

Whether and to what extent tougher bank regulation weighs on economic growth is an open empirical question. Using data from 28 manufacturing industries in 50 countries, we explore the extent to which cross-country differences in bank liquidity and capital levels were related to differences in sectoral activity around the period of the global financial crisis. We find that industries which are more dependent on external finance, in countries where banks had higher liquidity and capital ratios, performed relatively better during the crisis, with regard to investment rates and the creation of new enterprises. This relationship, however, exists only for bank-based systems and emerging market economies. In the pre-crisis period, we find only a marginal link to bank capital. These findings survive a battery of robustness checks and provide some solid support for the tighter prudential measures introduced under Basel III.

Banks’ capital, regulation and the financial crisis

The North American Journal of Economics and Finance, 2014

Banks' Capital, Regulation and the Financial Crisis This paper investigates whether regulatory capital requirements play an important role in determining banks' equity capital. We estimate equity capital regressions using panel data of a sample of 560 banks for 2004-2010. Our results suggest that regulatory capital requirements are not first order determinants of banks' capital structure. We document differences on the effect of most factors on banks' share of equity according to the type of bank and to the region of the bank. Finally, we show that the determinants of this share are sensitive to the recent international financial crisis and to a set of regulatory country factors.

Working Paper / Document de travail 2010-26 Capital Requirement and Financial Frictions in Banking : Macroeconomic Implications

2010

The author develops a dynamic stochastic general-equilibrium model with an active banking sector, a financial accelerator, and financial frictions in the interbank and bank capital markets. He investigates the importance of banking sector frictions on business cycle fluctuations and assesses the role of a regulatory capital requirement in propagating the effects of shocks in the real economy. Bank capital is introduced to satisfy the regulatory capital requirement, and serves as collateral for borrowing in the interbank market. Financial frictions are introduced by assuming asymmetric information between lenders and borrowers that creates moral hazard and adverse selection problems in the interbank and bank capital markets, respectively. Highly leveraged banks are vulnerable and therefore pay higher costs when raising funds. The author finds that financial frictions in the interbank and bank capital markets amplify and propagate the effects of shocks; however, the capital requirement attenuates the real impacts of aggregate shocks (including financial shocks), reduces macroeconomic volatilities, and stabilizes the economy.

On the Role of Regulatory Banking Capital

Financial Markets, Institutions & Instruments, 2008

In this paper the authors study the role of regulatory banking capital and analyze the incentive effects of the Basel II Accord. They argue that Basel II may become a source of systemic risk due to endogenous risk and the risk sensitivity of the capital requirements. In this context they note that financial instability may enter via the asset side of the banks' balance sheets when banks are forced to sell assets in order to maintain the capital buffer prescribed by Basel II.