How does bank equity affect credit creation? Multiplier effects under Basel III regulations

Both equity and regulation play key roles in determining the ability of banks to create credit. Equity varies endogenously, while regulations are exogenously imposed. This study proposes a banking model to investigate how changes in bank equity due to interest receipts and expenditures affect credit and money creation under Basel III regulations. Four Basel III regulations—the capital adequacy ratio, the leverage ratio, the liquidity coverage ratio, and the net stable funding ratio—are discussed. Their effect on credit creation are demonstrated by the changes that occur in the credit supply in response to the changes in equity arising from interest payments. This study identifies seven regulatory scenarios under these four regulations. In each scenario, there exists a multiplier that relates the change in equity to the resultant change in the credit supply. Correspondingly, there is a multiplier effect on the money supply. This study sheds new light on how bank equity and Basel III regulations affect credit and money creation.