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Banks' responses to binding regulatory capital requirements

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Author Info
Larry D. Wall
Pamela P. Peterson

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Abstract

Since the early 1980s U.S. bank regulators have focused increasingly on the adequacy of banks' capital ratios. This article begins with a review of the changes to U.S. capital regulations and theoretical models for determining banks' capital strategy. The authors then survey numerous studies that examine banks' responses, and the costs associated with their responses, to these regulations. ; The authors categorize banks' responses into two primary types. The first of these, termed cosmetic changes to the capital ratio, may be achieved in one of two ways: a bank may reduce its total assets while increasing the proportion of risky assets, or it may exploit differences between capital as measured for regulatory purposes and the bank's true economic capital. Such cosmetic changes may bring a bank's capital ratio within regulatory guidelines without reducing either the probability that the bank will fail or the losses to depositors and the deposit insurance agency if the bank fails. The second general type of response a bank may make to capital regulation is to effectively increase its capital cushion by either reducing its risk exposure or increasing its capital levels. ; The authors point out that regulators need to consider what response they want to elicit when formulating new regulations. If the regulations are being imposed to reduce the risk of a systemic problem and the expected losses of the deposit insurance agency, then regulations that encourage cosmetic responses are, by definition, unlikely to accomplish regulatory goals. The authors also note that the best way to reduce a bank's riskiness in many cases--diversification and hedging--is not adequately recognized under current capital standards.

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Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

Volume (Year): (1996)
Issue (Month): Mar ()
Pages: 1-17
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Handle: RePEc:fip:fedaer:y:1996:i:mar:p:1-17:n:v.80no.2

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Keywords: Bank capital;

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Philip Arestis & Panicos Demetriades & Bassam Fattouh, 2002. "Financial Policies and the Aggregate Productivity of the Capital Stock: Evidence from Developed and Developing Economies," Economics Working Paper Archive 362, Levy Economics Institute, The. [Downloadable!]
    Other versions:
  2. Bertrand Rime, 2000. "Bank Capital Behaviour: Empirical Evidence for Switzerland," Working Papers 00.05, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
  3. Klaus P. Fischer & Martin Chenard, 1997. "Financial Liberalization Causes Banking System Fragility," Finance 9706004, EconWPA. [Downloadable!]
  4. Inwon Song, 1998. "Korean banks' responses to the strengthening of capital adequacy requirements," Pacific Basin Working Paper Series 98-01, Federal Reserve Bank of San Francisco. [Downloadable!]
  5. Ralph C. Kimball, 1997. "Specialization, risk, and capital in banking," New England Economic Review, Federal Reserve Bank of Boston, issue Nov, pages 51-73. [Downloadable!]
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