Capital regulation and banks' financial decisions
AbstractThis 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 flat-rate 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Bank for International Settlements in its series BIS Working Papers with number 232.
Length: 46 pages
Date of creation: Jul 2007
Date of revision:
Capital requirement; economic capital; regulatory capital; actual capital holding; procyclicality effect; dynamic programming; prudential regulation;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-09-02 (All new papers)
- NEP-BAN-2007-09-02 (Banking)
- NEP-DGE-2007-09-02 (Dynamic General Equilibrium)
- NEP-MAC-2007-09-02 (Macroeconomics)
- NEP-REG-2007-09-02 (Regulation)
- NEP-RMG-2007-09-02 (Risk Management)
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.:
- Dell'Ariccia, Giovanni & Marquez, Robert, 2006. "Competition among regulators and credit market integration," Journal of Financial Economics, Elsevier, vol. 79(2), pages 401-430, February.
- Claudio Borio & Craig Furfine & Philip Lowe, 2001. "Procyclicality of the financial system and financial stability: issues and policy options," BIS Papers chapters, in: Bank for International Settlements (ed.), Marrying the macro- and micro-prudential dimensions of financial stability, volume 1, pages 1-57 Bank for International Settlements.
- Miguel A. Segoviano & Philip Lowe, 2002. "Internal ratings, the business cycle and capital requirements: some evidence from an emerging market economy," LSE Research Online Documents on Economics 24948, London School of Economics and Political Science, LSE Library.
- Koopman, Siem Jan & Lucas, Andre & Klaassen, Pieter, 2005. "Empirical credit cycles and capital buffer formation," Journal of Banking & Finance, Elsevier, vol. 29(12), pages 3159-3179, December.
- Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, December.
- Jacob A. Bikker & Paul A. J. Metzemakers, 2007.
"Is Bank Capital Procyclical? A Cross-Country Analysis,"
Credit and Capital Markets,
Credit and Capital Markets, vol. 40(2), pages 225-264.
- Jaap Bikker & Paul Metzemakers, 2004. "Is bank capital procyclical? A cross-country analysis," DNB Working Papers 009, Netherlands Central Bank, Research Department.
- Peura, Samu & Jokivuolle, Esa, 2004. "Simulation based stress tests of banks' regulatory capital adequacy," Journal of Banking & Finance, Elsevier, vol. 28(8), pages 1801-1824, August.
- Heid, Frank, 2005. "Cyclical implications of minimum capital requirements," Discussion Paper Series 2: Banking and Financial Studies 2005,06, Deutsche Bundesbank, Research Centre.
- Tsai, Jeng-Yan, 2013. "Optimal bank interest margins under capital regulation in a call-option utility framework," Economic Modelling, Elsevier, vol. 31(C), pages 557-565.
- Ines Drumond, 2009.
"Bank Capital Requirements, Business Cycle Fluctuations And The Basel Accords: A Synthesis,"
Journal of Economic Surveys,
Wiley Blackwell, vol. 23(5), pages 798-830, December.
- Inês Drumond, 2008. "Bank Capital Requirements, Business Cycle Fluctuations and the Basel Accords: A Synthesis," FEP Working Papers 277, Universidade do Porto, Faculdade de Economia do Porto.
- Claudio Borio & Haibin Zhu, 2008.
"Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?,"
BIS Working Papers
268, Bank for International Settlements.
- Borio, Claudio & Zhu, Haibin, 2012. "Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?," Journal of Financial Stability, Elsevier, vol. 8(4), pages 236-251.
- Jokivuolle , Esa & Vesala, Timo, 2007. "Portfolio effects and efficiency of lending under Basel II," Research Discussion Papers 13/2007, Bank of Finland.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Timo Laurmaa).
If references are entirely missing, you can add them using this form.