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Banks' responses to binding regulatory capital requirements

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  • Larry D. Wall
  • Pamela P. Peterson

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.

Suggested Citation

  • Larry D. Wall & Pamela P. Peterson, 1996. "Banks' responses to binding regulatory capital requirements," Economic Review, Federal Reserve Bank of Atlanta, issue Mar, pages 1-17.
  • Handle: RePEc:fip:fedaer:y:1996:i:mar:p:1-17:n:v.80no.2
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    Cited by:

    1. Bertrand Rime, 2000. "Bank Capital Behaviour: Empirical Evidence for Switzerland," Working Papers 00.05, Swiss National Bank, Study Center Gerzensee.
    2. 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.
    3. Philip Arestis & Panicos Demetriades & Bassam Fattouh, 2003. "Financial Policies and the Aggregate Productivity of the Capital Stock: Evidence from Developed and Developing Economies," Eastern Economic Journal, Eastern Economic Association, vol. 29(2), pages 217-242, Spring.
    4. Wall, Larry, 2014. "Measuring capital adequacy: supervisory stress-tests in a Basel world," Journal of Financial Perspectives, EY Global FS Institute, vol. 2(1), pages 85-94.
    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.
    6. Kishan, Ruby P. & Opiela, Timothy P., 2006. "Bank capital and loan asymmetry in the transmission of monetary policy," Journal of Banking & Finance, Elsevier, vol. 30(1), pages 259-285, January.
    7. Cherry, Barbara A., 2011. "Radical experimentation under deregulatory broadband policies: The rise of shadow common carriers," 8th ITS Asia-Pacific Regional Conference, Taipei 2011: Convergence in the Digital Age 52340, International Telecommunications Society (ITS).
    8. Rime, Bertrand, 2001. "Capital requirements and bank behaviour: Empirical evidence for Switzerland," Journal of Banking & Finance, Elsevier, vol. 25(4), pages 789-805, April.
    9. repec:nbp:nbpbik:v:48:y:2017:i:2:p:119-148 is not listed on IDEAS
    10. Klaus P. Fischer & Martin Chenard, 1997. "Financial Liberalization Causes Banking System Fragility," Finance 9706004, EconWPA.

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